Inflation Expectations, Adverse Aggregate Supply Shock and Long-Term Inflation Expectations

Abstract

This chapter examines whether the effects of a positive inflation expectations shock differ from those of an adverse aggregate supply shock. This includes assessing the role of positive aggregate demand shock and comparing it to those of the positive inflation expectations shock and an adverse aggregate supply shock. Evidence indicates that the concurrence of the adverse supply shocks and positive inflation expectations shocks can have devastating effects on economic activity. The repo rate is adjusted aggressively to a positive aggregate demand shock. This aggressive increase in the repo rate to a demand shock translates into a quick decline in the response of inflation expectations. Financial market participants do indeed believe that the monetary policy authority deals decisively with positive aggregate demand shocks. Hence, monetary policy conduct may have earned credibility in dealing with demand-driven inflationary shocks. But the absence of demand pressures plays a limited role in mitigating the inflationary effects of supply shocks and inflation expectations.

The results differ in relation to the policy responses due to supply shocks and positive inflation shocks. Irrespective of the fact that positive inflation expectations shocks and the adverse supply shocks lead to a persistent rise in inflation expectations and the depreciation in the exchange rate, agents have learned that policy is “partially accommodative” to these shocks. From a policy perspective, the findings reinforce the view that the concurrence of adverse supply shocks and positive inflation expectation shocks tend to move economic variables in the same direction and can have debilitating effects on economic activity. This means that policymakers should take appropriate action when necessary to mitigate that expected prices do not become realised prices.