Ch. 19 - The Phillips Curve and Inflation

Inflationary forces

1. Inflation expectations

2. Demand-pull inflation

3. Cost-push inflation

Inflation

= expected inflation + unexpected inflation

Self-fulfilling prophecy

if people expect inflation to increase, it will increase

How do people form inflation expectations?

1. Adaptive

2. Anchored

3. Rational

4. Sticky

Demand-pull inflation

• arises when demand exceeds the economy’s productive capacity (actual output > potential output)

• movement along Phillips Curve

Phillips Curve

• measures changes in unexpected inflation relative to changes in the output gap

• upward sloping

Labor market Phillips Curve

• measures changes in unexpected inflation relative to the change in the unemployment rate

• downward sloping

High output → low unemployment rate

• excess demand

• high unexpected inflation

Low output → high unemployment rate

• insufficient demand

• low unexpected inflation

Cost-push inflation

• occurs when prices rise due to unexpected increases in input costs (supply shocks)

• shifts Phillips Curve

Supply shocks

1. Input prices

2. Productivity

3. Exchange rates

Direct effect of exchange rates

imported goods become more expensive

Indirect effects of exchange rates

• imported inputs

• competition with foreign goods

• foreign buyers’ willingness to buy