Notes on the Phillips Curve and Inflation

Three main causes of inflation include:
- Inflation Expectations: The rate at which average prices are anticipated to rise next year.
- Demand-Pull Inflation: Inflation resulting from excess demand.
- Supply Shocks: External events that decrease supply, causing prices to rise.

The Bloomin’ Onion Example:
- Historical price data:
- 1993: $4.95
- 2008: $6.99
- 2022: $9.49
- Illustrates the trend of rising prices known as inflation.
Task: Understand what drives inflation and how it responds to economic conditions.

Definition:
- Inflation Expectations: Anticipated increase in prices that can influence business and consumer behavior.
Practical Application:
- Example from Outback Steakhouse: If inflation is expected at 2%, input prices would also be anticipated to rise, leading to a price increase of 2% for consumers.

Inflation expectations can create a self-fulfilling prophecy where agents in the economy adjust their prices based on anticipated inflation rates.
“The performance of our restaurant depends on our ability to anticipate and react to the changes in the price…of food.” - Outback Steakhouse annual report.

Definition:
- Inflation that arises when demand for goods exceeds their supply, resulting in price increases.
Example:
- Long wait times for tables at peak times at Outback Steakhouse indicate excess demand, which in turn leads the business to raise prices.
Long-Run Consideration:
- Managers may consider expanding operations to increase supply when demand is high, but in the short run, they can only raise prices.

Concept:
- A supply shock is an unexpected event causing a sudden decrease in supply, which can lead to cost-push inflation.
Example of supply shock:
- Russia’s invasion of Ukraine resulted in a reduction in oil supply, driving up prices for gasoline and heating oil, ultimately increasing production costs across various sectors.

Definition:
- Inflation that occurs when production costs rise unexpectedly, leading to increased prices.

Overall Equation:
- $Inflation = Expected inflation + Demand-pull inflation + Cost-push inflation$
- This suggests that increases in inflation expectations, the output gap, and production costs will all push inflation higher.

Understanding how inflation expectations lead to actual inflation involves analyzing:
- Reasons why expectations matter, and methods of measuring these expectations.

Surveys: Conducted among a representative group to gauge inflation sentiment.
Economists’ Forecasts: Ongoing analysis of inflation predictions amongst professional economists.
Financial Markets: The 10-year break-even inflation rate reflects what investors expect inflation to be over the next decade.

Adaptive Expectations: People base their expectations on recent inflation levels.
Anchored Expectations: Belief that authorities (like the Fed) will maintain low inflation (around 2%).
Rational Expectations: Incorporating all available data to make informed forecasts.
Sticky Expectations: Expectations that do not change frequently in response to new information.

The connection between the output gap and actual inflation is vital, where:
- Expect: Demand-pull inflation occurs due to excess demand exceeding production capacity.
- When the economy operates above potential (positive output gap), inflation will increase.
- Insufficient demand leads to lower inflation, as no excess demand pressures prices upward.

The Phillips Curve represents the inverse relationship between unemployment and inflation rates, illustrating:
- When output exceeds potential, inflation rises above expectations.
- Conversely, insufficient demand leads to inflation falling below expectations.
Graphing Convention:
- Quantities on the horizontal axis and prices (inflation) on the vertical axis; the curve slopes upward showing the relationship.

Analyzing Inflation and Employment:
- Low unemployment indicates greater inflation, while high unemployment suggests lower inflation.
Forecast Approach:
- Commence with current inflation expectations and articulated the output gap to predict unexpected inflation.
Example Calculation:
- If expected inflation is 5% and the output gap indicates a 1% drop, calculate:
- Inflation = 5 ext{% (expected)} - 1 ext{% (unexpected)} = 4 ext{% (needed salary raise)}

Shifts in the Phillips curve are a result of:
1. Input Prices: Rising costs of essential inputs leading to increased final prices.
2. Productivity Changes: Higher productivity can lower inflation via decreased marginal costs.
3. Exchange Rates: Effects from currency valuation changes impact domestic inflation rates.

Demand-pull inflation changes position along the Phillips curve due to movements in output gap.
Cost-push inflation leads to a shift in the whole curve due to enhanced production costs.

While inflation expectations dictate market behavior, it does not induce shifts or movements on the Phillips Curve itself in the long term.

Inflation Drivers:
1. Inflation = Expected inflation + Demand-pull + Cost-push inflation.
2. Higher inflation expectations result in actual inflation increment.
3. Output gaps significantly influence inflation rates.
4. Increased production costs will inevitably raise inflation levels.