Inflationary Expectations: Difference between revisions
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The change in the relationship between inflation and unemployment left policy makers with a sticky situation. The period between 1971 and 1984 was known as "stagflation". One of the major reasons that stagflation was such a problem was that since the relationship between the inflation and unemployment had broken down, monetary policy could not be used to control the situation without causing a recession. In the end, this is what Fed Chairman Paul Volker had to do. It was crucial to "wring out" the inflationary expectations that had been built into the economy by such a long period of inflationary increase. | The change in the relationship between inflation and unemployment left policy makers with a sticky situation. The period between 1971 and 1984 was known as "stagflation". Stagflation was a situation in which both the inflation rate and the uneployment rate were relatively high. One of the major reasons that stagflation was such a problem was that since the relationship between the inflation and unemployment had broken down, monetary policy could not be used to control the situation without causing a recession. In the end, this is what Fed Chairman Paul Volker had to do. It was crucial to "wring out" the inflationary expectations that had been built into the economy by such a long period of inflationary increase. | ||
==The History of Inflation in the United States== | ==The History of Inflation in the United States== | ||
Revision as of 06:57, 4 May 2006
It is hard to live in today's society and not be aware of inflation. Every year it makes the money we have stashed away in our mattresses worth less than it was last yaer. The inflation rate is therefore an important indicator that influences our general expectation for the future. Classically, inflation and unemployment are the two bugbears of macroeconomic policy. High inflation can seriously hurt an economy. At extreme levels, very high inflation is known as hyperinflation. This is bad for firms and consumers, but it's even worse for polititians.
So if everybody wants low inflation, why does it exist? One cause of inflation is inflationary expectations. We all have certain expectations for what the next year will bring. These expectations are usually based on the recent past. Therefore, if inflation has been very high the last couple of years, it may take a while for people to begin to expect lower inflation.
"So what?" you say. The problem is that through these inflationary expectations, people can actually cause inflation, whether other economic conditions predict it or not.
Inflation and Uncertainty
Classical economic theory of inflation predicted a negative empirical relationship between unemployment and inflation. This relationsihp is known as the Phillips curve. Such a relationship is an important concept with regard to economic policy. It means that policy makers can effectively force a tradeoff between inflation and unemployment. For example, by increasing the monetary supply, the Federal Reserve Bank can influence the inflation rate, and therefore also the employment rate.
For the most part, the Phillips curve appeared to be a good predictor of the relationship between inflation and unemployment. However, after the large oil supply shocks in the early 1970s, this relationship broke down. Two economists, Milton Friedman and Edmund Phelps predicted the breakdown in the relationship between the phillips curve. They argued over two distinctions, or refinements to the Phillips curve. They said that there was actually a negative relationship between unanticipated inflation and cyclical unemployment.
The equation for the phillips curve, with the integration of Friedman and Phelps' contributions became:
pi=pie-h(u-u)
The change in the relationship between inflation and unemployment left policy makers with a sticky situation. The period between 1971 and 1984 was known as "stagflation". Stagflation was a situation in which both the inflation rate and the uneployment rate were relatively high. One of the major reasons that stagflation was such a problem was that since the relationship between the inflation and unemployment had broken down, monetary policy could not be used to control the situation without causing a recession. In the end, this is what Fed Chairman Paul Volker had to do. It was crucial to "wring out" the inflationary expectations that had been built into the economy by such a long period of inflationary increase.
The History of Inflation in the United States
Inflation is measured by the Consumer Price Index (CPI).
Inflationary Uncertainty
Policy Tools
External Links
Fed Credibility? What's the Big Deal?
