Do People Really Have Inflation Expectations?

A common feature of macroeconomics is to run models assuming that individuals in the economy have inflation expectations. This flows naturally from assuming that they have rational expectations (can accurately predict the future and fully understand how the economy works). The standard reason for why we need inflation expectations is that during the 70s the government tried to trade off low unemployment in exchange for higher inflation. However, (so the story goes) people got wise to this trick and began to expect higher inflation and demand higher wages to compensate. As a result, government policy lost its effect and unemployment rose. Since then, economic modelling and discussions of unemployment and inflation must contain some provision for what consumers expect inflation to be. Continue reading “Do People Really Have Inflation Expectations?”