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Explaining expectations

July 27, 2014

 Abstract: Monetary authorities aim to keep inflation within an acceptable level; to achieve this goal, they also try to rein in inflationary expectations. When inflation is high, monetary policy is usually tightened to slow down output demand growth to cut down inflation. In a conventional business cycle scenario, inflationary expectations closely follow the trends in actual inflation rates and hence, both objectives (of controlling inflation and inflationary expectation) are typically aligned.

During 2009-2014, however, an exception occurred: while tight monetary policy during this period eased pressures on both output demand (resulting in a slowdown in GDP growth) and inflation, inflationary expectation (as measured by RBI’s quarterly household survey) remained stubbornly high. Figuring out why this happened is critical for policy. It is noted in this context that factors other than monetary, such as food price inflation, can strongly influence inflationary expectations.

Keywords: inflation; inflationary expectation; monetary policy; business cycle

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