Macroeconomics - Expectations of Monetary Policy

Expectations impact perceptions about inflation and the timing of those perceptions. The effectiveness of expansionary monetary and fiscal policy with regards to increases in output and employment is reduced by expectations. The reduction in output caused by restrictive monetary and fiscal policy will be moderated by expectations, as economic participants will more quickly anticipate the lowering of overall price levels.

Demand curves for labor and capital slope downward to the right. With other factors held constant, employers will only hire more workers if real wage rates have decreased and capital expenditures will increase only if real interest rates have declined.

Expansionary monetary and fiscal policy often assumes that workers will accept lower real wages and that investors will accept lower real rates of return. It is the willingness of workers to accept wages that are lower than what they would normally demand, and the willingness of investors to accept lower real interest rates than normal that causes employment and real production to increase. Nominal wages and interest rates remain the same; inflation is doing the job of cutting real wages and interest rates. Therefore, in order for employment and production to increase, inflation must increase so that real wages and interest rates can go down. This relationship is described by the original Phillips curve, which shows that inflation accompanies lower rates of unemployment.

As long as the public does not understand that inflation has increased, the economy can be moved according to the Phillips curve relationship.

Why would it take time for the public to recognize and adapt to the new rate of inflation?
One reason is that some workers may not be able to do anything about it. They may be locked into multi-year labor agreements that do not permit negotiation until the expiration of the labor agreement. Investors and employees might also be subject to money illusion - their attention could be focused on their nominal wages and nominal interest rates, and they may not realize that real wages and interest rates are declining. At some point in time, however, they will recognize that their real buying power (from wages and interest income) has gone down.

Also, they may not immediately see that inflation is occurring. Not all prices go up during times of inflation, so it may hard to see the big picture.

Eventually, the public will understand and adapt to the new inflationary environment and they will seek raises in wages and interest rates in order to bring them back to their old income levels. The economy will move to a long-term equilibrium position in which output and employment return to points where they were before the monetary and fiscal stimulus occurred. The major change will be that prices will be at a higher level.

This makes sense, as we should not expect major benefits to occur just from printing more paper money or running larger government deficits!

Expectations essentially reduce the time that government policymakers can fool the public into accepting cuts in real wage and real interest rates and, therefore, the positive effects of financial and monetary stimulus are moderated.

New Monetarist vs New Keynesian Feedback Rules
There are two famous new feedback rules for monetary policy. Those rules are:

  • The Taylor rule is a Keynesian feedback rule that focuses on short-term interest rates. The rule takes into account the target inflation rate, the difference between actual inflation and the target inflation rate, and the difference between real GDP and potential GDP.
  • The McCallum rule is a monetarist rule that emphasizes the growth rate of money. It states that the Federal Reserve should target a monetary base growth rate equal to the target inflation rate plus the ten-year moving average of the real GDP growth rate minus the four-year moving average of the monetary base velocity.

The major differences between the rules are:

·Targeting an interest rate versus monetary growth (as usual for Keynesians versus monetarists!).
·The Taylor rule provides for a response to fluctuations in real GDP, while the McCallum rule does not.

Related Articles
  1. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  2. Investing

    Asset Manager Ethics: Investment Process and Actions

    Managers, in developing their investment process, need to determine some “general rules” that make it meaningful. We offer six.
  3. Professionals

    Career Advice: Financial Analyst Vs. Investment Banker

    Read an in-depth comparison about working as a Financial Analyst vs. working as an Investment Banker, two highly prestigious business careers.
  4. Professionals

    Advisors: Which Certifications Are Essential?

    The right advisor credentials can make all the difference, but wading through some 100 certifications can be a challenge. Here's some help.
  5. Investing Basics

    Asset Manager Ethics: Valuation Is A Tricky Business

    Asset managers must accurately represent all of a clients assets in the client portfolio. This can be tricky for unique and hard-to-value assets.
  6. Personal Finance

    Top 10 Most Valuable Sports Teams in 2015

    Cleats, pads and profits: we take a look at the top 10 most valuable sports teams in the world.
  7. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  8. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  9. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  10. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  2. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  3. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  4. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!