Chapter 19

1. Three Inflationary Forces

The Phillips
2. Inflation Expectations
Curve and
Inflation 3. The Phillips Curve

4. Supply Shocks Shift the Phillips

Curve

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Chapter 19
Identify the three 1. Three Inflationary Forces
causes of inflation:
 Inflation expectations 2. Inflation Expectations
 Demand-pull inflation 3. The Phillips Curve
 Supply shocks
4. Supply Shocks Shift the Phillips
Curve

Macmillan Learning, ©2023

 The Bloomin’ Onion
and Inflation
Battered, deep-fried, and cut to
resemble a flower, this softball-
ball sized onion is a signature
dish at Outback Steakhouse.

Price over time:

 1993: $4.95
 2008: $6.99
 2022: $9.49
The Bloomin’ Onion reflects the
macroeconomic trend of rising prices
known as inflation!

Our Task: Understand what drives

inflation, and how it responds to
economic conditions.
3 Hofacker/Shutterstock
Brent Macmillan Learning, ©2023
 Three inflationary forces

Introduce the three causes of inflation, and then dig

deeper in the following sections:

1. Inflation expectations

2. Demand-pull inflation (the Phillips curve)

3. Supply shocks and cost-push inflation

4 Macmillan Learning, ©2023

 Previewing Inflationary Force 1: Inflation
expectations

Inflation expectations: the rate at which average prices are

anticipated to rise next year.

Outback Steakhouse example: If they expect inflation to be 2%

next year, then it’s likely the prices of their key inputs will also rise by
2% (beef, energy, rent, etc.).
 Thus, they’ll raise next year’s prices by 2% to keep up.
 Result: Inflation expectations create inflation!

“the performance of our restaurant depends on our ability to

anticipate and react to the changes in the price…of food.” -
5 Outback Steakhouse annual report Macmillan Learning, ©2023
 Previewing Inflationary Force 2: Demand-Pull
Inflation

Demand-pull inflation: inflation resulting from excess demand.

 When demand outstrips a business’ productive capacity, it raises
prices.

Outback Steakhouse example: When business is booming, it can

take over an hour to get a table.
 Long run: Managers consider opening new restaurants.
 Short run: Can’t increase supply of meals, so raise prices instead.

Scaling up: When demand exceeds the economy’s productive

capacity, prices rise.
 Widespread price increases create demand-pull inflation.
6 Macmillan Learning, ©2023
 Previewing Inflationary Force 3: Supply shocks and cost-push
inflation

RECALL the interdependence principle which emphasizes the

linkages between markets.
Ripple effect of Russia’s invasion of Ukraine:
 Reduction in oil supply pushed up oil prices.
 Gasoline, heating oil, and propane all became more expensive.
 Costs of production for many businesses rose.
 Businesses raised their prices to keep up.

Cost-push inflation: inflation that results from an unexpected rise in

production costs.
7
 Original catalyst was a supply shock. Macmillan Learning, ©2023
 Understanding the three inflationary forces

Putting all the pieces together:

Inflation = Expected inflation + Demand-pull inflation +

Cost-push inflation

↑ Inflation expectations  ↑ Inflation ↑ Production costs  ↑ Inflation

↑ Output gap  ↑ Inflation

8 Macmillan Learning, ©2023

Chapter 19
Explore how inflation
expectations lead to 1. Three Inflationary Forces
inflation:
2. Inflation Expectations
 Why inflation
expectations matter 3. The Phillips Curve
 Measuring inflation
4. Supply Shocks Shift the Phillips
expectations
Curve

Macmillan Learning, ©2023

 You set your prices to take account of inflation
expectations

Two key factors for setting prices:

1. Your marginal costs
 As a manager, if your suppliers raise their prices, then you’ll have to
charge higher prices to make up for the higher marginal costs you
expect to pay.
2. Your competitor’s prices
 Your competitors are also facing rising input costs, so they’ll likely
raise prices as well. Thus, you can raise your prices alongside them
and remain competitive!

Summary: You should raise your prices for next year because you expect
other businesses (both your suppliers and competitors) to raise their prices.
10 Macmillan Learning, ©2023
 Self-fulfilling prophecy: inflation expectations
create inflation
Widespread expectation of any particular inflation rate is
enough to push suppliers to raise their prices so that they’ll create
that inflation!

