ECON CH19

Measuring inflation expectations

1) Surveys ask people about their inflation expectations. 2) Inflation forecasts reveal the inflation expectations of economists 3) financial markets bet on the future of inflation 4) Inflation expectations can be adaptive, anchored, rational, or sticky

wage-price spiral

A cycle where higher prices lead to higher nominal wages, which leads to higher prices. Higher prices --> worker spending power falls --> nominal wages rise --> cost of production rises and it repeats. This continues as wages chase prices, and prices chase wages. Result is higher inflation that persists long after the initial inflationary impetus has receded. Wages are particularly important because they can amplify the effects of a temporary inflation shock and make it persistent.

unexpected inflation

Demand pull-factors cause inflation to either rise above inflation expectations (excess demand) or fall below inflation expectations (insufficient demand) this drives ____ ____ which is the difference between inflation and inflation expectations = Inflation - Inflation expectations. It goes on the vertical axis of the Philips curve because it's about prices. Phillips curve is all about ____ ____

demand-pull inflation

Inflation resulting from excess demand. Widespread price increases create ____ ____, which arises when demand exceeds the economy's productive capacity, pulling prices up. Alternatively, when demand falls short of productive capacity so that the output gap is negative, businesses are likely to moderate their price increases, leading to lower inflation. Higher output gap leads to higher inflation. Occurs when excess demand pulls inflation up, so that it rises above expected inflation. It can also pull inflation below inflation expectations when demand is unexpectedly weak. It is a separate force that operates in addition to inflation expectations. It is the imbalance between buyers demand for output versus the productive capacity of suppliers. It is driven by the output gap, which measures actual output relative to potential output.

classical dichotomy

Real and nominal variables are unrelated in the long run. a purely nominal change - like a change in the average price level - won't have any effect on real variables in the long run. This is the idea that in the long run, adding an extra zero at the end of every price tag (including wage rates, bank balances, and currency) wouldn't change how much stuff gets made, how many people work, or indeed, any real variable

excess demand

when the quantity demanded at the prevailing price exceeds the quantity supplied. EX) strong economy, people have healthy incomes, and so millions more people are willing to splurge to enjoy a steak dinner, but it's a dilemma b/c outback steakhouses are already overflowing therefore outback faces _____ _____ given its limited seating capacity. When demand for your product exceeds your capacity, it's time to think about raising your prices. If inflation expectations would normally lead you to raise your prices by 2%, the fact that you're also facing _____ _____ is a reason to raise your prices a bit more. ____ ____ leads inflation to rise above inflation expectations. Businesses will respond to their ____ ____ as Outback did, by raising their prices by a bit more than required just to keep pace with expected inflation. It pulls inflation to rise above inflation expectations. When output exceeds potential output-output gap is positive-there is ____ ____ and hence the greater the pressure to raise prices. It generates inflationary pressure

Three types of supply shocks shift the Phillips curve

1. input prices (high input costs -> rising production costs -> rising prices -> curve shifts up) 2. productivity (low productivity growth -> rising production costs -> rising prices -> curve shifts up) 3. exchange rates (low U.S. dollar -> rising production costs -> rising prices -> curve shifts up) AND VICE-VERSA

phillips curve

A curve illustrating the link between the output gap and unexpected inflation. When output exceeds potential output, excess demand leads managers to raise prices more, causing inflation to rise above expected inflation. When output is equal to potential output the absence of demand-pull inflation means that inflation will be equal to expected inflation. When output is less than potential output, insufficient demand leads to price restraint, causing inflation to fall below expected inflation. It describes inflation above and beyond that caused by inflation expectations, which is why the vertical axis measures unexpected inflation. It is upward sloping because higher output relative to potential output-a more positive output gap-leads to greater inflationary pressure, causing inflation to rise above inflation expectations. Vertical axis of the _____ ____ suggests that unexpected inflation can be either positive or negative. It is all about unexpected inflation. When it says that unexpected inflation will be negative, this simply means that actual inflation will be less than expected inflation. It is useful because it tells you by how much actual inflation will be above or below expected inflation. EX) Uber is like the ____ ____: there are more concert-goers trying to get a ride home than available Uber drivers, so there's excess demand. It's like a turbo-changed ____ ____, programmed to respond to excess demand by raising prices immediately. ____ ____ typically describes inflation rising or falling over a period of months. It describes how a surge in demand across the whole economy leads many businesses to raise their prices, and these widespread price rises create inflation. When economists try to figure out what the _____ _____ looks like, they compile data like this and compute a line that best fits the data. Investment banks, businesses, and government economists forecast inflation by using estimates of the ____ ___ that are similar to our line of best fit.

supply shocks

Any change in production costs that leads suppliers to change the prices they charge at any given level of output. ____ ____ shift the Phillips curve. Changes in costs shift producers' supply curves, an unexpected change in production costs that shifts the Phillips curve is called a ____ ____. The Phillips curve shifts in response to changes in: input prices, productivity, and exchange rates. ____ ____ can lead to higher inflation, even when output has declined. If you see higher unexpected inflation and lower output, you can infer that there has been a _____ _____.

cost-push inflation

Businesses raise their prices when their marginal costs rise. Widespread price increases create inflation and this is an example of ______ ______. It is inflation that results from an unexpected rise in production costs. It leads to more inflation at any given level of the output gap, and for any given level of inflation expectations. It causes the Phillips curve to shift. Any factor that leads to an unexpected rise in production costs will cause the Phillips curve to shift upward. It is an inflationary force and it reflects the influence of unexpected changes in production costs.

insufficient demand

When the quantity demanded at the prevailing price is below what's supplied therefore, you cut your prices. Lower prices help return to profitability b/c the marginal cost of serving extra is particularly low as there are barely enough customers to stay busy. In a weak economy, millions of businesses face ____ ____. Respond to ____ ____ with price restraint, either raising their prices by a bit less than they otherwise would or in some cases cutting them. _____ ____ leads inflation to fall below expected inflation. High unemployment rate corresponds with a negative output gap (where output is below potential, and so insufficient demand is a problem)

labor market Phillips curve

a Phillips curve linking unexpected inflation to the unemployment rate. It shows that higher unemployment leads to lower unexpected inflation, and lower unemployment leads to high unexpected inflation. that higher It summarizes the exact same ideas as the Phillips curve, but it relies on a different measure of excess demand, but the curves slope in different directions, it arises only because excess demand corresponds with a high level of GDP relative to potential output, but a low unemployment rate. Both versions of the Phillips curve suggest that excess demand leads to higher inflation.

inflation expectations

the rate at which average prices are anticipated to rise next year. EX) Outbacks top managers expect inflation to be 2% next year, then they'll probably follow suit and raise next year's prices by 2% to keep up. Price of their key inputs-beef, energy, rent-will also rise by 2%. Only way for Outback to maintain its profit margin will be to raise prices in line with this rate of expected inflation. When other managers across the economy make similar calculations they'll make similar choices, each raising their prices in line with their inflation expectations. Result, inflation expectations create inflation. They describe the rate at which you expect prices to rise, on average, across the whole economy over the next year. Raising your prices by the same percentage that you expect your competitors to raise their prices will maintain your competitive positioning. Raise your prices for next year because you expect other businesses-both your suppliers and competitors-to raise their prices. Inflation expectations create a self-fulfulling prophecy (high inflation expectations --> high inflation, low inflation expectations --> low inflation). Monetary policy tries to shape inflation. They neither shift the phillips curve nor cause a movement along it, but they still play an important role in driving inflation.