Phillips Curve L & R

What happened in 2000 that made all inflation move together?

• Inflation targeting was created instead of just trying to keep it as low as possible

• Central banks started communicating increasing credibility

3 Forces Behind Inflation

• Inflation Expectation: 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 supply shocks and unexpected increase in production costs

Inflation = Expected Inflation + Demand-pull inflation + Cost push inflation

Inflation Expectations

(π^e) The rate at which average prices are anticipated to rise next year

• Forms foundation for actual inflation

• Self fulfilling prophecy: high π^e can cause high π, (all firms bekive prices will rise by 2% next year, production costs and competitor prices will rise by 2%, firms will raise their own prices by 2% in response)

How are inflation expectations formed

1. Adaptive: history matters, backward looking, uses no information about the future

2. Anchored: faith in the central bank, central bank’s target

3. Rational: fully informed

4. Sticky: pnly pay attention when it matters, infrequent learning

Likely combo of all 4

Ways to track inflation expectations

• Surveys

• Economists Forecasts

• Financial markets deduce by comparing interest yields of real return and regular return bonds

Inflation expectations stats

• Highest for 18-24

• Highest for least educated

• Highest for lowest earners

Demand Pull Inflation

Excess demand leads inflation to rise above inflation expectations, insufficient demand leads inflation to fall below inflation expectation

• Generates unexpected inflation

• When at potential output inflation equals inflation expectation

Y(hat) > 0, vs Y(hat) < 0

• Demand greater than economy’s potential output, prices will rise

• Demand lower than economy’s potential output, prices will fall

Cost Push Inflation

Determined by unexpected shocks in production costs, in normal times value is 0

1. Input prices: raw materials, intermediate goods and labour,

   1. Wage-price spiral: a cycle where higher prices lead to higher nominal wages, which leads to higher prices

2. Productivity: faster than expected productivity growth lowers the marginal costs of production. Instead, slower than expected productivity growth increases the marginal cost of production

Phillips Curve