Anticipated and unanticipated inflation
The effects of inflation depends in part on whether inflation is anticipated or
When people/businesses can make accurate predictions of inflation, they can take steps
to protect themselves from its effects.
e.g. Households may also be able to switch savings into deposit accounts offering a
higher nominal rate of interest or into other financial assets such as housing or equities
where capital gains over a period of time might outstrip general price inflation.
e.g. Companies can adjust prices and lenders can adjust interest rates.
When inflation is volatile from year to year, it becomes difficult for individuals and
businesses to correctly predict the rate of inflation in the near future.
Unanticipated inflation occurs when economic agents (i.e. people, businesses and
governments) make errors in their inflation forecasts.
Actual inflation may end up well below, or significantly above expectations
causing losses in real incomes and a redistribution of income and wealth
from one group in society to another.
People confuse nominal and real values in their everyday lives because they are misled
by the effects of inflation.
Money illusion is most likely to occur when inflation is unanticipated, so that people’s
expectations of inflation turn out to be some distance from the correct level.
When inflation is fully anticipated there is much less risk of money illusion affecting both
individual employees and businesses