How do expectations about future inflation affect the economy?

Expectations about future inflation play a crucial role in shaping economic behavior. When individuals and businesses anticipate higher inflation in the future, they adjust their behaviors accordingly. For instance, workers may demand higher wages in anticipation of rising prices, while businesses might increase their prices preemptively to maintain profit margins. This collective adjustment can lead to a self-fulfilling prophecy where the mere expectation of inflation contributes to actual inflation occurring.

Moreover, when consumers expect prices to increase, they may choose to purchase goods and services sooner rather than later, which can spur demand and further drive up prices. Similarly, if lenders expect inflation to rise, they may increase interest rates to compensate for the anticipated loss of purchasing power over time. All these actions taken in response to inflation expectations can contribute to the actual rate of inflation increasing, providing a clear connection between expectations and real economic outcomes.