Measuring and Interpreting Inflation Expectations
Inflation expectations are people's beliefs about where inflation is headed. These beliefs matter because they directly shape how people spend, save, invest, and set prices right now. From the neoclassical perspective, expectations are central to understanding why certain policies work and others don't.
How economists measure inflation expectations
There are two main approaches:
- Surveys ask consumers, businesses, or professional forecasters what they think inflation will be. The University of Michigan Survey of Consumers and the Federal Reserve Bank of Philadelphia's Survey of Professional Forecasters are two widely used examples.
- Market-based measures look at the difference in yields between regular Treasury bonds and inflation-indexed bonds (called TIPS). This difference is the breakeven inflation rate, and it reflects what bond traders collectively expect inflation to be.
Why policymakers care about these measurements
Inflation expectations can become self-fulfilling. If people expect higher prices, workers demand higher wages and firms raise prices preemptively, which actually pushes inflation up. That's why the Fed watches expectations closely:
- Rising expectations may signal a need for tighter monetary policy (raising interest rates) to keep inflation from spiraling.
- Falling expectations may call for expansionary policy, like quantitative easing, to prevent deflation and stimulate spending.
Rational expectations
The neoclassical perspective relies heavily on the idea of rational expectations: people don't just look at past inflation to guess the future. They use all available information, including knowledge of current policy, to form their expectations. This has major implications for policy, because it means people will anticipate and adjust to policy changes, potentially neutralizing their intended effects.
Effects of Fiscal and Monetary Policies
Both fiscal and monetary policy shift aggregate demand, but the neoclassical perspective is skeptical about whether these demand-side shifts can improve real output in the long run.
Fiscal policy
Fiscal policy uses government spending and taxation to influence the economy.
- Expansionary fiscal policy (increased spending or tax cuts) shifts aggregate demand to the right. Think stimulus packages.
- Contractionary fiscal policy (spending cuts or tax increases) shifts aggregate demand to the left. Think austerity measures.
A key neoclassical concern here is the crowding out effect: when the government borrows heavily to fund expansionary spending, it pushes interest rates up. Higher interest rates discourage private investment, which partially (or fully) offsets the stimulus. So the net boost to aggregate demand may be much smaller than intended.
Monetary policy
Monetary policy involves the central bank adjusting the money supply and interest rates.
- Expansionary monetary policy (lowering the federal funds rate or increasing the money supply) shifts aggregate demand right.
- Contractionary monetary policy (raising the federal funds rate or reducing the money supply) shifts aggregate demand left.
From the neoclassical view, monetary policy affects prices but not real output in the long run, especially if people have rational expectations and adjust their behavior quickly.
Supply-side policies
This is where neoclassical economists put more faith. Supply-side policies aim to shift aggregate supply to the right through measures like:
- Tax reforms that incentivize investment and work
- Deregulation that lowers costs for businesses
- Incentives for innovation and productivity growth
These policies can increase real output and lower prices simultaneously, which is why neoclassical economists tend to favor them over demand management.
The Neoclassical Phillips Curve
The Phillips curve describes the relationship between inflation and unemployment. The neoclassical version of this relationship differs sharply from the traditional Keynesian one.
In the neoclassical view, inflation expectations adjust quickly to match actual inflation. Because of this rapid adjustment:
- The short-run Phillips curve is vertical at the natural rate of unemployment. Changes in aggregate demand only change the price level; they don't move real output or employment.
- The long-run Phillips curve is also vertical at the natural rate, which is consistent with the broader neoclassical idea that the economy gravitates toward full employment on its own.
The core policy implication: monetary policy cannot permanently push unemployment below the natural rate. If the Fed tries to do so by expanding the money supply, people will adjust their inflation expectations upward. The result is higher inflation with no lasting reduction in unemployment. This is why neoclassical economists argue that central banks should focus on price stability rather than trying to fine-tune employment.
Comparing Neoclassical and Keynesian Perspectives
These two schools of thought disagree on some fundamental questions about how the economy works, which leads to very different policy recommendations.
| Neoclassical | Keynesian | |
|---|---|---|
| Price/wage flexibility | Prices and wages adjust quickly | Prices and wages are sticky in the short run |
| Market self-correction | Markets tend toward equilibrium naturally | Markets can get stuck in prolonged recessions |
| Primary concern | Long-run growth and efficiency | Short-run fluctuations and demand shortfalls |
| Preferred policies | Supply-side policies, limited intervention | Active fiscal and monetary demand management |
| View of government role | Minimal; markets allocate resources best | Essential for stabilizing output and employment |
The neoclassical perspective leans toward a laissez-faire approach: let markets work, focus on creating conditions for long-run growth, and avoid demand-side interventions that may cause more distortions than they fix. The Keynesian perspective counters that waiting for markets to self-correct can mean years of unnecessary unemployment and lost output, so active government intervention is justified.
Policy Challenges and Critiques
Even within the neoclassical framework, there are recognized difficulties with implementing policy.
The time inconsistency problem arises when policymakers have an incentive to deviate from their announced plans. For example, a central bank might promise to keep inflation low, but once people have set their expectations accordingly, the bank faces a temptation to surprise the economy with expansionary policy to temporarily boost output. If people anticipate this temptation, the promised policy loses credibility, and expectations become harder to anchor.
The Lucas critique is a foundational challenge to traditional macroeconomic modeling. Robert Lucas argued that when a policy changes, people change their behavior in response. Models built on historical data from a previous policy regime can't reliably predict what will happen under a new one. This critique pushed economists toward models that explicitly account for how expectations shift with policy.
Real business cycle (RBC) theory takes the neoclassical perspective further by arguing that most economic fluctuations come from real shocks to the economy, like changes in technology or productivity, rather than from shifts in aggregate demand or monetary policy. If RBC theory is correct, demand management policies are not just ineffective but unnecessary, since fluctuations represent efficient responses to real changes in the economic environment.