Overview
One of the drivers of inflation is the expectation of inflation. That is, workers will demand higher pay raises if they expect prices to be rising, and companies will preemptively raise their prices to cover the higher costs that they expect to face. This means that inflation expectations can actually create inflation.
The Lucas Supply Function
The Lucas supply function hypothesizes that changes in output are driven by price level suprises.
{% y_t - y_t^* = \beta(p_t - \mathbb{E}[p_t|I_{t-1}]) + \epsilon_t %}
- {% y %} - the log of real output
- {% y^* %} - if the potential value
- {% p %} - the log of price level
- {% \mathbb{E}[p_t|I_{t-1}] %} - the expected price level given the information up to time t
(see Blinder chpt 6)
The Lucas supply function was important in introducing the concept of expectations into economic models. That is, expectations of economic variables can be just as important, if not more, to future economic outcomes as the actual values of variables.