Inflation and the Phillips Curve

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Hi, my name is Samir Benoir and I am the
owner of Milk, a coffee restorers here in Sacramento, California
that sells everything from cappuccinos to macha to coffee bags
on the shelf. Right now, we're thinking about raising our
prices and giving our staff raises to help them with
the rising cost of living, specifically in Sacramento due to
a lot of influx from the Bay Area and rent
costs rising and general food costs rising.
We talked with our friend Samir during our microeconomics season
about how he sets prices. It's a big issue for
his business and it's never far from his mind.
We're constantly thinking about price.
It's also a big deal for the economy because if
a lot of businesses raise their prices at the same time,
then we'll get inflation.
So today we're going to ship from thinking about the
microeconomics of how managers and business owners set prices to
focusing on the big picture of how the state of
the macroeconomy shapes pricing decisions and how the choices of
millions of business owners like Samir determine the economy wide
inflation rate. The link between inflation and the state of
the economy is our topic on this episode of Think
Like an Economist with Me Betsy Stevenson.
And I'm Justin Wolfers. We're teaching you the supertools of economics,
tip you make better decisions whether price is arising quickly
or not much at all. Journalists and former economic student
Nestra and Tabercoli fires with us.
Business owners like Samir have to think about a lot
of factors when they're deciding if they should raise their
prices and by how much. They need to consider the
wages they have to pay their workers.
Currently, we're looking at raising our prices in part due
to the raising minimum wage. We try to stay ahead
of the minimum wage.
They consider the price of their are other inputs.
The price of coffee beans has gone up mostly due
to shipping and kind of ports being closed due to COVID.
And they need to keep an eye on their competitives
and what they expect them to do.
We look at kind of everyone else's prices to make
sure that we're not like three dollars above.
They also need to factory in just how much of
their product people want to buy and how much that
demand compares to their capacity constraints.
There's a lot going on here. Business People review their
prices all the time, and they need to factor in
a whole host of things when deciding how much to charge,
say for a cup of coffee.
Yes, smiffled me on on how he prices his drinks.
A latte at our coffee shop is five point fifty.
The way we get to that price, there's kind of
a mixture of things. First, we look at the inputs
such as the actual coffee, the milk that goes into it,
the cup, the lid, the labor, all the way down
to electricity bills and things like that. We create a
little bit of a chart that takes all of those
inputs and breaks them down over a monthly number.
So right now Samir's reviewing his prices to see how
much he should raise the price of a latte. When
he's thinking about raising his prices and other businesses are
doing the same thing, that's going to affect inflation overall.
There's three factors to consider here.
The first one is expectations about inflation, So how much
you actually think prices are going to be changing, and
I mean prices for all goods across the economy and
for wages.
Two, the next factor influencing inflation has to do with
excess demand. So this is about price rises based on
how much of your product people will want. We economists
call this demand pull inflation.
The final factor that really impacts inflation has to do
is supply sharks. This is anything that happens to change
the cost of your inputs. We also call this supply
push inflation.
We're going to speak to Samir, and go through each
of these factors that drive inflation. Next.
The first five so that drives inflation is expectations about inflation.
What's all this about.
Let's say you own a business and inflation's two percent
a year, So prices across the whole economy are rising
on average two percent per year. And let's say inflation
has been close to two percent for the past couple
of years. It's a good bit. You'll expect inflation to
be about two percent this year as well.
That means that on average, you expect most prices to
rise by two percent. That includes the cost of food, wages, rent,
and the electricity used to heat and light your sharp
and so on. All those prices are likely to rise
by about two percent on average.
So if you expect all of your cost to rise
by two percent, then you're going to need to raise
your price by two percent just to maintain your profit margin.
Yeah, so submit to me a little more about how
expectations of higher prices are translating into expectations that his
costs will rise.
As for cost of living in Sacramento, we're seeing a
huge influx from the area. We're seeing like crazy housing prices.
People selling houses for one hundred dollars dollars over asking
in cash deals, and the market is hot here and
that's really going to have a really huge effect on
the rental market going forward, especially since a lot of
these houses that are being sold right now are being
sold as investment properties for rentals, and if they're being
sold at a higher cost, that means the mortgage is
a little bit higher, and that means that rentals are
going to go up, which is going to in turn
force us to charge more for a cup of coffee.
