Not so Great Expectations

People have expectations about the world. When those expectations are violated, they usually change their behavior in order to account for the new information (on the margin at least). Does unexpected inflation affect people’s behavior? Of course. William Phillips thought so (the famous version of the Phillips Curve assumes constant inflation expectations).

Macroeconomists often separate the world into reals and nominals. Sometimes we produce more and other times we produce less. Those are the reals. The prices that we pay and the money that we spend are the nominals. There is what’s sometimes called a ‘loose joint’ between reals and nominals. That is, they do not move in tandem, nor are they entirely independent. If the Fed suddenly slows the growth of the money supply, then economic activity growth might also slow – but not by the same amount. In the long run, reals and nominals are largely independent. Whether we have 2% vs 3% annual inflation over the course of some decade is probably not important for our real output at the end of that decade.

It Takes Two to Tango.

It is often said that the Fed can achieve any amount of total spending in the economy that it prefers. It can achieve any NGDP. But, the Fed doesn’t control NGDP as a matter of fiat. The Fed changes interest rates and the money supply in order to change the total spending in our economy. Importantly, the effect of Fed policy changes is contingent on how the public reacts. After all, the Fed can increase the money supply. But it is us who decides how much to spend.

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