Question

The indication is that inflationary expectations have become entrenched and strongly rooted in world markets. As a result, the risk of global stagflation has become significant. A drawn-out inflationary process always precedes stagflation. Following the attritional effect of inflation, the economy starts to grow below its potential. It experiences a persistent output gap, rising unemployment, and increasingly entrenched inflationary expectations. Evaluate the claim that if "inflationary expectations" become strongly "entrenched" an economy will experience "a persistent output gap."

Short answer

Entrenched inflationary expectations cause persistent inflation, reducing economic growth, leading to a persistent output gap.

Step-by-step solution

Understand Key Terms

Identify and understand the key terms used in the exercise: 'inflationary expectations,' 'entrenched,' 'persistent output gap,' and 'stagflation.' Inflationary expectations refer to the rate at which people expect prices to rise in the future. If these expectations become entrenched, it means they are deeply ingrained and unlikely to change. A persistent output gap occurs when an economy's actual output is less than its potential output over a long period.

Link Inflationary Expectations to Economic Outcomes

Consider how entrenched inflationary expectations impact economic performance. When people expect high inflation, they demand higher wages, and businesses pass these costs onto consumers, leading to price increases. This cycle continues and becomes difficult to break, leading to sustained periods of high inflation.

Examine the Impact on Economic Growth

Analyze how high inflation affects economic growth. Persistent inflation can lead to uncertainty, reducing investments and savings. High inflation also erodes purchasing power, reducing consumer spending. As a result, the economy grows below its potential, leading to a persistent output gap.

Understand Unemployment Trends

Recognize the relationship between stagflation, inflationary expectations, and unemployment. Typically, inflation is associated with lower unemployment (Phillips Curve). However, when inflation becomes entrenched without corresponding economic growth, unemployment can rise even as inflation remains high.

Evaluate Causal Relationships

Evaluate the claim by considering the cause-and-effect relationships in the economy. Entrenched inflationary expectations lead to high and persistent inflation, contributing to reduced economic growth and a sustained output gap. The drawn-out inflation process creates a negative feedback loop, further entrenching expectations and widening the output gap.

Key concepts

Inflationary Expectations

Inflationary expectations refer to the rate at which people expect prices to rise in the future. When consumers and businesses believe prices will continue to increase, they act in ways that can actually cause this to happen. For example, workers might demand higher wages to keep up with expected inflation. Meanwhile, businesses might raise prices preemptively to cover higher future costs.
When these expectations become entrenched, meaning they are deeply ingrained and hard to change, it creates a cycle of rising prices and wages. This can be difficult to break and leads to prolonged periods of high inflation.
The main issue with entrenched inflationary expectations is that they make it hard for policymakers to control inflation without causing significant harm to the economy. Even if the central bank raises interest rates to slow down the economy, expectations of inflation will keep pushing prices up.

Persistent Output Gap

A persistent output gap happens when an economy's actual output is consistently less than its potential output over a long period. This gap indicates that the economy is underperforming. It's not producing as many goods and services as it could with full employment and efficient use of resources.
Several factors can contribute to a persistent output gap. One is entrenched inflationary expectations, which can lead to reduced investment and consumer spending. High inflation creates uncertainty, making businesses hesitant to invest in new projects. At the same time, it reduces the purchasing power of consumers, leading them to cut back on spending.
The persistent output gap is a sign that the economy is stuck in a low-growth mode. Over time, this can lead to higher unemployment and lower income levels, further aggravating economic woes.

Economic Growth

Economic growth is the increase in the production of goods and services in an economy over a period of time. It is usually measured by the rise in Gross Domestic Product (GDP). For an economy to grow, it needs healthy levels of investment, consumer spending, and productivity.
High inflation and entrenched inflationary expectations can stall economic growth. When inflation is high, the cost of borrowing increases, which can discourage businesses from investing in new projects. Similarly, high prices can erode consumer purchasing power, reducing overall demand.
Without strong economic growth, an economy may experience a persistent output gap. This means it's not reaching its full potential, which can have long-term negative effects on livelihoods and living standards. In such a scenario, policymakers might face a difficult balancing act between controlling inflation and fostering growth.

Unemployment Trends

Unemployment trends refer to the patterns and changes in the rate of unemployment over time. Typically, there is an inverse relationship between inflation and unemployment, illustrated by the Phillips Curve. In the short-term, higher inflation is often associated with lower unemployment because businesses need more workers to meet increasing demand.
However, this relationship can break down in cases of stagflation, where high inflation and high unemployment occur simultaneously. When inflation becomes entrenched without corresponding economic growth, businesses may cut back on hiring, leading to higher unemployment.
Stagflation poses a significant challenge for policymakers because traditional tools like raising interest rates to control inflation can exacerbate unemployment. Similarly, efforts to reduce unemployment by stimulating the economy can further fuel inflation.

Phillips Curve

The Phillips Curve is an economic concept that illustrates the inverse relationship between inflation and unemployment. It suggests that with higher inflation, unemployment tends to be lower, and vice versa. This relationship works well in the short term.
However, when inflationary expectations become entrenched, the Phillips Curve may not hold true. During periods of stagflation, when high inflation and high unemployment occur together, the standard Phillips Curve relationship breaks down.
This breakdown happens because entrenched inflationary expectations cause prices to rise even when the economy is not growing. In such situations, policies aimed at controlling inflation can cause further unemployment, while efforts to reduce unemployment can lead to even more inflation. This makes managing the economy particularly challenging during times of stagflation.