Inflation and Rational Expectation

Presented by:

Lohit Datwani Neha Goel

Madhur Agarwal Nirmit Gupta
Mayank Abrol Nitin Gupta
Meenu Karmwar Prashant Agarwal
Meetu Jain Prashant Arora
Moniza Ahmed
Inflation
• Inflation is a persistent increase in the price level over
time.
• Inflation erodes the purchasing power of a currency.
• If it accelerates unchecked, inflation ultimately can
destroy a country's monetary system, forcing
individuals and businesses to adopt foreign money or
revert to bartering physical goods
Types of Inflation
The two types of inflation are demand-pull and cost-
push. Demand-pull inflation results from all increase
ill aggregate demand. while cost-push inflation results
from a decrease in aggregate supply.
 Demand-Pull Inflation
Demand-pull inflation can result from an increase in
the money supply, increased government spending, or
any other cause that increases aggregate demand.
Cost-Push inflation
Inflation can also result from an initial decrease in
aggregate supply caused by an increase in the real
price of an important factor of production. such as
wages or energy.
 Built-in Inflation
It is induced by adaptive expectations, often linked to
the "price/wage spiral" because it involves workers
trying to keep
their wages up.
It reflects events in the past, and so might be seen as
hangover inflation.
Keynesian Inflationary-Gap Analysis
Types of Cost-Push inflation
Wage push inflation
Profit- Push Inflation
Material- Cost Push Inflation
Income- shares Inflation
 Inertia in AD-AS
P
In the AD-AS
AS
framework inflation
inertia is characterized
by persistent upward
shifts of both AD and AD
AS. Q
Most often the upward
shifting aggregate demand
curve is caused by persistent
growth in the money supply.

Aggregate supply shifts up because

of expected inflation.
 Inertia in AD-AS AS would stop
Suppose the central bank is pursuing an shifting up.
expansionary monetary policy causing AD P
to shift out.
AS
If prices have been rising quickly, people
will expect them to continue to do so.
Because AS depends on expected inflation
the AS curve will continue to shift upward.
AD
It will continue to shift upward until some
P  P  (1/  )(Y  Y )
Y
event, such as a recession or a supply e

shock, changes inflation and thereby

changes expectations of inflation.

This would cause a recession. High

If for example the central bank unemployment would reduce
tightened the money supply, AD inflation and expected inflation,
would shift back. causing inflation inertia to subside.
 Building the Phillips Curve
   e   (u  u n )  v
The Phillips curve states the deviation of and supply shocks.
that inflation depends unemployment from the
on expected inflation… natural rate (cyclical
unemployment)…

Two Causes of Rising and Falling Inflation

   1   (u  u )  v n

The second term shows that
cyclical unemployment exerts
upward or downward pressure
on inflation. Low
unemployment pulls inflation
up. This is called demand-
pull inflation because high
AD is the cause.
The third term shows that
inflation also rises and falls
with supply shocks. An
adverse supply shock
would push production
prices up. This type of
inflation is called cost-
push inflation.
 Phillips Curve
Phillips curve the relationship between the rate of
change of money wages(W’) and rate of
unemployment(U).
W ª% P
P `

PHILLIPS CURVE
5

3 0

0 1 2 3 4 5
U%
Original Phillips curve was a relation between U and
W’, it can be used to show relation between U and
P’( rate of inflation)

P’= W’- X’
Average value of x’ =3%
Where x’= increasing productivity of a worker at a
certain time.
Cost of living influence on wages
When P’(rate of inflation) increases, cost of living of
workers also increases as a result workers demand
increase in W’ in order to maintain their real wages.

Thus, both the inflation and wages are inter-related.

