Question

Why do workers, firms, banks, and investors in financial markets care about the future rate of inflation? How do they form their expectations of future inflation? Do current conditions in the economy have any effect on how they form their expectations? Briefly explain.

Answer 1

Future rates of inflation affect the real values or we can say values adjusted due to inflation. Workers have to anticipate the fluctuations in inflation in future years, so that they can get to know what their real wages will be. Similarly proper estimation of future rate of inflation will help the firms, banks and investors to know their real profits, real interest rates and real returns from financial markets.

Correct forecast of Inflation will help in increasing the real gains of firms, banks, investors and workers. When inflation is low, people generally ignores the inflation rate and do not form any expectations of future inflation. During the periods of moderate but stable inflation, people generally form their expectations about future inflation on the basis of adaptive expectations. This means that people assume that future rates of inflation will follow the pattern of rates of inflation in the recent past. When rate of inflation is high and unstable, people generally form their expectations about future inflation rate on the basis of rational expectations which is based on the available information including current policy of Federal Reserve.

Yes, current conditions in the economy effect the future expectations of workers, bankers, firms and investors. Adaptive Expectations or Rational Expectations by the people about future rates of inflation are dependent on the rate of inflation that is currently prevailing in the economy i.e. the rate of inflation is moderate, stable or high.