Academic journal article Business Economics

The Changing Dynamics of Inflation: Expectation of Stability Tend to Be a Self-Fulfilling Prophecy

Academic journal article Business Economics

The Changing Dynamics of Inflation: Expectation of Stability Tend to Be a Self-Fulfilling Prophecy

Article excerpt

Inflation in the United States and elsewhere has become lower and more stable over the past two decades. It is likely that monetary policy has played an important role in this change in inflation dynamics by creating expectations of stability. This paper traces the evolution of the role of expectations in thinking about inflation, the supporting evidence over the past two decades, and role of central banks in influencing expectations. Increased global integration has magnified these effects. However, the importance of factors other than monetary policy implies that policymakers must consider a wide range of information before acting. Moreover, expectations of inflation stability cannot be taken for granted; and policymakers must be vigilant against complacency.


Since the mid-1980s, we have seen important improvements in the control of inflation dynamics--inflation is now much lower and more stable than it once was, and Table 1 shows that it appears to be less closely correlated with movements in other economic factors than it was during the 1960s and 1970s. Moreover, we have seen these improvements not only in the United States but in other countries as well. Questions of intense interest to the private sector as well as the Federal Reserve are, "What caused these changes in the inflation process?" and "What are their implications for monetary policy?"

Having spent many years as a University of Chicago professor, my first reaction to these changes is to think "money." As Milton Friedman famously said many years ago, "Inflation is always and everywhere a monetary phenomenon." Unfortunately, given the lack of a stable relationship between money growth and inflation, the pure monetarist view has taken a beating since then. However, Friedman was right that inflation is, ultimately, something that central banks determine, at least on average, over time.

My second reaction is to think about another factor that Friedman emphasized--expectations. Views about the inflation process vary, but expectations are at the heart of almost all of them. And in any model in which expectations are important, monetary policy will also be important. So monetary policy, if not money itself, remains a central determinant of inflation dynamics. Accordingly, one of my principal themes will be that expectations are important in the inflation process and that the improved conduct of monetary policy, by influencing the formation of expectations in a favorable manner, may account for many of the changes in inflation dynamics that we observe. At the same time, I am wary of ascribing all of the changes in dynamics to monetary policy. We should not place too much faith in any one framework, and so we need to keep an open mind about other possible explanations for the recent changes in inflation dynamics.

The Expectational Approach to Thinking about Inflation

Now almost forty years old, the expectational approach to inflation dynamics--developed simultaneously by Friedman and recent Nobel Prize winner Edmund Phelps--is still the dominant framework for thinking about inflation. Let me begin with a quick review of what Friedman and Phelps said forty years ago and then discuss very briefly how it relates to current thinking about the inflation process.

In Friedman's framework, as expressed in his 1967 presidential address to the American Economics Association, inflation is related to inflation expectations as well as the level of resource utilization. Friedman explained that for a variety of real-world reasons, wages and prices might not always adjust immediately to changes in the money supply. If they did not so adjust, monetary policy could affect resource utilization. The reason that Friedman's work, and that of Phelps, was so revolutionary was that it overturned the earlier belief that monetary policy could have a permanent influence on resource utilization in favor of a new view that monetary policy could affect real activity only temporarily. …

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