The Expectations Trap Hypothesis

Abstract

Introduction and summary Many countries, including the U.S., experienced a costly, high inflation in the 1970s. This article reviews some research devoted to understanding why it happened and what can be done to prevent it from happening again. We take it for granted that the high inflation was the result of high money growth produced by the U.S. Federal Reserve. But, to make sure that it does not happen again, it is not enough to know who did it. It is also necessary to know why the Fed did it. We hypothesize that the Fed was in effect pushed into producing the high inflation by a rise in the inflationary expectations of the public. In the language of Chari, Christiano, and Eichenbaum (1998), we say that when a central bank is pressured to produce inflation because of a rise in inflation expectations, the economy has fallen into an expectations trap. We call this hypothesis about inflation the expectations trap hypothesis. We argue that the dynamics of inflation in the early 1970s are consistent with the expectations trap hypothesis. We describe two versions of this hypothesis. We also describe an alternative hypothesis, which we call the Phillips curve hypothesis. According to this hypothesis, inflation occurs when a central bank decides to increase money growth to stimulate the economy and is willing to accept the risk of high inflation that that entails. The expectations trap hypothesis and the Phillips curve hypothesis both maintain that high inflation is a consequence of high money growth. Where they differ is in the motives that they ascribe to the central bank. Much of our analysis assessing the various hypotheses about inflation is based on an informal review of the historical record. We supplement this discussion by studying a version of the expectations trap hypothesis using a general equilibrium, dynamic macroeconomic model. There are two reasons that we do this. First, we want to demonstrate that the expectations trap hypothesis can be integrated into a coherent view of the overall macroeconomy. [1] Second, we want to document that that hypothesis has the potential to provide a quantitatively realistic account for the 1970s take-off in inflation. The model we use is the limited participation model studied in Christiano and Gust (1999). [2] It requires a specification of monetary policy in the 1970s, and for this we use the policy rule estimated by Clarida, Gali, and Gertler (1998). The account of the early 1970s that we produce using the model posits that a bad supply shock (designed to capture the various commodity shortages of the early 1970s) triggered a jump in expected inflation, which then became transformed into higher actual inflation because of the nature of monetary policy. We find that, consistent with the data, the model predicts stagflation. We view this result as supportive of the expectations trap hypothesis. We compare our model with an alternative quantitative model of the 1970s inflation proposed by Clarida et al. That model can also explain the rise in inflation in the 1970s as reflecting a self-fulfilling increase in inflation expectations. It is a sticky price, rational expectations version of the IS--LM model. [3] When we use that model to simulate the 1970s, we find that it is inconsistent with the observed stagflation of the time. It predicts that the rise in expected and actual inflation triggered by a bad supply shock is associated with a sustained rise in employment. We conclude that the limited participation model provides a better account of the high inflation of the 1970s than does the sticky price, IS-LM model with Clarida et al. 's representation of policy. This result is potentially of independent interest, since the latter model is currently in widespread use. We begin with a description of the expectations trap hypothesis and what it implies for policy. Then, we review the 1960s and 1970s and provide an informal assessment of the expectations trap and Phillips curve hypotheses. …