Phillips Curve Contd..
Professor A.W.Phillips
The curve sloped down from left to right and seemed
to offer policy makers with a simple choice - you have
to accept inflation or unemployment. You can't lower
both.
However, in the 1970s the curve appeared to break
down as the economy suffered from unemployment
and inflation rising together (stagflation).
Milton Friedman - a monetarist economist. He
developed a variation on the original Phillips Curve
called the expectations-augmented Phillips Curve.
Friedman argued that there were a series of different
Phillips curves for each level of expected inflation. If
people expected inflation to occur then they would
anticipate and expect a correspondingly higher wage
rise. Friedman was therefore assuming no 'money
illusion' - people would anticipate inflation and account
for it. We therefore got the situation shown below:
Expectations-Augmented Phillips Curve.
Short run Phillips Curve
Say the economy starts at point U with expected
inflation at 0%
To decrease unemployment ,govt. Boost demand by
5%->shift in AD curve and hence unemployment fall to
V.
However , it lead to demand pull inflation->price rise.
The increase in these prices leads people to seek wage
demands that give them a 'real' increase, i.e. is above
inflation. Since inflation has risen people could
reasonably be expected to build an anticipated inflation
rate into their wage demands
Rise in wage->increase in cost for business->AS curve
to shift left-> unemployment would be at W.
Firms would either increase price or shed labour to
maintain their profit margin. Hence, economy would
be back to same unemployment level but at higher
inflation i.e. 5%
If the government insist on trying again to reduce the
unemployment the economy will do the same thing
(W to X to Y), but this time at a higher level of
inflation.
As a result , people will push for higher wage push (5%
+ x%) to have real increase. They might think that
given that inflation had risen by 5% last year it might
rise by 8% next and so put in for a wage rise of 11% to
ensure they get a real pay increase plus cover
themselves for any anticipated inflation.
Therefore ,any attempt to reduce inflation below the
level U will simply be inflationary. For this reason the
rate U is often known as the Natural Rate of
Unemployment.
Long run Phillips Curve
What shifts the LONG RUN PHILLIPS CURVE?
Changes in government benefits to the
unemployed/underemployed
Changes in the composition of the Labor force
Changes in Supply-Side policies
Phillips Curve
LRPC LRPC1
10%
Inflation

SRPC
0% NRU NRU1 10%
(5%) (7%)

Unemployment
Changes in Govt. Benefits towards the UNEMPLOYED and the UNDEREMPLOYED
If the Govt. INCREASES the benefits they pay to the unemployed/underemployed in
general this produces a higher level of FRICTIONAL unemployment. People tend to stay
Unemployed for longer periods of time because the replacement income they receive
from the govt. is closer to their lost income…In other words, the incentive to look for a
Job is diminished and the tendency to stay unemployed increases..
The LONG RUN PHILLIPS CURVE SHIFTS TO THE RIGHT
Phillips Curve LRPC1 LRPC
10%
Inflation

SRPC
0% NRU1 NRU 10%
(3%) (5%)

Unemployment
Changes in Govt. Benefits towards the UNEMPLOYED and the UNDEREMPLOYED
If the Govt. DECREASES the benefits they pay to the unemployed/underemployed in
general this produces a lower level of FRICTIONAL unemployment. People tend to stay
Unemployed for shorter periods of time because the replacement income they receive
from the govt. is much LESS then their original income…In other words, the incentive to
look for a job is INCREASES and the tendency to stay unemployed DECREASES...
The LONG RUN PHILLIPS CURVE SHIFTS TO THE LEFT
Structural Inflation in LDC’s
 Least developed country (LDC) is the name given to
a country which, according to the United Nations, exhibits the
lowest indicators of socioeconomic development, with the
lowest Human Development Index ratings of all countries in the
world.
A country is classified as a Least Developed Country if it meets three
criteria based on:
Low-income (three-year average GNI per capita of less than US $905,
which must exceed $1,086 to leave the list)
Human resource weakness (based on indicators
of nutrition, health, education and adult literacy) and
Economic vulnerability (based on instability of agricultural
production, instability of exports of goods and services, economic
importance of non-traditional activities, merchandise export
concentration, handicap of economic smallness, and the percentage
of population displaced by natural disasters)
The gaps and Bottlenecks
Resource Gap
Food Bottleneck
Foreign Exchange Bottleneck
Infrastructural (physical) Bottlenecks
Other Structural Factors
Money and Inflation
Cost of Inflation
What Does Rational Expectations Theory
Mean?
It means that the people in the economy make choices
based on their rational outlook, available
information and past experiences.
The theory suggests that the current expectations in
the economy are equivalent to what the future state of
the economy will be.
This contrasts the idea that government policy
influences the decisions of people in the economy.
The idea is that rational expectations of the players in
an economy will partially affect what happens to the
economy in the future.
 If a company believes that the price for its product
will be higher in the future, it will stop or slow
production until the price rises.
In sum, the producer believes that the price will rise in
the future, makes a rational decision to slow
production and this decision partially affects what
happens in the future.
Rational Expectations Are Unbiased

