Wednesday 4 November 1998
 
 

1. If inflation is actually accelerating, adaptive expectations will tend to make people

  1. consistently underestimate inflation
  2. consistently overestimate inflation
  3. on average, estimate inflation correctly
  4. produce unbiased estimates of inflation
a.  Adaptive expectations imply that you assume what is happening now will also happen next period; if inflation is accelerating, next period it will be faster than this period, but you have assumed it will be the same. So adaptive expectations will mean you consistently underestimate inflation when it is accelerating.

2.  If inflation is actually slowing down, rational expectations would result in people

  1. consistently underestimating inflation
  2. consistently overestimating inflation
  3. on average, estimating inflation correctly over half the time
  4. producing unbiased estimates of inflation
d.  Rational expectations is a jargon phrase; it implies that all information is taken into account, so estimates are unbiased – that is, in effect, the definition. Unbiased in this context means that the error is random, not that you get it right any particular fraction of the time.

3.  If government and the Fed wanted to reduce an unusually high inflation rate using discretionary macro policy, would success at low cost be more likely if

  1. people really believed they were going to do it
  2. people did not have faith that the restrictionary policy would be maintained if unemployment increased
  3. it would not make any difference
  4. nobody knows
a.  This is the credibility of policy issue. In the short run, restrictionary monetary/macro policy – what is needed to reduce inflation – is likely to cause more unemployment. If people do not believe that the policy will be maintained in the face of higher unemployment, their expectations will not change, and the reduction in inflation will be slower, and the rise in unemployment larger, than if they do believe policy will remain restrictionary until the inflation is reduced –in which case their expectations do change, and the reduction in inflation is achieved quicker and with less rise in unemployment.