Causes of inflation – inflation expectations
Rising expectations of inflation can often be self-fulfilling.
If people expect prices to rise, they will want higher pay rises to protect the real purchasing
power of their incomes.
For example a booming economy might see a rise in inflation from 3% to 5% due to an
excess of AD. Workers will seek to negotiate higher wages and there is then a danger that
this will trigger a ‘wage-price spiral’ that then requires the introduction of deflationary policies
such as higher interest rates or an increase in direct taxation.