Inflation: Is it supply or demand?
As is so often the case in macroeconomics, the title of this post isn’t even a question. Terms like ‘supply’ and ‘demand’ are not clearly enough defined to make this a meaningful question. Whatever answer you provide is defensible, depending on how one defines terms.
Let’s consider a few plausible possibilities.
1. Total aggregate demand (NGDP) has been rising at a rate of just under 4% over the past 7 quarters. This is close to trend. Thus there has been no unusual demand shock by this metric.
2. But the Fed doesn’t target NGDP; it targets inflation. Inflation has somewhat exceeded the Fed’s 2% target over the past few years. Thus policy was too expansionary by this metric. Therefore the problem is excessively expansionary monetary policy, i.e., too much demand.
3. But the Fed doesn’t just target inflation; it has a dual mandate that includes employment. Employment is still somewhat depressed. Indeed NGDP is one plausible way of think about the dual mandate, as it includes both inflation and real growth. And as we saw in point #1, by that metric demand is right on target.
The question of whether there is too much supply or too much demand depends in part on what sort of benchmark you use. What is a “normal” or “appropriate” increase in aggregate demand? Opinions will differ.
Even worse, the terms ‘supply’ and ‘demand’ have ambiguous meanings that differ between macroeconomics and microeconomics. And even worse, many people (most?) don’t understand this distinction.
Ramesh Ponnuru has a tweet linking to an article that argues the inflation is due to supply issues. Someone responded to his tweet as follows:
This tweet raises an interesting point; how do we think about sectoral demand shifts that look like supply shocks at the aggregate level?
Readers of this blog know that I frequently point out that the AS/AD model has almost nothing to do with supply and demand as we use the terms in microeconomics. Thus consider a sudden drop in demand for services due to Covid. If the Fed does enough stimulus to keep total demand rising at 4%/year, then by necessity the demand for goods will soar well above trend to offset the decline in services.
The problem here is that it’s difficult to suddenly turn unemployed hotel workers into truck drivers delivering goods. Even harder to suddenly build more port capacity. At a macro level, the excess demand for physical goods looks like a negative supply shock, and indeed in a sense it is a negative shock to aggregate supply. For a given level of nominal spending, our economy is not capable of producing as much real output (goods and services) as before, at least relative to trend. Reallocation is difficult. That’s a negative aggregate supply shock at the macro level, and an excess demand for goods shock at the sectoral level.
In the end, the debate about whether this is “actually” a supply or demand shock is completely sterile. The terms are not well enough defined to offer a definitive answer. It’s not an interesting question. What is an interesting question is whether monetary policy is appropriate, too expansionary or too contractionary. I suppose that those who view the current problem as “supply” are mostly content with the recent monetary stimulus. Those who regard the inflation as due to “demand” mostly think Fed policy has been too expansionary. If so, then they should say that directly.
PS. Nick Rowe once said:
Some people argue about whether the macroeconomy is inherently stable or unstable. I don’t think that’s a very useful question. Because…..it depends. And one of the things it depends on is monetary policy. And that is a useful discussion to have, because we can actually do something about monetary policy.
After I wrote the final paragraph of this post I was reminded of this Nick Rowe comment, and looked it up. Now I feel that I almost plagiarized Nick. Sometimes other people influence our thinking without us even realizing it.