The Effects of Economic Shocks on Heterogeneous Inflation Expectations

IMF Working Papers, July 1, 2022

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The dynamics of households' expected inflation distributions are driven by three distinctive functional shocks that influence the expected inflation distribution through: disagreement, level shift and ambiguity.
Contractionary monetary shocks:
- increase the average level of inflation expectation with anchoring effects,
- reduce disagreement,
- increase the share of households expecting future inflation to be between 2 to 4 percent.
The anchoring effects from contractionary monetary shocks are not observed when the high inflation periods prior to the Volcker disinflation are included.
Expansionary government spending shocks have inflationary effects on both short and medium-run inflation expectations.
An increase in personal income tax shocks is inflationary for mediumrun.
A surprise increase in gasoline prices:
- increases the level of inflation expectations,
- lowers the share of households with 2 percent inflation expectations.

The paper examines how economic shocks affect the distribution of household inflation expectations by linking functional shocks in the distribution (disagreement, level shift, ambiguity) to identified economic shocks.
Data and approach focus on household survey measures of inflation expectations and the transmission of economic shocks to heterogeneous beliefs.

Monetary policy:
- Contractionary monetary policy can raise average inflation expectations while simultaneously producing anchoring effects that reduce disagreement and concentrate expectations in the 2 to 4 percent range (except when including pre-Volcker high inflation periods).
Fiscal policy:
- Expansionary government spending can raise both short- and medium-run inflation expectations.
- Increases in personal income tax can be inflationary for mediumrun expectations.
Commodity price shocks:
- Gasoline price surprises raise overall inflation expectations but can reduce the proportion of households expecting 2 percent inflation.