Chapter: the Short-Run Tradeoff Between Inflation and Unemployment

CHAPTER: THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT

“Expected inflation” plays a key role in the inflation-unemployment tradeoff, as you learned reading this chapter. One student asks: Is there any way to measure “expected inflation”?

In fact, expected inflation is more difficult to measure than most economic variables, but economists have developed four approaches to this problem.

The simplest approach, called adaptive expectations, assumes that expected inflation is a weighted average of past values of inflation. This makes some intuitive sense. We all look to the past as a guide to the future. If inflation has been particularly high or low in recent years, then it’s plausible that people would expect the same going forward.

Another approach, called rational expectations, assumes that people form their expectations as the best possible guess using all available information, including information about economic policy. For example, suppose the central bank announces that it’s becoming more concerned about unemployment, and is willing to tolerate higher inflation to reduce unemployment. Under rational expectations, people would immediately revise their expectations in response to this news. By contrast, under adaptive expectations, expected inflation would change only slowly after the actual inflation rate starts rising. Economists have developed various statistical techniques to estimate expected inflation under the assumption that people form expectations rationally.

A third approach is to just ask people what they expect. For example, the University of Michigan surveys consumers every month. One question in the survey is about their inflation expectations. We can use an average of the survey responses as a proxy for expected inflation. One concern with such survey data is that the people filling out the questionnaires don’t have a strong incentive to be careful and accurate in their answers.

The fourth approach to measuring expected inflation relies on bonds markets. In 1997, the U.S. Treasury Department began selling inflation-indexed bonds, in addition to its standard, non-indexed bonds. If we assume that both bonds offer the same real return, then the difference in the stated yields on the bonds must be inflation as expected by the bondholders.

Here’s an example. Suppose the inflation-indexed Treasury bond pays 3 percent after inflation, while a standard Treasury bond without indexation pays 5 percent. We can infer that the bond market expects 2 percent inflation during the term of the bond.

None of these four methods for estimating expected inflation is perfect. Yet each offers a plausible way to try to measure one of the most important variables in the analysis of inflation and unemployment.