How expectations affect the economy and the monetary policy?

In economics a crucial role is defined by expectations, made up by economic agents, about future economic variables. Every day we are affected by a lot of economic’s informations, expecially in newspapers and on television.
In economics, in order to understand the state of the economic system, economists and research insitutes creates, using mathematical models, a lot of statistics to measure the most important variable’s trend, like inflation, unemployment, production and so on.
Inflation, for example, is defined like the rate change of prices during a specific time. In mathematical term we can define it as follow:

π = Pf – Pi / Pi

Where:
π = Inflation rate;
Pf = Final price’s level;
Pi = Initial price’s level.

Inflation, as we know, is one of the most important variables to estimate how a certain bundle of goods and services, that statically represent the average purchaising’s decisions of consumers in an economy, changes its value across time.
In an economy, to mantein as smooth as possible the aggregate demand and to not create particular problems to consumers and firms, is crucial that inflation’s rate remains as smooth as possible and close to lower values.
The European Central Bank, for the European countries that have adopted in their economies the euro, and the Federal Reserve System, for the United States of America, are the two most important Central Banks in the world and their task is to set the monetary policy in their economy.
Actually, Christine Lagarde is the president of the ECB while Jerome Powell is the president of the FED.
To define their monetary policy decisions they have to adopt several econometrics models in order to understand how a specific monetary policy can affect the economic system and how economic’s variables, like inflation, will react to these policies.
Central Banks can stimulate the economy, substantially, increasing or decreasing the interest rates. For example, during an expansionary period when the aggregate demand exceeds the aggregate supply, prices rises up an inflation occurs in the economy. As we have said before, Central Banks of the most developed countries, want to mantein inflation to 2% by year.
No one want to have an elevated inflation, because it affects negatively the economy, principally for two reasons:
I. The purchasing power of households and consumers decreases, because with the same amount of money and wages people can now buy less goods and services rather that in the past.
II. High inflation brings in the economy uncertainty, because consumers have no idea regarding the future price’s level and firms, at the same time, are not aible to sell their products, because economic agents will tend to decrease demand for goods and services. Inflation, if policymakers doesn’t control it massively, can develop in an hyperinflation. (A period in time in which inflation rate acrosses 50% per year).
III. For this reason we could think that a deflation could be desiderable for the economy. How beautiful would be a world with a speedly decreasing of prices’s level! No one could desire something of better!

Unfortunately this is not true, and now I will just try to explain why a deflation could be worst than a positive inflation.
If in the economy the general level of prices is getting down, firms and expecially entrepreneurs will be worried because it is probable that consumers, due a rising down of prices’s level, will decide to postpone their purchases for durable goods and services, because they image to buy them in the future, hoping that prices will continue to decrease.

If this prediction will be confirmed in the economy firms would have to cut employment, in order to contain costs due a reduction of profits and production. Deflation is very dangerous and it is one of first elements that appears during a recession.

In economics, thank the contribute of Alfred Phillips, a very important relation is expressed by the Phillips’ curve.
The Phillips’curve shows an important relation between inflation and unemployment. Phillips realised, using econometric models, that in the UK, between 1913 and 1948 the inflation rate was negatively related to the unemployment rate. During period of high inflation the unemployment went down, and in the opposite case, so when the inflation rate was very low, the unemployment increased a lot. The economic interpretation to this results is the following:
During economic growth the inflation rate goes up because the aggregate demand increases and firms, in order to equilibrate demand and supply, are going to rise up prices. During economic growth firms, also, tend to hire new workers in order to increase production, and for this reason the unemployment rate goes down.
In the opposite situation, when a recession occurs in the economy, the inflation rate deeply goes down and unemployment increases significantly.
During a recession, when GDP falls down sharply, firms experiment an excess of costs on revenues, because the aggregate demand decreases and to sell their products they have to reduce prices, and it affects profits negatively. For this reason firms starts to fire workers in order to contain costs, and this measure contributes to increase unemployment in the economy.

This relation, for its characteristics and peculiarities, was used a lot by policymakers in order to choose a combination of inflation and unemployment in the economy. If the policymakers want to reach a certain level of inflation in the economy, they have to accept the corresponding unemployment associated to that inflation’s level.

