Question

Expectations

a.        Explain briefly how expectations by firms of inflation can lead to inflation.

b.        Explain briefly how expectations by workers of inflation can lead to inflation.

c.        Explain briefly how expectations of interest rates rising can lead to interest rates rising.

d.        Explain briefly how expectations of exchange rates rising can lead to exchange rates rising.

Answer 1

(A).  As firms reach full capacity, they respond by putting up prices leading to inflation. Also, near full employment with labour shortages, workers can get higher wages which increase their spending power. We tend to get demand-pull inflation if economic growth is above the long-run trend rate of growth.

(B).  If workers expect future inflation, they are more likely to bargain for higher wages to compensate for the increased cost of living. If workers can successfully bargain for higher wages, this will contribute towards inflation. Higher wages: increase inflation demand-pull inflation ( workers have more disposable income)

(C). Effect of raising interest rates. The Central Bank usually increase interest rates when inflation is predicted to rise above their inflation target. Higher interest rates tend to moderate economic growth. They increase the cost of borrowing, reduce disposable income and therefore limit the growth in consumer spending.

(D).  An expectation of a future shift in the exchange rate affects both buyers and sellers that is, it affects both demand and supply for a currency. In this example, the rising demand for pesos is causing the quantity to rise while the falling supply of pesos is causing quantity to fall.