Inflation and the formation of expectations

Abstract

This paper develops a model of expectations which generates paths that are consistent with observations that an acceleration of the monetary growth rate initially raises and eventually lowers real holdings of cash balances. It introduces a two-part expectations hypothesis where individuals are assumed to form expectations about the entire path of the price level and about the short-term inflation rate. Interaction between regressive and extrapolative elements induces a transitory rise in money holdings during the initial phase of inflation as expectations are that the process will reverse itself. Subsequently, as expectations catch up, the decline in desired holdings induces an overshooting of the inflation rate.