AQA Specification focus:
‘The effects of expectations on changes in the price level’
Introduction
Expectations play a critical role in influencing inflationary pressures, as households, firms, and governments adjust behaviour in anticipation of future changes in prices.
Understanding Expectations in Economics
Expectations refer to the beliefs that households and firms hold about future economic variables, particularly inflation and price levels. These expectations can significantly influence decision-making, from wage bargaining to investment choices.
Expectations: The beliefs held by households, firms, and policymakers about future economic variables, especially inflation and price changes.
Economic theory suggests that expectations about inflation can become self-fulfilling, as behaviours based on these beliefs contribute to actual price changes.
Types of Expectations
Adaptive Expectations
Based on past experiences.
Individuals assume that future inflation will mirror historical patterns.
Can lead to persistent inflation if price rises continue.
Rational Expectations
Formed using all available economic information.
Suggests that households and firms anticipate policy effects and adjust behaviour accordingly.
Aligns with the idea that people are forward-looking.
Expectations and Wage-Price Spirals
When workers and firms expect higher future inflation, they act in ways that can drive inflation upwards. For example:
Workers demand higher wages to maintain real income.
Firms increase prices to cover rising wage costs.
This cycle, known as a wage–price spiral, reinforces inflationary pressures.
Wage–Price Spiral: A situation where rising wages cause firms to raise prices, which in turn leads to further wage demands and higher inflation.
The Role of Inflationary Expectations
Short-Term Impact
Anticipated inflation may prompt consumers to spend sooner, accelerating demand-pull inflation.
Businesses might bring forward investment, further fuelling demand.
Long-Term Impact
Persistent inflation expectations can lead to indexation, where wages, pensions, or contracts are automatically adjusted in line with expected inflation.
This reduces the flexibility of the economy and can entrench inflationary pressures.
Expectations and Central Bank Policy
Central banks, such as the Bank of England, place strong emphasis on inflation expectations when setting monetary policy. If expectations become unanchored, inflation becomes harder to control.
Credibility of monetary policy is essential for anchoring expectations.
Clear communication about targets (e.g., 2% inflation in the UK) stabilises behaviour.
Failure to anchor expectations may result in higher interest rate interventions.
Expectations in the Aggregate Demand and Aggregate Supply Model
Expectations can shift both AD and AS curves:
If households expect rising prices, consumption (C) increases, shifting AD rightward.
If firms anticipate higher costs, short-run aggregate supply (SRAS) shifts leftward.
Together, these amplify inflationary pressures.
The Expectations-Augmented Phillips Curve
The Phillips Curve illustrates the trade-off between unemployment and inflation. However, once expectations are included, the relationship changes:
In the short run, inflation expectations shift the curve.
In the long run, rational expectations imply there is no trade-off, and the Phillips Curve becomes vertical.
Expectations-Augmented Phillips Curve: A version of the Phillips Curve which includes expected inflation as a determinant, altering the relationship between unemployment and inflation.
Inflationary expectations shift the SRPC curve, indicating that higher expected inflation leads to higher actual inflation at every level of unemployment.
Anchored vs Unanchored Expectations
Anchored Expectations
Occur when individuals trust that inflation will remain close to the target.
Policy credibility ensures stable behaviour.
Unanchored Expectations
Arise when households and firms lose faith in monetary policy.
Lead to destabilising behaviour, such as panic wage demands or rapid spending.
Can push inflation higher even without immediate demand or supply shocks.
In the long run, the Phillips Curve becomes vertical at the natural rate of unemployment, and the level of inflation is determined by inflation expectations.
Global Influences on Expectations
Expectations are not only domestic but also shaped by global economic conditions:
Rising commodity prices (oil, gas, food) increase expectations of future inflation.
Global financial instability can heighten inflation fears and reduce consumer confidence.
Exchange rate movements affect import costs, influencing expectations about future price levels.
Summary of Key Processes
Expectations influence behaviour: Households and firms adjust wages, prices, and spending.
Expectations drive inflation: Anticipated inflation can be self-fulfilling.
Policy credibility matters: Central banks must anchor expectations to maintain stability.
Global shocks matter: International markets shape domestic inflation expectations.
FAQ
When people expect prices to rise, they change behaviour in ways that actually cause inflation. For instance:
Workers demand higher wages.
Firms raise prices to cover wage costs.
Consumers spend earlier to avoid higher prices later.
These actions reinforce the initial expectation, making it self-fulfilling.
Surveys of households, firms, and financial markets help central banks gauge future inflation beliefs.
Household surveys ask consumers how they expect prices to change.
Business surveys focus on cost pressures and planned pricing.
Financial market data, such as bond yields, also signal inflation expectations.
Together, these tools inform monetary policy decisions.
If expectations are stable, people trust inflation will remain near the target. This prevents overreaction in wage and price setting.
Unanchored expectations, however, lead to instability. People may push for higher wages or firms may increase prices unnecessarily, causing inflation to rise even without demand pressures.
Adaptive expectations rely heavily on past inflation. If prices have risen recently, people expect the trend to continue.
Rational expectations assume people use all available data, including government policy and forecasts, to form accurate predictions.
In reality, most individuals blend both approaches, depending on their access to information.
International developments affect how people in one country perceive future prices. Examples include:
Rising oil prices raising expectations of higher transport and energy costs.
Exchange rate depreciation making imports more expensive, feeding into inflation fears.
Global financial instability reducing confidence and altering spending plans.
Expectations can shift quickly in response to global shocks.
Practice Questions
Define what is meant by inflation expectations. (2 marks)
1 mark for stating that inflation expectations are the beliefs individuals, firms, or policymakers hold about future inflation.
1 mark for noting that these beliefs influence economic decisions such as wage bargaining, pricing, or spending behaviour.
Explain how inflation expectations can affect the relationship between unemployment and inflation as shown by the Phillips Curve. (6 marks)
1 mark for correctly describing the short-run Phillips Curve trade-off between unemployment and inflation.
1 mark for stating that inflation expectations can shift the short-run Phillips Curve (SRPC).
1 mark for explaining that higher expected inflation raises actual inflation at any given level of unemployment.
1 mark for mentioning that in the long run, the Phillips Curve becomes vertical (LRPC) at the natural rate of unemployment.
1 mark for linking rational expectations to the lack of long-run trade-off between inflation and unemployment.
1 mark for clear use of relevant economic terminology such as “SRPC”, “LRPC”, “expected inflation”, or “natural rate of unemployment.”
