Chpt 19.1 - Phillips curve and inflation

Phillips Curve

A concept in economics that suggests a trade-off between inflation and unemployment rates.

Inflation

A sustained increase in the general price level of goods and services in an economy.

Demand-Pull Inflation

Inflation due to excess demand (when demand outpaces a business’ productive capacity, it raises prices ); when demand exceeds the economy’s productive capacity, prices rise

Supply shocks

Unexpected events that disrupt the supply of goods or services, leading to cost-push inflation.

Cost-push inflation

Inflation resulting from an increase in production costs, often due to supply shocks.

Putting Inflationary Forces Together

Inflation is the sum total of three components

• Expected inflation: Inflation Expectations (up) → Inflation (up)

• Demand-Pull Inflation: Output Gap (up) → Inflation (up)

• Cost-Push Inflation: Production Costs (up) → Inflation (up)

Inflation Expectation

You should raise your prices for next year because you expect other businesses (both your suppliers and competitors) to raise their prices (influence economic decisions and pricing strategies.)

Inflation Expectations (Setting Prices)

Marginal Costs: if your suppliers raise their prices then you have to charge higher prices to make up for the higher marginal costs

Competitor’s Prices: They’ll also raise prices due to facing similar rising marginal costs; you can raise your prices alongside them and remain competitive

Adaptive Expectations

people who expect recent levels of inflation to continue

Anchored expectations

Belief that the Fed will deliver on its promise to ensure inflation stays around 2%

Rational expectations

Forecasting based on all available data to gather the most accurate prediction

Sticky Expectations

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

Self Fulfilling Prophecy

Once the expectation of an inflation rate is established, it is enough to push suppliers to raise their prices so that they will create that inflation

Vicious cycle

If people expect high inflation, they’ll get high inflation

Virtuous cycle

if people expect low inflation they’ll get low inflation

Three Ways To Track Inflation Expectations

Surveys: survey a representative group of people about their inflation expectations

Economic Forecasts: Professionals economists survey regarding their inflation forecasts

Financial Markets: “10-year break-even rate” is the rate that suggests what investors expect inflation to be over the next 10 years

Phillips Curve Shifters

1. Input Prices (up) → Phillips Curve Shift (up), Input Prices (down) → Phillips Curve Shift (down)

2. Productivity (up) → Phillips Curve Shift (down), Productivity (down) → Phillips Curve Shift (up)

3. Exchange Rate (down) → Phillips Curve Shift (up), Exchange Rate (up) → Phillips Curve Shift (down)

Phillips Curve Shift vs Move

Demand-pull inflation causes movement along the Phillips Curve, and Cost-Push Inflation causes a shift in the Phillips Curve