Accuracy and bias in target shooting

Rational Expectations and Aggregate Supply

Long And Short Run Aggregate Long And Short Run Aggregate
Supply with Irrational Expectations Supply with Rational Expectations
Policy Ineffectiveness Proposition
 The Policy Ineffectiveness Proposition (PIP) is a theory
proposed in 1976 by Thomas J. Sargent and Neil Wallace
based upon the theory of rational expectations.
Any consistent set of government policies will be learned
and anticipated by a population with Rational
Expectations. Since they are anticipated, they will not come
as a surprise.
Instead, people will shift their short-run aggregate supply
curves in such a way that production will be back at the
NAIRGDP and unemployment at the NAIRU.
If the policies are designed to move the economy away from
the NAIRGDP, then they will be ineffective -- regardless
what mix of fiscal and monetary policies they are.
This leads to the general Policy Ineffectiveness
Proposition :

Policy Ineffectiveness Proposition :

Any consistent government policies designed to

influence the economy to a level of production other
than the NAIRGDP will be ineffective if the population
have rational expectations.
Rational Expectation
While rational expectations is often thought of as a school of
economic thought, it is better regarded as a ubiquitous modeling
technique used widely throughout economics.
First proposed by John F. Muth of Indiana University in the early
1960s.
 He used the term to describe the many economic situations in
which the outcome depends partly on what people expect to
happen.
Many earlier economists, including A. C. PIGOU, JOHN
MAYNARD KEYNES, and JOHN R. HICKS, assigned a central role
in the determination of the business cycle to people’s
expectations about the future. Keynes referred to this as “waves of
optimism and pessimism” that helped determine the level of
economic activity.
Rational Expectation & Outcome
The influences between expectations and outcomes flow both ways
In forming their expectations, people try to forecast what will actually
occur. They have strong incentives to use forecasting rules that work
well because higher “profits” accrue to someone who acts on the basis
of better forecasts, whether that someone is a trader in the “stock
market” or someone considering the purchase of a new car.
And when people have to forecast a particular price over and over
again, they tend to adjust their forecasting rules to eliminate avoidable
errors. Thus, there is continual feedback from past outcomes to
current expectations.

Thus, in recurrent situations the way the future unfolds from the
past tends to be stable, and people adjust their forecasts to conform
to this stable pattern.
Applications of Rational Expectation
Random Walk-A sequence of observations on a variable
(such as daily stock prices) is said to follow a random walk
if the current value gives the best possible prediction of
future values.
In their efforts to forecast prices, investors comb all
sources of information, including patterns that they can
spot in past price movements.

Friedman’s Permanent Income Theory - person’s

consumption ought not depend on current income alone,
but also on prospects of income in the future.
Robert Lucas’s “policy ineffectiveness proposition.”- If
people have rational expectations, policies that try to
manipulate the economy by inducing people into
having false expectations may introduce more “noise”
into the economy but cannot, on average, improve the
economy’s performance.