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

If people expect low inflation, they’ll get low inflation.

11 Macmillan Learning, ©2023

 Key take-aways: Inflation expectations lead to actual
inflation

12 Macmillan Learning, ©2023

 Inflation rates vary across countries
High-inflation countries
are stuck in a vicious
cycle.
Low-inflation countries
enjoy a virtuous cycle.

Monetary policy tries to shape inflation expectations.

Policymakers’ goal:
 Convince people that future inflation is going to be
low, even when businesses are experiencing a
temporary rise in inflation.

13 Macmillan Learning, ©2023

 Three ways to track inflation expectations

Survey a representative group of people

Survey about their inflation expectations.
s  University of Michigan survey

Economi Ongoing survey of professional

sts’ economists regarding their inflation
Forecast forecasts.
s
Financi The 10-year break-even rate suggests what
al investors expect inflation to be over the next 10
years.
Markets
14 Macmillan Learning, ©2023
 University of Michigan Inflation Expectation

15 Macmillan Learning, ©2023

 Inflation forecasts reveal the inflation expectations
of economists

16 Macmillan Learning, ©2023

 Analyzing financial markets to measure inflation
expectations

17 Macmillan Learning, ©2023

 Key take-aways: Inflation expectations

Inflation = Expected inflation + Demand-pull inflation +

Cost-push inflation

Cause #1. Inflation expectations

 the rate at which you expect prices to rise, on average,
across the whole economy over the next year.
 ↑inflation expectations  ↑inflation.
 Monetary policy tries to shape inflation expectations.

Ways to track inflation expectations:

 surveys, economists’ forecasts, financial markets

18 Macmillan Learning, ©2023

Chapter 19
Analyze the link between
the output gap and 1. Three Inflationary Forces
inflation:
 Demand-pull inflation 2. Inflation Expectations
 The Phillips curve
3. The Phillips Curve
framework
 U.S. Phillips curve 4. Supply Shocks Shift the Phillips
 Labor market Phillips Curve
curve

Macmillan Learning, ©2023

 Inflationary Force 2: Demand-Pull
Inflation (1 of 2)

Demand-pull inflation: when excess demand pulls

Excess
inflation up, so that it rises above expected inflation.
demand
 Excess demand: when the quantity demanded at
the prevailing price exceeds the quantity supplied.
Expected
inflation
Demand-pull inflation can also pull inflation below
Insufficient
inflation expectations when demand is unexpectedly
demand
weak.
 Insufficient demand: when the quantity demanded
at the prevailing price is below what’s supplied.

20 Macmillan Learning, ©2023

 Inflationary Force 2: Demand-Pull
Inflation (2 of 2)

When demand matches the economy’s productive

Excess
capacity, there’s no demand-pull inflation.
demand
 Thus, inflation equals inflation expectations.
Expected
inflation
BIG PICTURE: Demand-pull inflation is the
imbalance between buyers’ demand for output Insufficient
versus the productive capacity of suppliers. demand
 Demand-pull inflation is driven by the output
gap!
 RECALL: Output gap measures actual output
relative to potential output.
21 Macmillan Learning, ©2023
 Two summary observations

Observation 1: Demand-pull inflation is driven by the output gap.

 When there’s a positive output gap (actual > potential), there’s excess
demand.
 When there’s a negative output gap (actual < potential), there’s
insufficient demand.

Observation 2: Demand-pull inflation leads inflation to diverge from inflation

expectations.
 It drives unexpected inflation!
 Unexpected inflation = Inflation − Inflation expectations

Let’s explore the link between the output gap and unexpected inflation!
22 Macmillan Learning, ©2023
 The Phillips Curve (1
of 3) Unexpec
ted Phillips
A When output exceeds potential output:inflation curve
 excess demand leads managers to A
raise prices more. 1% Inflation
 inflation rises above expected rises

inflation. When there’s B above

insufficient demand expected
0% inflation
B When output is equal to potential
Inflation
output: When there’s
falls below excess demand
 absence of demand-pull inflation. expected
 inflation equals expected inflation. -1% inflation

C When output is less than potential

C
output:
 insufficient demand leads to price - 5% 0% 5%
restraint.
 inflation falls below expected Output gap
inflation. (Output relative to potential
23 Macmillanoutput)
Learning, ©2023
 The Phillips Curve (2 of 3)

