Adaptive inflation expectation

Adaptive inflation expectations are forecasts of inflation rates that are derived from past experience and incorporate estimation errors for correction. The economic agents learn from their mistakes and try to correct them in their new expectation formation: They revise their expectations from period to period "according to the deviation of the actual inflation rate from the expected inflation rate". In general, inflation expectations are the ideas that an economic subject develops about the inflation rate of this period before the start of a certain period.

The expected rate of inflation

• remains the same if the actual inflation rate corresponds to the expected inflation rate of the previous period,
• is increased if the actual inflation rate is higher than the expected inflation rate in the previous period,
• is reduced if the actual inflation rate is lower than the expected inflation rate in the previous period.

Definition of terms

The specialist literature differentiates between static, autoregressive and rational inflation expectations.

• With static inflation expectation, the expected inflation rate is constant, that is, it is independent of changes in the economic environment.
• The auto-regressive expectations include the extrapolative and adaptive ones, which are identical in terms of content and only differ formally.
• In both approaches, expectations are formed from past values. A counter-hypothesis are the rational expectations that derive future inflation rates from an economic model assumed to be known.

calculation

The equation below states that “the expected inflation rate in the period depends on the previously expected inflation rate and the weighted deviation between the actual and the expected inflation rate”. Where is a number between zero and one. "The larger the correction factor h, the faster the expectations are adjusted to the actual development." ${\displaystyle t+1}$ ${\displaystyle h}$ ${\displaystyle h}$

${\displaystyle \Pi _{t+1}^{e}=\Pi _{t}^{e}+h(\Pi _{t}-\Pi _{t}^{e})\!\,}$

In general, the calculated inflation expectation is not a constant, "but a variable that depends on the past inflation expectation and is therefore in principle variable". Due to the adjustment of the inflation expectation to the actual inflation rate, the errors in the expectation tend to be reduced. However, ongoing misconceptions are inevitable if the actual inflation rate is not constant.

By recursing the previous equation, one can see that adaptive inflation expectations depend on the previous actual inflation rates:

${\displaystyle \Pi _{t+1}^{e}=h\sum _{i=0}^{\infty }(1-h)^{i}\Pi _{t-i}\!\,}$

According to this, the expected inflation rate is “a weighted arithmetic mean of past experience”. The weighting of the individual values ​​decreases with increasing i, which is why "the experiences far in the past only have a small influence on the actual formation of expectations"

Subject classification

The Phillips curve describes the relationship between changes in nominal wages or prices and unemployment. At this trade-off, the monetarists Edmund Phelps and Milton Friedman expressed criticism in 1967 and 1968 that there was no long-term, but only a short-term negative relationship between inflation and unemployment , since they assumed that economic agents had adaptive expectations.

Accordingly, an increase in the inflation rate leads to a decrease in the unemployment rate in the short term , but only as long as there is still an error in expectations about the inflation rate. If this error of expectation has been revised and the expected and actual inflation rates coincide, the unemployment rate will in the long term decline to its natural level.

Application example

This connection between inflation and unemployment, according to Friedman and Phelps, should be explained using an example.

Requirements according to Friedman and Phelps:

• the economic subjects (here: employees ) are subject to a money illusion, d. H. they make the decisions about their labor supply and their wage demands dependent on the expected inflation expectation,
• the employees only recognize an increase in the price level at the end of a period,
• the companies, on the other hand, realize the price level increase at the beginning of a period.

If the price level now rises, the demand for labor in companies increases with unchanged nominal wages. The labor supply, on the other hand, remains the same as the employees have not yet realized the price increase. With the expansion of the money supply in the context of rising prices, the central bank can now increase employment. If workers have adaptive expectations, they gradually adjust their expectations to the actual rate of inflation and demand correspondingly higher wage supplements. In this way they hope to be able to compensate for the loss of purchasing power that has occurred. It follows that the real wage rises and this in turn causes the level of employment to fall back to its original level (see figure).

If the central bank continues its expansionary monetary policy , the inflation rate will remain at its new, higher level. These adjustment processes can be repeated "as often as desired, each time producing a short-term Phillips curve (in Figure PK1 to PK3), in which the natural unemployment rate is always coupled with a higher inflation rate." In summary, it can be said that with these processes although the inflation rate is increasing, employment remains unchanged. Here it becomes clear that the trade-off between inflation and unemployment actually only comes about in the short term. In the long term, employees adapt to the current economic situation according to their adaptive expectations.

Individual evidence

1. ↑ See Jürgen Kromphardt: Unemployment and Inflation, p. 163 f.
2. ↑ ^{a b} Manfred Neumann: Theoretische Volkswirtschaftslehre I, p. 217
3. ↑ See Rüdiger Pohl: Theory of Inflation, p. 112
4. ↑ See Rüdiger Pohl: Theory of Inflation, p. 123
5. ↑ See Rüdiger Pohl: Theory of Inflation, p. 121f
6. ↑ Horst Hanusch, Thomas Kuhn, Uwe Cantner: Volkswirtschaftslehre I, p. 389
7. ↑ Uwe Westphal: Macroeconomics, p. 49
8. ↑ ^{a b} Rüdiger Pohl: Theory of Inflation, p. 124
9. ↑ Uwe Westphal: Macroeconomics, p. 50
10. ↑ See Rüdiger Pohl: Theory of Inflation, p. 135
11. ↑ See Bernhard Felderer, Stefan Homburg : Macroeconomics and new macroeconomics, p. 245
12. ↑ See Horst Hanusch, Thomas Kuhn, Uwe Cantner: Volkswirtschaftslehre I, p. 389
13. ↑ See Bernhard Felderer, Stefan Homburg: Macroeconomics and new macroeconomics, p. 246
14. ↑ Horst Hanusch, Thomas Kuhn, Uwe Cantner: Volkswirtschaftslehre I, p. 392

literature

• Bernhard Felderer , Stefan Homburg : Macroeconomics and New Macroeconomics. 9th, improved edition, 133-142. Thousand. Springer, Berlin a. a. 2005, ISBN 3-540-25020-4 .
• Horst Hanusch, Thomas Kuhn, Uwe Cantner : Economics. Volume 1: Basic Micro and Macroeconomics. 6th, improved edition. Springer, Berlin a. a. 2002, ISBN 3-540-43288-4 .
• Jürgen Kromphardt : Unemployment and Inflation. An introduction to the macroeconomic controversies (= UTB 1452). 2nd, revised edition. Vandenhoeck & Ruprecht, Göttingen 1998, ISBN 3-525-03171-8 .
• Manfred Neumann : Theoretical Economics. Volume 1: Macroeconomic Theory. Employment, Inflation, and Balance of Payments. 5th, revised edition. Franz Vahlen, Munich 1996, ISBN 3-8006-2127-4 .
• Rüdiger Pohl : Theory of Inflation. Basic features of monetary macroeconomics. Franz Vahlen, Munich 1981, ISBN 3-8006-0874-X .
• Uwe Westphal : Macroeconomics. Theory, empiricism and policy analysis. 2nd, revised and expanded edition. Springer, Berlin a. a. 1994, ISBN 3-540-57934-6 .