Figure 4.13: A Comparison of Inflation Over Three Years at Different Unemployment Levels

Inflation Dynamics in a Booming Economy

In a given year, an economy's central bank and most private forecasters anticipated an inflation rate of 3%. However, the actual measured inflation for that year turned out to be 5%. Assuming that the forecasted rate was the basis for wage and price setting, what is the most likely explanation for the difference between the expected and actual inflation rates?

Suppose that in a particular year, the inflation rate that both workers and firms anticipate is 3%. However, due to weak labor market conditions, there is a downward pressure on wages and prices equivalent to 1%. Under these circumstances, the actual inflation rate will be ___%.

The Two Components of Inflation