Graphing convention:
 Quantities go on the horizontal
axis.
Inflation
 Prices go on the vertical axis.
rises more
Phillips curve tips:
 Extend both axes into negative
When output
is higher territory.
relative to  Zero should be in the middle.
potential

The Phillips curve is upward-

sloping:
 Higher output relative to
potential leads to greater
24 inflationary pressure. Macmillan Learning, ©2023
 The Phillips Curve (3 of
3)
The Phillips curve predicts how far
inflation will diverge from expected
inflation.
If unexpected inflation is…
 Zero: actual inflation equals
expected inflation.
 Negative: actual inflation will be
less than expected inflation.
 It does NOT mean actual
inflation is negative.
 Positive: actual inflation will be
greater than expected
inflation.
25 Macmillan Learning, ©2023
 How Uber is like the Phillips

Hadrian/Shutterstock
curve
A concert ends late on a rainy Saturday
night, and you pull out your phone to book
an Uber ride home, just like hundreds of
other concert attendees.
 A ride that normally costs $10 now costs
$30!

There are more people looking for a ride

home than available Uber drivers.
 There’s excess demand!

Uber’s surge-pricing algorithm is like a

turbo-charged Phillips curve.
 Respond to excess demand by raising
prices immediately.
26 Macmillan Learning, ©2023
 The Phillips curve for the United States

27 Macmillan Learning, ©2023

 Using the Phillips curve to forecast inflation

Step 1: Assess inflation

expectations
 Analyze surveys of inflation
expectations, surveys of
economists, or financial-based
measures.

Step 2: Forecast unexpected

inflation
 Start with your output gap
estimate.
 Look up and across the Phillips
curve to get your forecast of
unexpected inflation.
28 Macmillan Learning, ©2023
 Concept check: Using the Phillips Curve

Scenario: You’re going to negotiate

your salary for next year. You expect
GDP to be 5% below potential
output. Inflation expectations are
currently 5%.
Question: Using the Phillips curve
provided, how much of a pay raise
will you need to be able to buy the
same stuff you currently buy?

Solution: Inflation = expected inflation + unexpected inflation

 Inflation = 5% - 1% = 4%, so you’ll need a 4% raise in salary.

29 Macmillan Learning, ©2023

 Historically, the Phillips curve was
An alternative illustration: drawn a little differently:
The labor market Phillips curve
 The unemployment rate was
used to represent unused
resources.
• High unemployment = below
potential = low unexpected
inflation
• Low unemployment = above
potential = high unexpected
inflation
• equilibrium unemployment rate =
at potential = zero unexpected
inflation

Same take-away: excess demand

(i.e., low unemployment) drives
demand-pull inflation.
30 Macmillan Learning, ©2023
 Key take-aways: The Phillips curve

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

inflation
Cause #2. Demand-pull inflation
 The output gap drives inflation to rise above or fall below inflation
expectations.
 ↑Output gap  ↑Inflation (relative to expected inflation)

Demand-pull inflation creates a link between the output gap and

unexpected inflation.
 The Phillips curve graphically depicts this link.
 Excess demand  inflation rises above expected inflation
 Insufficient demand  inflation falls below expected inflation

31 Macmillan Learning, ©2023

Chapter 19
Analyze how shocks to
production costs shift the 1. Three Inflationary Forces
Phillips curve:
 Shifter 1: Input prices 2. Inflation Expectations
 Shifter 2: Productivity 3. The Phillips Curve
 Shifter 3: Exchange
rates 4. Supply Shocks Shift the Phillips
Curve
 Shift versus movement

Macmillan Learning, ©2023

 Inflationary Force 3: Supply shocks and cost-push
inflation

Cost-push inflation: when an Unexpected inflation

New
unexpected boost to production Phillips
costs pushes sellers to raise their 1%
curve
prices.
 Raise prices above and beyond Old
existing inflation expectations and 0% Phillips
demand-pull pressures. curve

 ↑ production costs  ↑inflation (at

-1%
any given level of the output gap)
Take-away: any factor that leads to - 5% 0% 5%
an unexpected rise in production
Output gap
costs will cause the Phillips curve to (Output relative to potential
33 shift upward. Macmillanoutput)
Learning, ©2023
 Supply shocks that shift the Phillips curve

Supply shocks: Any change in production costs that leads

suppliers to change the prices they charge at any given level of
output.
 Supply shocks shift the Phillips curve.