This model was modified and partially rejected by several economists when during 1970 inflation and unemployment appeared together in a lot of countries due the oil crise. When inflation and unemplyoment appears together in the economy, economists speak about stagflation. A stagflation is a very strange and particular state of the economy in which GDP progressively reduces its speed but inflation remains very high. This is an event that economist have studied a lot and it also happened due a supply shock, like an increasing of the commodity’s prices and some particular inputs that is crucial for the whole global production, that is not predictable in the past and in which Government and policymakers have no a direct control on the mitigation of its effects.

For public authorities it is easier to manage a demand shock when, for example, aggreate demand increases or decreases because it is a direct consequence of the state of the economy. If the aggregate demand is high probably the labor market in the economy is working very well, with great efficiency and no particular distortions in the market. Firms want to hire new people and workers want to exchange their time for a wage. In this way workers get a wage and they can consume, invest and operate in the economy. When this occours the aggregate demand increases a lot and firms have to increase production or have to set new high prices to reach the equilibrium point. The opposite case, so when the labor market is very rigid due a crise, the aggregate demand goes down and prices falls down.

A Government, only for demand shock, can easily solve the disequilibrium. During an economic boom fiscal policy, made up by an increasing in taxations or a decreasing in public expenditure, is important to mantein the sustainability of the balance constraint of the country. At the same time, during a recession, an expansionary fiscal or monetary policy is useful to stimulate and pump the economy.

This model is crucial to understand how the Government and the Central Banks fix expectations of economic agents.

If the Government, in order to stimulate the economy after a recession, decided to increase the public expenditure (for example subsidies), in this way he wants to fix people’s expactions about the future, that in economics are crucial.

People in the economy, seeing a direct intervention of the Government in the economy, expect a rising inflation and a progressively reduction in unemployment. At the same time a Central Bank, with the monetary policy, can affect people expectations about the economy. For example, if a Central Bank wanted to rise interest rates to fight inflation, people would understand that the Central Bank is seriously interested in cutting down inflation.

If Central Bank didn’t do this, probably people would expect increasing inflation in the future.
In an economy, if people would expect rising prices, a salary-prices spiral could appear in the economy. This is determinated by the fact that the economic agents try to mantein as stable as possile their real wages that, as we have said before, represents their purchasing power. If the Central Banks didn’t fight inflation in the economy, increasing interest rates or decreasing the quantity of money available in the economy, people future expectation’s on the economy will determine an increasing on the nominal wages because, in a situation characterized by a deep inflation, workers will ask firms to speed up their nominal wages in order to preserve their purchasing power. Firms, at the same time, will increment their sell prices in order to equilibrate revenues and costs, because the increasing on the nominal wages, that have to be correspond to the workers, will cause a significant rising up of costs on their balance sheets.

If this economic adjustment process will remain persistent in the future, economy could be affected by a period of hyperinflation. Weimar’s Republic, in the 1920s, registered a terrible and scared hyperinflation, with an inflation rate per year approximately equal to 325.000.000%.
Germany had to pay war’s debts and sanctions and, for that reason, the Central Bank began to print a lot of money but this expansionary monetary policy’s decision caused the depreciation of the value and a massive increasing of the inflation rate.
To conclude, we have to understand that Central Banks have to drive people’s expectations. How an economic agent could believe to the policy decisions adopted by the Central Banks? Why he should have confidence on the monetary policy’s authority?
Using the Phillip’s curve we can say that a Central Bank, in order to communicate to the whole economy its decision to fight inflation, has to generate a volountary recession. Only in this way people, observing an increasing in the unemployment, will mantein their confidence on the Central Bank because, during a recession, the aggregate demand falls and prices begin to decrease.
Ben Bernanke, nobel prize for economics in 2022 and president of the Federal Reserve System from 2006 and 2014, said that:

«Today the monetary policy is 98% words and 2% facts»

With this sentence I really hope to have shared with you which is the real secret of the economy.
In economics, but also in real life, words and communication have more effects rather actions. We, obviously, have to be good speakers infusing confidence, determination and competence. Only with this three tools monetary and fiscal policy can affect positively the economy.