Chapter 19 - Notes

19.1 - Three Inflationary Forces

The Big Picture Formula:

Inflation = Inflation expectations + Demand-pull inflation + Cost-push inflation (supply shocks)

The Three Forces Explained

1. Inflation Expectations

• Inflation expectations: the rate at which average prices are anticipated to rise next year
• If managers expect 2% inflation next year, they'll raise their prices by ~2% to keep up (because their input costs — wages, rent, materials — will also rise ~2%)
• When millions of businesses all do this → inflation expectations create inflation
• It's self-fulfilling: if everyone expects 2% inflation and raises prices accordingly, you get 2% inflation

2. Demand-Pull Inflation

• Demand-pull inflation: arises when demand exceeds the economy's productive capacity, pulling prices up
• When actual output > potential output (positive output gap) → businesses can't keep up with demand → they raise prices → inflation rises
• When actual output < potential output (negative output gap) → businesses have excess capacity → they moderate price increases → inflation falls
• The relationship between the output gap and inflation is described by the Phillips curve (covered in detail later)

3. Cost-Push Inflation (Supply Shocks)

• Cost-push inflation: prices rise in response to an unexpected rise in production costs
• Caused by supply shocks — unexpected events that raise costs across many businesses
• Examples: shipping container shortages, port congestion, supply chain disruptions, floods knocking out freight lines, rising transportation costs, higher input prices
• COVID recovery example: ports clogged, containers misplaced, workers sick → costs rose across many sectors → businesses raised prices → inflation
• The interdependence principle is key here — a cost increase in one sector (transportation) ripples through many others

19.2 - Inflation Expectations

Why Inflation Expectations Matter

Two factors drive pricing decisions, and inflation expectations affect both:

1. Marginal costs: if you expect 2% inflation, your suppliers will likely raise their prices ~2% → your costs rise ~2% → you need to raise your prices ~2% to maintain profit margins
2. Competitors' prices: if you expect 2% inflation, your competitors will likely raise their prices ~2% → you should match to stay competitive

Result: if the average manager expects 2% inflation, they raise prices by 2% → millions of managers doing this → you GET 2% inflation

Inflation expectations are self-fulfilling:

• Expect 2% → raise prices 2% → 2% inflation happens
• Expect 6% → raise prices 6% → 6% inflation happens
• ANY inflation rate can become a long-run equilibrium through this mechanism

Vicious vs Virtuous Cycles

• Vicious cycle (high-inflation countries): expect high inflation → raise prices a lot → high inflation → expect high inflation → repeat
• Virtuous cycle (Canada, recent decades): expect low inflation → raise prices modestly → low inflation → expect low inflation → repeat
• Policy implication: the key to low inflation in the long run is convincing people inflation will be low — once they believe it, it becomes true
• This is why the Bank of Canada's credibility matters enormously

Three Ways to Measure Inflation Expectations

1. Surveys

• Ask people directly what they expect inflation to be
• Bank of Canada surveys ask about 1-year and 5-year expectations
• Short-term expectations (1 year) move around more; long-term expectations (5 years) are more stable
• In 2021, short-run expectations rose but 5-year expectations didn't budge → people expected inflation spike was temporary

2. Professional Economist Forecasts

• Survey professional forecasters for their inflation predictions
• More accurate than the general public
• The average of many economists beats any individual forecaster
• Government publishes the average forecast from private-sector banks in the federal budget

3. Financial Markets (Bond-Based)

• Compare yields on real-return bonds (adjust for inflation) vs regular nominal bonds
• The difference ≈ expected inflation
  • e.g., nominal bond yields 3.2%, real-return bond yields 1% → expected inflation ≈ 2.2%
• Reflects collective wisdom of sophisticated traders in real time
• Downside: real-return bond market is small → can be noisy

Four Types of Inflation Expectations

• Adaptive: expect recent inflation to continue (backward-looking)
• Anchored: believe the Bank of Canada will deliver on its ~2% target
• Rational: use all available data and deep macro understanding to form the most accurate forecast possible
• Sticky: people don't update their views frequently, so expectations change slowly

In reality, most people use some combination of all four

19.3 The Phillips Curve

Demand-Pull Inflation

• Excess demand (positive output gap): businesses can't keep up with demand → raise prices more than expected → inflation rises ABOVE inflation expectations
• Insufficient demand (negative output gap): businesses have excess capacity → show price restraint → inflation falls BELOW inflation expectations
• Demand matches capacity (output gap = 0): no demand-pull pressure → inflation EQUALS inflation expectations

The Phillips Curve

• Phillips curve: graphs the relationship between the output gap (horizontal axis) and unexpected inflation (vertical axis)
• Unexpected inflation = Actual inflation − Inflation expectations
  

Key Features:

