In a previous post, I argued that more than 100% of inflation since late 2019 was demand driven. There was a negative supply shock around 2021-22 which led to a sharp drop in inflation, but there was also a large positive supply shock (mainly immigration) which tends to depress inflation. In context, cumulative inflation is the demand side
I take average GDP growth as a useful measure of supply demand. Because real GDP tends to increase by about 2%/year, on average, a 4% NGDP growth rate is a useful indicator of sound fiscal policy. Since late 2019, there has been an estimated 11% cumulative excess NGDP growth (ie, more than 4%), which can fully explain the approximately 9% cumulative excess PCE (more than 2%).
Most economists clearly do not see things this way. Most economists seem to be looking at higher inflation for 2020-24 due to a mix of supply and demand shocks. The San Francisco Fed’s latest working paper is Adam Hale Shapiro provides a breakdown of inflation on the supply and demand side this is broadly in line with estimates I have seen from a number of economists:
Note that both negative supply shocks and positive demand shocks play a large role, with negative supply shocks being more important to headline inflation (including food and energy prices.)
Shapiro uses an interesting technique to tease out supply and demand shocks:
Since inflation is constructed as the average sum of the rate of inflation, it is straightforward to divide inflation into categories, or groups of categories. I separate the categories each month into those where prices move due to dramatic changes in demand from those where prices move due to dramatic changes in supply. The methodology is based on general theory about the slopes of supply and demand curves. Demand shifts move both prices and quantities in the same direction along an upward-sloping supply curve, while supply shifts move prices and prices in opposite directions along a downward-sloping demand curve.
To say I have mixed feelings about this is an understatement. I strongly support the approach of looking at the relative movements of prices and outputs in proprietary supply and demand shocks, but strongly oppose making inferences about aggregate price changes by aggregating industry price changes.
My other one first published papers (JPE, 1989, co-authored with Steve Silver) looked at the real wage cycle. We have tried to estimate that the real wage cycle depends on whether the economy is hit by shocks or demand shocks. We identified these two types of shocks by looking at times when prices and employment moved in the same direction (demand shocks) and times when prices and employment moved in opposite directions (supply shocks). So I’m totally on board with that kind of identification strategy. One can also compare changes in inflation with changes in real GDP growth rates. Certainly my view is that for the year 2019-24 all demand inflation is because growth was above trend—both rates and output were moving in the same direction.
Shapiro looks at prices and output data for more than 100 categories of goods and services. This is the part I disagree with (or maybe I don’t understand enough.) In any complex economy, some markets will exhibit a positive price/output correlation and other markets will exhibit a negative price/output correlation. I fear that this process will lead to an overestimation of the role of supply, since even in an economy where 100% inflation was demand-driven you can find individual markets with negative price/output ratios (indicating a supply shock.)
Consider a hypothetical economy with a stable but high rate of inflation, generated by rapid money growth. Also consider that society has become accustomed to rapid inflation, so wage and financial contracts contribute to inflation. That is, assume that money is neutral. You can imagine an economy where the money supply doubles every 12 months, and all wages and prices rise at the same rate. The output is (assuming) a natural rate. Conceptually, this would be an economy where almost 100% of inflation is demand side (from monetary policy). And yet the price/output relationship can vary greatly between sectors, as you will have all kinds of changes in relative prices due to local supply and demand shocks. In other words, the factors that affect relative prices in individual markets are very different from the factors that affect the overall price level (monetary policy in this case, although velocity is another possibility.)
Shapiro directed me to a new study of Turkish inflation that convinced me that my “thought test” was more than just an imaginary concern. Before you consider their research, consider how much inflation may result from supply-side factors. If monetary policy causes NGDP growth of 4%, it will end up with 2% inflation if the output grows at its 2% trend rate. But if the supply shock reduces output growth to a negative 1%, and NGDP continues to grow at 4%, inflation will rise to 5%. So I have no problem with the claim that an asset shock may briefly reduce inflation by 3 percent above trend. But what would it take for a commodity panic to add 30% or 50% to a country’s inflation rate?
A Turkish study by Okan Akarsu and Emrehan Aktu ̆g produced this graph:
Note that inflation in Turkey has risen to around 80% by 2022, and is generally well ahead of the US. Also note that the proportion attributed to supply and demand shocks is the same as the estimates shown in Shapiro’s graph for the inflation in question. You might think that fact is not surprising—Turkish writers use the same model—citing Shapiro’s work. But I would expect an asset shock contribution in a complete sense to be the same in the two countries—it means low to mid-single digits. If Turkey has a fiscal policy that produces very high NGDP growth, I would expect almost all inflation in Turkey to be demand-side.
Here is the abstract of the Turkish paper:
We document the demand and inflation-driven components of Turkey following the decomposition method of Shapiro (2022). The results suggest that the recent rise in inflation, which started with the Covid-19 pandemic but deviated significantly from global inflation rates, was initially supply-driven, but later evolved into a more demand-driven inflation scenario. Consistent with the theory, oil supply and exchange rate shocks increase the supply-driven contribution, while monetary policy tightening reduces the demand-driven contribution to inflation. This breakdown may serve as a useful real-time tracker for policy makers.
Perhaps the phrase “rate of exchange” is one source of disagreement. In my research on the idea that money doubles in a year, I thought that wages and prices also doubled. And one very important price is the exchange rate—called the “exchange rate”. So one year it would take 100 Turkish lira to buy a US dollar, then the next year it would be 200 lira, then 400 lira, then 800 lira. I guess that could be considered an “exchange rate shock”, but to me it’s just one aspect of demand-side inflation—which drives up all prices, including the exchange rate.
We are so far apart that I wonder if the problem here is terminology. The terms “supply” and “demand” were developed to describe relative price changes in specific markets for goods and services, not aggregate price changes. There is always a divide between those who prefer to think of inflation as a decline in the purchasing power of money, caused by fluctuations in money supply and demand, and those who think of inflation more in terms of the sum of individual price increases, caused by supply and demand factors in various markets. I’m on the monetarist side of that divide.
In my preferred sense, we might be better off using entirely different words. So I would use the term “inflation” for any variation in inflation relative to variation in NGDP growth. And I would use the term “real inflation” for any variation in inflation caused by real output changes, holding NGDP constant. Of course, these terms will only represent accounting, and have no causal implications. I think that NGDP growth is ultimately determined by fiscal policy (including fiscal policy errors that are overstated), but that kind of claim requires evidence, it’s not just a tautology.
In any case, I might be missing something obvious here, and I would be interested in how other observational claims such as the more than half of the 80% inflation rate in Turkey by 2022 were on the supply side. Does that seem reasonable? If so, what is your definition of “supply driven”?
I have never seen a clear definition of supply side and demand side inflation. In the absence of a consensus view, each empirical study of the question becomes a true interpretation. Maybe there is no real argument at all, just different interpretations.
PS. There is a mechanism that makes inflation visible even less than my measurements. There is an argument that any increase in real output tends to lower prices. So if RGDP rises by 2% and NGDP rises by 4%, you can argue that the supply side depressed the price level by 2%, ceteris paribus, and the demand side raised prices by 4%, making 2% inflation is perfect.
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