The Role of Price Expectations in Inflation

Readers Question: I have 2 questions if you could help me with them I would greatly apperciate it….1 Need to create an aggregate demand -aggregate supply model and explain the impact of  the U.S federal Reserve cutting interest rates on real income (y), the level of employment (l), real wages (w/p),  nominal wages (W), price level (P), and interest rates (R)?

A cut in interest rates leads to an increase in the supply of money. Equilibrium needs to be maintained in the money markets so lower interest rates causes higher money supply and higher demand for money. (interest rates explained

This increase in the money supply causes higher nominal wages, increase in output, increase in price level e.t.c.

But, they are looking for a specific answer, which I can’t give at the moment.

2. How do I explain the role of price expectations (Pe) in the labour markets and on the shape of the aggregate supply function.  Need to to explain the Classical and Keynesian views on it?

• Suppose people expect inflation to be 0%.
• Then assume there is an increase in Aggregated Demand and the Money supply. This leads to an increase in nominal wages of say 2%.
• Because people expect inflation to be 0%, they feel that real wages (w/p) have increased by 2%.
• Therefore, with an increase in real wages, people are willing to work longer hours (substitution effect of higher wages). Because people work longer hours firms can increase production. Therefore, there is a movement along the SRAS (short run aggregate Supply). This leads to an increase in real output, but also causes inflation.
• Later, workers realise that their inflation expectations of 0% were wrong. Because inflation has increased by 2%, their real wage has stayed constant. Therefore, they stop working overtime, the SRAS shifts to the left to readjust to the new inflation expectation of 2%.
• Therefore, in the long run the Aggregate Supply stays the same (inelastic).
• In the classical model the Long Run Aggregate Supply is inelastic. Increase in the money supply only causes a nominal increase in GDP.

The classical model assumes that labour markets are efficient and competitive.

The Keynesian view is different. They argue that Labour markets can be inefficient and in a state of disequilibrium. For example trades unions can cause wages to be above the equilibrium. Therefore, they argue the Long run aggregate supply function may not be perfectly inelastic. Often they can be spare capacity in the economy, due to underutilised resources – especially in a recession. Therefore, if there is an increase in aggregate demand it can cause an increase in real output.