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The Dominant Role of Expectations and Broad-Based Supply Shocks in Driving Inflation

Author

Listed:
  • Beaudry, Paul
  • Hou, Chenyu
  • Portier, Franck
Abstract
The object of this paper is to assess the role of supply shocks, labour market tightness and expectation formation in explaining bouts of inflation. We begin by showing that a quasi-flat Phillips curve, which was popular prior to the pandemic, still fits the post-2020 US data well and that changes in short term inflation expectations induced by supply shocks likely played a major role in the recent inflation episode. We then document features of the joint dynamics of inflation and inflation expectations. Given the difficulty of reproducing these dynamics under rational expectations, we propose and evaluate a model with imperfect information and bounded rationality. In our model, agents see sectoral inflations as being driven by a component common to all the sectors of the economy and by sector-specific shocks. When supply shocks affect many sectors (what we refer to as a broad-based supply shock), agents infer that the common component of inflation has increased, which drive persistent inflation dynamics through their effect of expectations. We show that departure from full rationality is minor, but that it is enough for broad-based supply shocks to be amplified and propagated over time in a manner needed to explain the data.

Suggested Citation

  • Beaudry, Paul & Hou, Chenyu & Portier, Franck, 2024. "The Dominant Role of Expectations and Broad-Based Supply Shocks in Driving Inflation," CEPR Discussion Papers 18963, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:18963
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    References listed on IDEAS

    as
    1. Xavier Gabaix, 2014. "A Sparsity-Based Model of Bounded Rationality," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 129(4), pages 1661-1710.
    2. Jonathon Hazell & Juan Herreño & Emi Nakamura & Jón Steinsson, 2022. "The Slope of the Phillips Curve: Evidence from U.S. States," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 137(3), pages 1299-1344.
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    More about this item

    Keywords

    Inflation; Phillips curve; Supply shocks; Inflation expectations;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • E7 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics

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