10. The Phillips Curve

3 inflationary forces

inflation expectations, demand-pull inflation, cost-push inflation

2 key factors for setting prices

marginal costs and your competitor’s prices

ways to track inflation expectations

surveys, economists’ forecasts, financial markets

adaptive expectations

people who expect recent levels of inflation to continue

anchored expectations

people who believe the RBA will deliver on its promises

rational expectations

people who use all available data to come up with the most accurate forecast

sticky expectations

people who revisit their views on inflation irregularly, so they stick with their previous view

excess demand

when quantity demanded at P exceeds the quantity supplied

insufficient demand

when quantity demanded at P is below quantity supplied

when there’s a positive output gap there’s … demand

excess

when there’s a negative output gap there’s … demand

insufficient

the phillips curve

predicts how far inflation will diverge from expected inflation

if unexpected inflation is 0…

actual inflation = expected inflation

if unexpected inflation is negative…

actual inflation < expected inflation

if unexpected inflation is positive…

actual inflation > expected inflation

3 phillips curve graphing conventions

output gap on the X axis and unexpected inflation on the Y axis; 0 should be in the middle of each; upward sloping

how to forecast unexpected inflation

start with output gap estimate; look up and across to get unexpected inflation

the unemployment rate was used to represent…

unused resources

high unemployment (insufficient demand) =

below potential = low unexpected inflation

low unemployment (excess demand) =

above potential = high unexpected inflation

equilibrium unemployment rate = 

at potential = 0 unexpected inflation

cost-push inflation

when an unexpected boost to production costs pushes sellers to raise prices

an unexpected rise in production costs will cause the Phillips curve to…

shift upward

supply shocks

any change in production costs that leads suppliers to change prices at any given level of output

if input prices rise, the phillips curve…

shifts upward

if input prices fall, the phillips curve…

shifts downwards

productivity growth shifts the phillips curve…

down

weak productivity shifts the phillips curve

up

depreciating australian dollar shifts the phillips curve…

up

appreciating australian dollar shifts the phillips curve

down

… leads to movements along the phillips curve

demand-pull inflation

… leads to a shift in the phillips curve

cost-push inflation