Inflationary Expectations
1. The Psychology of Prices: Why Beliefs Matter
Imagine you hear that next month the price of your favorite video game will double. What would you do? You’d probably buy it right now. This simple decision is inflationary expectations at work. When many people think prices will rise, they rush to buy things today. This sudden increase in demand actually pushes prices up, confirming the original belief. Economists call this a self-fulfilling prophecy. It’s not just about shopping; it affects everything from factory orders to housing markets.
2. Wages and the Vicious Cycle
If workers believe the cost of living will go up by 5% next year, they will ask for a 5% raise. If businesses agree, their costs increase. To cover these higher costs, businesses raise the prices of their goods. This creates a cycle: high expectations lead to higher wages, which lead to higher prices, which confirms the original high expectations. Central banks (like the Federal Reserve in the U.S.) pay close attention to these expectations to prevent the cycle from spinning out of control.
3. Real-World Example: The Used Car Lot
Let’s look at a concrete example. In 2021, news reports suggested a shortage of computer chips would make new cars scarce. People expected that used cars would become more valuable and expensive. Because of this expectation:
- Car rental companies started buying used cars immediately, fearing higher prices later.
- Individuals rushed to used car lots, creating bidding wars.
- Sellers, seeing the frenzy, raised prices—not just because of the chip shortage, but because they knew people expected prices to rise.
The expectation alone drove prices up by over 40% in some markets. The belief itself became the main event.
Important Questions About Inflationary Expectations
A: They use surveys! For example, the University of Michigan surveys consumers and asks: "By what percent do you expect prices to go up (or down) in the next 12 months?" They also look at financial markets. If investors expect higher inflation, they demand higher interest rates on bonds. The difference between regular bond rates and inflation-protected bond rates gives a market-based measure of expectations.
A: Absolutely. If everyone expects prices to be lower next year (for example, with new technology like TVs), they might delay purchases. "Why buy a laptop today if it will be $200 cheaper in six months?" This drop in demand forces companies to lower prices, which can lead to a deflationary spiral. Japan experienced this for many years.
A: When people trust that a central bank will keep inflation low and stable (e.g., around 2%), their expectations are "anchored." Even if gas prices spike for a month, they don't panic and change their long-term view. This stability helps the economy run smoothly. If trust is lost, expectations become "unanchored" and volatile, making it hard to control inflation.
| Scenario | Expectation | Typical Reaction | Result |
|---|---|---|---|
| Holiday Toy Sale | Prices will rise next week | Buy now, clear the shelves | Store runs out, prices are stable for those who missed out |
| New Smartphone Launch | Price will drop in 3 months | Wait to buy, demand falls now | Manufacturer cuts price early to boost sales |
| Nationwide Economic News | 5% inflation expected next year | Unions ask for 5% raises | Businesses raise prices 5% to cover wages, inflation hits 5% |
Footnote
[1] CPI (Consumer Price Index): A measure that examines the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. It’s the most common way to measure inflation.
[2] Central Bank Credibility: The degree to which economic agents (people and businesses) believe that a central bank will follow through on its policy announcements, such as keeping inflation low.