Three causes of supply shocks that shift the Phillips curve:

Focus on unexpected changes in costs
1. Input prices because anticipated rises/falls will have
2. Productivity already been factored into inflation
expectations.
3. Exchange rates

34 Macmillan Learning, ©2023

 Phillips curve shifter 1: Input prices

If the prices of your inputs rise…

 Your marginal costs rise
 You will raise your prices
 Boosts inflation at any
given level of the output
gap (shifts Phillips curve
up)

Same forces operate in reverse if

your input prices fall.

35 Macmillan Learning, ©2023

 Important input prices that can spark cost-push
inflation

Oil is a major input in many sectors

Oil and commodity of the economy and can act as a
prices key source of cost-push inflation.

Rising wages
Wages can amplify a temporary inflation
shock and make it persistent (oh no!).
 Wage-price spiral: a cycle where
higher prices lead to higher nominal
wages, which leads to higher prices.

36 Macmillan Learning, ©2023

 Phillips curve shifter 2: Productivity

Faster-than-expected
productivity growth lowers your
marginal costs.
 Greater price restraint at any
given output gap.
 Form of negative cost-push
inflation.
 Phillips curve shifts down.

Same forces operate in reverse if

your productivity growth is
weaker.
 Phillips curve shifts up.
37 Macmillan Learning, ©2023
 Phillips curve shifter 3: Exchange rates
When the nominal exchange rate
changes, there’s a direct and indirect
effect.
 We’ll look at both effects, but first,
let’s establish the big picture.
 Depreciating U.S. dollar shifts
the Phillips curve up.
 Appreciating U.S. dollar shifts
the Phillips curve down.
Recall: The exchange rate is the price
of a U.S. dollar.
 When the U.S. dollar depreciates, it
38 means the U.S. dollar becomes Macmillan Learning, ©2023
 Exchange rates: Digging into the details

Direct effect: When the U.S. Indirect effect: More expensive foreign
dollar depreciates, foreign goods lead to higher prices on domestic
goods.
goods are more expensive for
people in the United States.  U.S. businesses that use imported
inputs now have higher marginal
 It now takes more U.S. dollars costs, and thus, raise prices.
to pay for imported goods.  U.S. businesses that compete with
 Increases the price of foreign- imported products face less
made goods. competitive pressure and can raise
prices.
 Boosts inflation.  U.S. businesses that export their
products have foreign buyers who
are now willing to pay more, and may
also raise prices for U.S. customers.
39 Macmillan Learning, ©2023
Shifts versus movements along the Phillips curve (1 of 2)

Recall, the Phillips curve illustrates the link between the output gap
and unexpected inflation.
 Demand-pull inflation leads to movements along the Phillips
curve.

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 Shifts versus movements along the Phillips curve (2 of 2)

Cost-push inflation leads to a shift in the Phillips curve.

 Any factor that changes producers’ pricing decisions for a given
output gap leads to a shift.

41 Macmillan Learning, ©2023

 Inflation expectations: short-run versus long-run

Phillips curve focuses on the short run, when inflation deviates from
inflation expectations.
 Thus, inflation expectations neither shift nor cause a movement along
the Phillips curve.
 Instead, inflation expectations are a key long-run factor in
determining overall inflation at any given level of the output gap for
any given set of input costs.

42 Macmillan Learning, ©2023

 Key take-aways: Supply shocks shift the Phillips curve

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

push inflation
Cause #3. Cost-push inflation
An unexpected rise in production costs will cause higher
inflation.
 ↑Production costs ↑Inflation
 Shifts the Phillips curve
 Three shifters:
1. Input prices
2. Productivity
3. Exchange rates

43 Macmillan Learning, ©2023

Chapter 19
1. Inflation = expected 1. Three Inflationary Forces
inflation + demand-
pull inflation + cost- 2. Inflation Expectations
push inflation
3. The Phillips Curve
2. ↑Inflation
expectation  4. Supply Shocks Shift the Phillips
↑inflation Curve
3. ↑Output gap 
↑inflation
4. ↑Production costs 
↑inflation Macmillan Learning, ©2023