Macroeconomic Theory

Businesses May Face Excess Demand

A healthy economy increases the demand for goods and services.
When the quantity demanded at the prevailing price exceeds the quantity supplied, there is excess demand.
A short-run solution is increasing prices.

Excess demand leads inflation to rise above inflation expectations.
Insufficient demand leads inflation to fall below inflation expectations.
When the economy is operating at full capacity, inflation equals inflation expectations.
The output gap measures the imbalance between output and productive capacity.

Demand-pull inflation is driven by the output gap. It leads inflation to diverge from inflation expectations

Unexpected inflation is the difference between inflation and inflation expectations.
The Philips curve illustrates the link between the output gap and unexpected inflation.
The output gap drives inflation to rise above or fall below inflation expectations.

Investment banks, businesses, and government economists forecast inflation using estimates of the Phillips curve.

It is a two-step process:

The labor market Phillips curve links unexpected inflation to the unemployment rate (rather than the output gap.)

↓Unemployment rate → ↑Unexpected inflation

Unexpected boosts to production costs push sellers to raise their prices, resulting in cost-push inflation.
Cost-push inflation leads to more inflation at any given level of the output gap and for any given level of inflation expectations.

Any change in production costs that leads suppliers to change the prices they charge at any given level of output is called a supply shock.

Supply shocks shift the Phillips curve.

The Phillips curve shifts in response to unexpected changes in

Oil and commodities: Increased oil prices lead to higher electric heating bills, gas prices, transportation prices, etc.