With a higher cost of living, we're going to have
to pay people more, and that is going to mean
our prices are going to go up. We're going to
see the cost of food when you go out. Is
this going to be a dollar to two dollars? Your
checks are going to be five to ten percent more
expensive when you go buy a meal at a restaurant.
Pricing also really matters for your competitive positioning compared to
your rivals.
That's right. If you want to maintain how competitive your
products are, ravels, you got to need to keep price
with them. You'll want to raise your prices by as
much or as little as you expect them to raise
their prices.
A latte at our coffee shop is five point fifty.
I think we have a bit of a unique situation
since we actually include the price of tip inside of
our drink. So with that, we kind of think of
us at being about fifty cents above everyone else. So
everyone's around four fifty to five dollars per latte right now,
and so we charge about fifty cents more. But I
do believe that everyone is going to be going into
the five to five point fifty to possibly even six
dollars range within the next year due to not only
inflation but also COVID. You know, a lot of people's
rents are going to start to become do a lot
of people's loans that they took out during this period
are going to start having to be paid. And I
think we're going to see kind of a jump in price.
Samir's keeping a close eye on how much everyone else
is charging, the more that if he expects their prices
to go up, the more he's going to be willing
to raise his prices.
And so once again we see that inflation expectations really
matter as you set your price. If you expect inflation
to be two percent. Then you also expect your competitors
likely to see their costs rising by two percent, and
so the same logic says that they'll raise their prices
by two percent. Look, if your competitors are raising their
prices by two percent, that's another reason to raise your
prices in lockstep within to keep up.
The point is, if you expect inflation to be two
percent on average, it's likely a good idea to raise
your prices by well two percent.
Now here's where it gets interesting. What if you expect
inflation to be three percent.
Then I expect my costs will rise by three percent
on average, and my competitors will likely also raise their
prices by three percent. So whether it's about maintaining my
profit margin or my competitive positioning, I should raise my
prices by three percent as well.
Yeah, it's sort of mind blowing. The simple fact that
businesses expect prices to rise by three percent can be
enough that each of them will end up raising their
prices by three percent.
This is why inflation expectations are so important. They're like
a self fulfilling prophecy. If everyone expects inflation of ten percent, well,
your best response will be to raise your prices by
ten percent, which if everyone does, that causes inflation to
be well ten percent.
So you're saying that inflation occurs because people expect inflation
to occur.
That's right. Inflation expectations cause inflation.
That's why economists emphasize it. Inflation expectations are the key
long run driver of inflation. Whatever rate of inflation people expect,
whether it's two percent or three percent or ten percent,
that rate ends up occurring at least on average.
If you expect prices are going up five percent next year,
just think about what you want to have happened to
your salary. Now, imagine like every business is doing that
thinking about their prices. Sometimes I think people get really
confused when they think about the role of expectation, but
it's actually really intuitive. If you expect prices going up
like that, you're going to start planning for it.
Now. Onto our second factor that drives inflation, that's greater demand,
which can also lead to price rises.
That's right. The starting point here is that if the
economy is doing well well, of course that's good news
for businesses who see more people wanting to spend money
on their products. But if they can't produce more stuff,
then maybe price rises are on the horizon.
Right now, samirra seeing more people coming in to Milk
A Coffee.
Roasters compared to two or three months ago. Demand is
definitely up, I would say about thirty percent, and I
think that's mostly due to the fact that we started
the year with the stay at home order and that
the weather is a lot nicer, and people are feeling
a little bit more confident in the fact that we're
going to have possibly an end to this by the
end of the summer. So people are kind of just
getting out and trying to get back into their normal routines,
trying to find normalcy in their day, which coffee is
like kind of one of those ritualistic things where normalcy
is kind of like, Hey, I'm going to go get
my coffee from Milk every morning and that's going to
make me feel normal. So I think people are getting
back into those grooves again and that's kind of creating
a nice uptick in our sales.
Now. Samir's sales are growing a lot. Over time, he
may eventually start thinking about opening another shop or franchising
or expanding, but in reality that could take some time.
So the big question he faces is what should he
do right now?
It sounds like he ought to consider raising his prices.
After all, if he's got as many customers as he
can serve with the current equipment, there's not much point
in keeping his prices low. More people want his coffee,
can raise his profit march and still sell as much
coffee as he can produce.
