A2 Economics Revision - Price Expectations and Money Illusion

Expectations of what lies ahead can influence how we behave today and price expectations in the economy remain topical and relevant to the handling of macroeconomic policy in the UK.

There was a spike in price expectations in 2008 when the problems of high energy and food prices were headline news on a daily basis and when the published rate of CPI and RPI inflation surged above 5 per cent, more than twice the official target for the UK. Since then inflation expectations have moved lower – the consequence of the recession and a reduction in inflationary pressures in the economy. But they remain positive which can be seen as a favourable situation given fears of sustained price deflation and a depression when the financial and economic crisis was at its worse.

Our expectations of inflation can have a significant effect on the wider economy:

1. Price expectations impact on wage demands – for example people wanting to protect their real incomes by bidding for a pay rise that compensates them for higher prices

2. Price expectations may affect the timing of our major purchases. When prices are falling (deflation) many may choose to postpone spending in anticipation of lower prices a few months down the line

3. In the conventional model of the expectations-augmented Phillips Curve, each short-run Phillips Curve is drawn on the assumption of a given expected rate of inflation. If price expectations decline, the SR Phillips Curve may shift inwards

Money Illusion: Money illusion occurs when people confuse nominal and real values when making economic decisions. Money illusion is most likely to occur when inflation is unanticipated, so that people’s expectations of inflation turn out to be some distance from the correct level.