Draw a graph to illustrate and explain how “growing inflation expectations may become self-fulfilling.”
It’s important to differentiate between a general increase in prices—a situation in which aggregate demand exceeds their aggregate supply—and a relative price shock. For example, a specific shock to energy prices can become generalized if producers are able to pass on the higher costs. So far, global competition has made that difficult for companies, while higher input costs have largely been neutralized by rising labour productivity. Since 2003, core inflation has averaged less than 2 percent a year in the 30 major economies. History also suggests the U.S. Federal Reserve’s gamble that slowing growth will shackle core inflation is a winning wager. The risk is that if U.S. consumers don’t believe price increases will slow, growing inflation expectations may become self-fulfilling.