The Effect of Inflation Expectations on Consumption Decisions

This thesis investigates the impact of inflation expectations on consumption decisions in a volatile inflation environment and explores the role of deviations from rational expectations using the consistency of reported inflation expectations as a proxy. The findings reveal that the high share of consumers with inconsistent inflation expectations cannot explain the lack of evidence of the intertemporal substitution effect postulated by the Euler equation. However, I find that compared to consumers with consistent inflation expectations, consumers with inconsistent inflation expectations respond significantly less to expected inflation with regards to spending, despite the volatile inflation environment. For consistent individuals, on the other hand, I observe a significant relation only between inflation expectations and planned spending while current spending is not affected by expected inflation. Given that the results reveal a positive correlation between inflation and unemployment expectations, the results suggest that consistent consumers adopt a stagflationary view of the economy.