The idea of rational expectations has been used

extensively in such contexts to study the design of
monetary, fiscal, and regulatory policies to promote
good economic performance.
Inflationary Expectations
 During the 1960s and 1970s, Milton Friedman helped change
attitudes to Monetary policy and inflation with his theory of
adaptive expectations.
 However, a limitation of the model was that it assumed that
people's expectations were always based on the past, leaving no
room for future trends.
One of the most misunderstood causes of inflation is in
fact inflationary expectations. When people believe that
there is going to be inflation, inflation itself tends to grow.
This is not in any way a new concept. John M. Keynes came
up with a theory, no longer widely accepted, which
nonetheless deals with this issue. It's called the sticky
wage theorem. Here's how it works. Suppose I am a
worker. I believe that there is going to be inflation. To me
this means that I cam going to be able to buy fewer goods.
In response to this threat, I will go to my employer and
demand higher wages. My demand of higher wages will in
turn force employers to raise prices. In this way, because I
feared inflation, I created it.
What inflation does do, especially when it is unexpected, is
to hurt productivity. When firms cannot make correct and
accurate decisions because they are hampered by or
unwary of inflation, they tend to delay investment and
growth in productivity will generally slow. Currently,
inflationary expectations have many important impacts
dealing with the financial markets, which can cause
inflation.
If people expect an increase in the price level, the FC will shift
leftward to exactly the expected price level. Suppose, for example,
that people on the average expect 40% inflation during the
coming year. This is shown in the following diagram, in which the
line marked "FC1" represents the Friedman Curve for the current
year, and "FC2'" is the Short run Aggregate Supply Curve for the
coming year.
 What Determines Inflation
Expectations?
Current Inflation
Perceived Inflation
Cost Push or Demand Pull Inflation.
Difference Between Nominal Bond Yields and Index
Bond Yields: One gauge of measuring inflation is the
difference between the yield on index linked bonds and
ordinary nominal bonds. The theory is that if people expect
inflation to rise, they will need a higher yield on nominal
bonds to compensate for the threat of inflation. However,
there are limitations of this method, as the market for
index linked bonds is relatively small and other factors can
affect bond yields as well as inflation expectations.
How Inflation Expectations Influence Inflation and
Monetary Policy
 If people expect low inflation, monetary policy is more effective.
A quarter point rise may be sufficient to reduce inflation. If
people have high inflationary expectations, the Central Bank
may need to increase interest rates by a much bigger % to have a
similar effect.

For example, in 1990, interest rates in the UK needed to rise to

12% to reduce the inflation of the Lawson boom. In the US,
interest rates were 10%, when inflation was only 4%.

Central banks definitely have much benefit from keeping

inflationary expectations low. The only problem is that reducing
inflation with rising oil prices, could push the economy into
recession; it is certainly a difficult dilemma.
Q. Discuss Reasons for Low Inflation in the UK? (30)
Despite recent increases in inflation, by historical standards,
inflation in the UK is very low (3% as opposed to 10% in
1990). Since independence of the B of England, in 1997,
inflation has remained close to the governments target of 2%
Many feel the MPC has played a pivotal role in keeping
inflation low. However, there are also other reasons to
consider such as; globalization, commodity prices and supply
side reforms.
Factors explaining Low Inflation in UK

1. Independent Bank of England - MPC

The MPC has sought to maintain low inflation and sustainable

economic growth. It has managed interest rates to avoid
inflationary growth. If the economy was expanding too quickly
interest rates were increased to prevent future inflation. This is
known as pre-emptive monetary policy, interest rates
increased BEFORE inflation becomes a problem. As a
consequence of this policy, growth has been close to the long
run trend rate, and this has been a significant factor in
maintaining low inflation.
(AD increasing at same rate as AS)
2. Lower Inflation Expectations

Related to the independence of the MPC, is the fall in inflation

expectations. Because people expect low inflation it is easier to
create low inflation. For example, workers do not bargain for
high wage increases. Firms don't expect to be able to pass price
increases on. It is a virtuous circle.

3. International Price trends.

It is not just in the UK that inflation has fallen. Other OECD

countries have seen low inflation. For example, the process of
globalization has seen falling prices of manufactured goods,
often produced in China. Several commodity prices have also
been increasing at low rates, although recently they have
started to increased.
4. New Technology.

New technology has helped to reduce the costs of firms. Therefore, the
AS curve will shift to the right. For example, the internet and
improvements in microchip computers have helped to reduce costs for
firms.

5. Supply side reforms in the UK.

Supply side policies implemented since the 1980s have helped to reduce
cost push inflation. For example, privatization has seen public
companies become more efficient, leading to lower prices. Privatization
was often accompanied by deregulation, which seeks to increase
competition and therefore reduce prices. It is hard to quantify the
contribution of supply side reforms to reducing inflation, but, they have
had a benefit.
THANK YOU