• Upward-sloping: more positive output gap → more unexpected inflation
• Passes through the origin: when output gap = 0, unexpected inflation = 0 (inflation = expectations)
• When unexpected inflation is positive → actual inflation is above expectations
• When unexpected inflation is negative → actual inflation is below expectations (doesn't mean prices are falling, just rising slower than expected)

How to Use the Phillips Curve to Forecast Inflation (Two Steps)

1. Assess inflation expectations (from surveys, economist forecasts, or bond market data)
2. Use the Phillips curve to forecast unexpected inflation: find your output gap on the horizontal axis → read up to the curve → read across to find unexpected inflation

Inflation forecast = Inflation expectations + Unexpected inflation (from Phillips curve)

• e.g., inflation expectations = 2%, output gap = +5%, Phillips curve says unexpected inflation = 1% → forecast inflation = 2% + 1% = 3%

The Labour Market Phillips Curve (Alternative Version)

• Instead of the output gap on the horizontal axis, uses the unemployment rate
• An inverse relationship between unemployment and unexpected inflation.
• Same ideas, just a different measure of excess demand
• Downward-sloping (opposite direction from the regular Phillips curve) — but this is purely cosmetic:
  • Excess demand = high output gap = LOW unemployment → both versions say inflation rises
  • Insufficient demand = negative output gap = HIGH unemployment → both versions say inflation falls
• Connected by Okun's rule: high unemployment ↔ negative output gap, low unemployment ↔ positive output gap
  
  Equilibrium unemployment rate (also called "natural rate" or NAIRU):
• The unemployment rate where unexpected inflation = 0 (inflation is stable at expectations)
• Not zero — frictional and structural unemployment still exist (Chapter 11)
• Economists debate the exact number but it's roughly between 3% and 6%
• Unemployment below this → inflation creeps up
• Unemployment above this → inflation falls

19.4 - Supply Shocks Shift the Phillips Curve

Cost-Push Inflation (Inflation Force #3)

• Cost-push inflation: an unexpected rise in production costs pushes sellers to raise prices
• This is a SEPARATE force from inflation expectations and demand-pull — it causes higher inflation at ANY given output gap
• Rising production costs → Phillips curve shifts UP
• Falling production costs → Phillips curve shifts DOWN

Three Types of Supply Shocks

1. Input Prices

• Rising input prices → higher marginal costs → businesses raise prices → Phillips curve shifts UP
• Oil prices are the most important — oil is used for electricity, gasoline, diesel, plastic, heating, transportation → ripple effects throughout the entire economy
  • 1973 oil embargo: oil price quadrupled → US inflation shot from 6% to 12%
• Commodity prices (especially agricultural) — severe weather disrupts harvests → feed prices rise → meat prices rise → cost-push inflation rises
• Wages — rising wages raise marginal costs → businesses raise prices
  • Wage-price spiral: workers demand higher wages because of inflation → businesses raise prices because of higher wages → workers demand even higher wages → and so on
  • This is dangerous because it can make a temporary inflation shock persistent — inflation keeps going long after the original cause is gone
  • Dollarama example: executives warned higher wages would eventually be passed on to customers

2. Productivity

• Faster-than-expected productivity growth → need fewer inputs per unit of output → lower marginal costs → Phillips curve shifts DOWN (good news for inflation)
• Slower-than-expected productivity growth → costs rise → Phillips curve shifts UP
• 1970s example: productivity growth slowed but wages kept rising fast → costs rose → cost-push inflation

3. Exchange Rates

• Canadian dollar depreciates → Phillips curve shifts UP
  • Direct effect: imported goods cost more in C$ → higher prices
  • Indirect effects (three channels):
    1. Businesses using imported inputs face higher costs → raise prices
    2. Businesses competing with imports face less competitive pressure (foreign rivals now more expensive) → raise prices
    3. Exporters find foreign customers willing to pay more (in C$) → may raise domestic prices too
• Canadian dollar appreciates → Phillips curve shifts DOWN (all the above in reverse)

Movements Along vs Shifts of the Phillips Curve

Where Do Inflation Expectations Fit?

• Inflation expectations neither shift the Phillips curve nor cause movement along it
• They determine the baseline level of inflation
• Total inflation = expected inflation + unexpected inflation (from Phillips curve)
• Phillips curve explains short-run deviations from expectations
• Inflation expectations explain the long-run level of inflation

How to Diagnose What's Happening

• Output gap and inflation move in the same direction → demand shock (movement along Phillips curve)
• Inflation rises while output falls (double whammy) → supply shock (Phillips curve shifted up)
• Inflation rises in line with inflation expectations → expectations have shifted

Questions

1. The labour market Phills curve shows:'
   an inverse relationship between unemployment and the output gap.