Inflation and the Phillips Curve
1
Three Inflationary Forces
2
Inflation Expectations
3
The Phillips Curve
Inflation Expectations: The rate at which average prices are anticipated to rise next year.
Demand-pull inflation: Inflation resulting from excess demand.
Cost-push inflation: Inflation that results from an unexpected rise in production costs.
Inflation = Expected inflation + Demand-pull inflation + Cost-push inflation
Businesses consider current input costs and competitor prices when setting the prices of their goods and services
They also use information about future prices to set prices for goods and services.
Expectations matter.
If businesses expect prices to rise by 2%, they will increase their prices by 2%, ensuring prices actually rise by at least 2%.
In other words, expectations can become self-fulfilling
If expectations are a signficant driver of inflation, then one solution might be for the central bank to convince people that inflation will be low
How can they convince people? By taking your inflation targeting goal very seriously.
If people doubt that you will be willing to tackle inflation, expectations of inflation might rise
Three methods to measure expectations:
Inflation expectations can be:
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:
↓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
Read “The Fed Model”
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