[MUSIC] In this module, I want to introduce two key concepts that will help us come to better understand how inflation can sometimes spiral upward and sometimes spin out of control. The first key concept is that of the core rate of inflation, also called the inertial rate of inflation. And the key point here is that most economists believe that a core rate of inflation exists in any economy. And this core rate, or inertial rate of inflation, tends to persist at the same rate over time. At least, until some kind of demand or supply side shock comes along to change things. As for our second key concept, that would be inflationary expectation. In this key definition, inflationary expectations represent expectations consumers and businesses have about the future trajectory of inflation. Will the price level be rising or falling, and if so, by how much? [SOUND] The reason inflationary expectations are important is that they play a critical role in how labor and management interests determine wage levels in the collective bargaining process. And such inflationary expectations can also strongly influence the savings and spending pattern of consumers. In these ways, inflationary expectations can contribute to actual inflation. [SOUND] Let me show you what I mean with an example from the collective bargaining process using a behavioral model known as adaptive expectation. [MUSIC] In general, economists use two forms of expectations in their models and theories, adaptive expectations and rational expectations. [SOUND] With adaptive expectations, people are assumed to use past information as the best predictor of future events. Thus, if inflation was 3% last year, people are likely to assume it'll be 3% next year, that's adaptive expectation. In contrast with rational expectation, people use all available information to predict future events. Thus while inflation may have been 3% last year, people see more inflation coming, in the form of an oil price shock or more deficit spending by the government. They may rationally assume a higher rate than 3%, that’s rational expectation. [SOUND] Now let me show you how inflationary expectations can help determine the actual rate of inflation under the assumption of adaptive expectation. Note that I will come back to a more detailed discussion of rational expectations later in this lesson. [MUSIC] Suppose now that you are the chief negotiator for the Auto Workers Union in Germany. Suppose further that you believe your workers will achieve a 1% increase in productivity annually. Now, because increases in real wages are tied to labor productivity, also believe the auto workers your union represents deserve at least 1% increase in the real inflation adjusted wages. Assuming you have adaptive expectation, last year's inflation rate was 3%. What is the percentage increase in nominal inflation adjustment wages that you will demand at the bargaining table? Let's take a minute to jot down your answer before moving on. [MUSIC] So if labor productivity is rising at 1% and you expect inflation to keep rising at 3%, we will of course as chief negotiator for your union ask for at least a 4% increase in nominal wages for your workers. This constitutes a 1% increase to get the real increase based on productivity gains. And an additional 3% to adjust for the expected or forecast inflation adjustment under adaptive expectation. But look what happens now if automaker negotiators agree to this 4% rates demand. This agreement then becomes the industry standard for the rest of Europe. This increase in wages caused by your unions and inflationary expectations will lead to an actual increase in the auto industry's labor cost across the continent of Europe. This in turn will put upward pressure on business executives in the auto industry to raise auto prices. And in this way, the expectation of inflation becomes a self fulfilling prophecy. Now, here's a key point, in this example, and because of the power of inflationary expectations, the core rate of inflation has been maintained. This figure illustrates how adaptive expectations do indeed lead to a core or inertial inflation rate. In the figure, the price level is on the vertical axis, real output is on the horizontal axis. And we start off at point E where the aggregate supply and demand curves cross at potential output Q superscript P. At this point the core rate of inflation is 3%. Now, because of their adaptive expectations, everyone expects average cost and prices to rise at least 3% this year, because that's what it did last year. So workers demand and receive higher nominal wages. This pushes up the aggregate supply curve, even as their increased spending pushes up the aggregate demand curve. And over time the aggregate supply and demand curves continue to rise by 3% a year as macro-economic equilibrium moves from E to E prime and then to E double prime. You can see in this case, the core or initial rate of inflation is indeed maintained. Now the next questions we must address in our next module are these what might cause the core or initial rate to change? More importantly, how might inflation might start to spiral out of control such as it has at times in the past? When you're ready, let's move on to a discussion of inflationary spirals, a really interesting and quite controversial macroeconomic tool known as the Phillip's Curve. [MUSIC]
