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Inflation Expectations On The Rise Shifts Aggregate Demand Outward

Inflationary expectations are the expectations that consumers have concerning future inflation. If buyers expect higher prices in the future, they increase their demand in the present. This shifts the aggregate demand curve outward (to the right) which is good for the economy. For example, if the price of a house is expected to be higher next year, consumers decide not to wait, but to buy now. The increase in inflationary expectations causes an increase in consumption expenditures and subsequently an increase in aggregate demand.

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Inflation expectations are on the rise in the U.S. which increase the possibility of a Federal Reserve rate hike soon.

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Institutional traders and money managers are increasingly moving to hedge inflation risk in their portfolios by buying the iShares TIPS Bond ETF.

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Are Inflation Expectations Really That Important?

A common question I get is if inflation expectations are that important. The answer is yes, and we can look back at history to see why. During the 1970s the importance of inflationary expectations as an aggregate demand determinant was revealed to economists. During the 1970s, inflation rates kept rising. The government deployed contractionary fiscal policies, but inflation continued to rise. The reason inflation kept rising is that the public “expected” it to. Once economists determined what was going on, manipulation of inflationary expectations was used during the 1980s to reduce inflation and to keep it low throughout the 1990s.

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