What's interesting is that this extra demand for coffee is
due to some big changes going on in society and
the broader economy. In this case, life is going back
to normal after we're having more COVID vaccinations taking place,
and also just the fact that it's spring and people
are out and about more so. Both these factors mean
there's less huddling indoors and more going outside and picking
up a coffee while you're at it.
That's right, and it's not just Samir. It's likely the
improving economy means that other cafes and restaurants are also
seeing a lot of demand, and so they're also raising
their prices.
Yeah, and so the same macroeconomic forces that lead to
Meir to raise his prices will also lead to other
coffee shops and supermarkets and restaurants to also raise their prices.
So if everyone starts raising their prices at once, well
that's inflation.
And because this inflation is being driven by demand, we
call it demand pull inflation.
One important thing to note here is that whether we
have excess demand or insufficient demand is really all about
how much stuff people want to buy relative to our
potential to produce that stuff. That it's about the gap
between output and our potential output, which is called the
output gap.
So when our actual output is more than potential output,
that's likely to cause inflation.
That's right. And the more that output overshoots potential, the
higher our rate of inflation. Part of the problem is
that when we're producing a lot more than our sustainable levels, well,
bottlenecks are going to start to emerge, and it can
be costly to produce more. Those higher costs are going
to get passed on as prices rise. If you think
about Samir's business, he probably has to pay over time
if he wants to keep those workers working past forty
hours a week.
The way an economist thinks about this, the output gap
measures how much excess demand there is across the whole economy,
and so how much pressure there is to raise prices.
And if the output gap is negative, so actual output
is less than potential output, meaning that demand undershoots the
economy's potential, then there's more pressure to show restraint when
it comes to prices.
Absolutely, what we really need to stress is that demand
pull inflation happens on top of our expectations about the
inflation rate. So inflation due to excess demand actually leads
inflation to diverge from our expectations about the inflation rate.
One way of saying this is that demand pull inflation
leads to unexpected inflation, that's inflation over and above what
Samir had already expected.
And that big idea is summarized in a grap that
economists lovingly call the Phillips curve.
They named that I have to Bill Phillips, New Zealand economists.
It's just a curve that summarizes the idea that the
higher output is relative to the economy's potential, the more
excess demand they'll be, and so the more inflationary pressure
they'll be. And to be clear, I mean the more
inflation they'll be above and beyond the first factor we
talked about, which was our inflation expectations.
I actually just have to stop for a minute now
and just confess that I hate it when we name
curves after people. But Bill Phillips, the New Zealand economist,
is actually such a very cool character.
Oh wow.
Before he's work on inflation, he was a crocodile hunter
and a gold miner.
Oh wow, Phillips was also an engineer. When he was
a prisoner of war, he pieced together a radio that
he hid in a clog.
And if you ever feel like you're struggling with economics,
realize that Bill Phillips just passed his initial course by
one point. The problem apparently was that he wasn't allowed
to continue chain smoking during the exam.
This guy's a total character.
I just we have to Actually, he's the Crocodile Dundee
of economics, and he's the most famous inflation scholar in
a generation. And when asked about the work that led
to the Phillips curve, he called it a wet weekends
bit of work. And you know, we're still talking about it.
So I will let him have his due because it
gives me joy to think about him. So we will
talk about the Phillips curve. The Phillips curve shows the
relationship between the inflation rate and the output gap. So
the more output there is, or the less excess capacity
the economy has, the higher the rate of unexpected inflation.
The Phillips curve is really helpful because it helps us
to use the output gap to predict how far inflation
will rise above or fall below expected inflation. So we
can use the Phillips curve to forecast future inflation based
on our estimates of the output gap.
And the term the Phillips curve is actually often used
to describe just a broader set of ideas. It's that
when the economy has access demand, that all sorts of prices,
including wages which are the price of labor, will start
to rise. So some economists talk about a price Phillips
curve which is about inflation, but others will talk about
a way Phillips curve which describes growth and monetary wages
and its relationship to the output gap.
And while we've talked about the Phillips curve as being
about the output gap, other economists will measure the extent
of excess demand using other indicators like the unemployment rate
or capacity utilization. Instead, they're all different Phillips curves. But
they're all the same idea. When we produce more than
our potential, bottlenecks are going to emerge, creating inflationary pressure.
This is why you sometimes hear people talking about like,
will we start to see wages going up when you
know we're at really high levels of employment. They're just
basically describing the question of a Phillips.
Curve, same ideas, sometimes different economic variables.
We've looked at the first two factors that determine inflation,
these being expectations and excess demand. Now, whenever we talk
about demand, we end up also talking about supply. So
let's look the third and final force, which is how
supply side shocks cause inflation.
In order for Semir to sell coffee, he has to
buy all the inputs that go into making coffee, coffee
beans and cups and paying his workers. And one of
the things that we've heard from him is that the
supply conditions for those inputs have changed recently, and what
he's seeing is the price of a lot of the
things he buys to make coffee has gone up.
The price of coffee beans has gone up mostly due
to shipping and kind of ports being closed due to COVID.
I mean, especially in the specialty sector that we're in,
they've kind of risen almost a dollar a pound, if
not in some of the higher quality specialty stuff, two
to three dollars from where they would have been maybe
two years ago. Without COVID, we would have expected the
prices to rise, you know, twenty five cents, fifty cents,
but not not a dollar, two dollars or even three dollars.
More expensive coffee beans will mean that lattes will cost
more to make, not just at Milker, but at all
coffee shops, and so I bet this means that the
price of lattes will rise just about everywhere.
This is an example of a supply shark. A rise
of the price of coffee beans probably won't affect the
whole economy because most businesses don't use coffee beans as
an input.
I will say that our household lives on coffee beans, but.
We would get a much bigger shock if the thing
that changes is like the price of oil, the price
of steel, something that's a really important input into a
lot of things. You know, the price of oils and
input into powering and heating, just about every part of
the economy. From the electricity that powers Sever's expressive machines,
to the gas that power the trucks to deliver his
beans to him, to the plastic lids on his coffee cups.
That's why everyone from stock market analysts and traders to
policy makers follows the price of oil so closely. It's
a major input across the economy, and so higher oil
prices leads to huge ripple effects across the economy.
Arise in all prices will increase the cost of production
of nearly every business, and when that gets passed on
to consumers as higher prices, well, the result is inflation.
Oils are not the only important input. Think about labor
are the people who work for Samir. He talked about
having to raise wages because people are moving to Sacramento
and pushing up the prices for everything from rent to food,
and so as workers really need to be paid more.
And those higher wages are going to be higher costs,
leading him to charge higher prices.
And how about supply sharks that can reduce the cost
of production.
The main one is improvements in productivity. If Samir's buristas
can make more coffees per hour, or if he buys
equipment that helps his baristas make more coffee. Well, he'll
be making more cups of coffee while he's labour costs
haven't changed at all.
And the final factor we need to bring in when
we look at supply sharks and how the impact inflation
is exchange rates.
Yeah, submit imports as coffee beans from several different countries,
including places like Honduras and Costa Rica.
I wish he used coffee from Papu New Guinea, which
is where I was born. The currency there, the Quina,
really matters, and fluctuations in the Quina affect the price
of coffee.
So when the dollar appreciates against the Quina, imports are
going to be more expensive, therefore increasing the cost of
making a latte and generally more expensive foreign goods lead
to higher prices if you use imports as an input
for making your product.
And let me recommend coffees from the highland regions of
Papu New Guinea.
Okay, we've learned a lot. How can we summarize all
of this.
We've just gone through the three factors that determine inflation,
and in fact, these are the three factors that people
pay attention to to try to forecast what's going to
happen to prices in the economy. And these three factors
also give us a framework known as the Phillips curve
for trying to understand the relationship between prices and output
in the economy. So those three factors that determine inflation
are expectations. That's pretty simple. You get what you expect.
So if we expect two percent inflation, we're gonna get
two percent inflation. And then we also have demand pull inflation.
There's a lot of demand we can see prices getting
pulled up. There's also supply push inflation, which is if
the inputs into the things we buy, if they start
becoming much more expensive, it becomes more expensive to make things.
That is going to push prices up.
And justin other things we can think about over the
coming days. To really get to grips with these concepts.
Yeah, I want you to take in a moment of
annoyance and turn it into a moment of insight. None
of us like price rises. You're going to see them
over the next week. And next time you see a
price rise, I want you to think, is this price
rising just because everyone expects it to rise, or is
it rising because there's a lot of demand, and so
demand is pulling that price up. Or maybe the inputs
have become scarce and there have been supply disruptions, and
so those supply disruptions, the more expensive inputs are pushing
that price up.
Betsy justin, thanks for getting us to grips with inflation.
I hope I didn't inflate your expectations of what this
episode's going to deliver.
Thanks for listening.
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