There are many bad explanations for inflation. I address some of them here. So let’s explore some good ones. They are not iron-clad, but they are understandable in terms of basic economic theory.
As always, the starting point is the exchange equation: MV = PQ, where M is the money supply, V is the velocity of transmission (on average, how many times the same dollar is spent for goods and services), P is the price level, and Q is the real (inflation-adjustment) ) Output. The equation of exchange is an identity. It just tells us that the total amount spent (MV) must be equal to the nominal value (PY) of the cost.
We need to add some assumptions to make the exchange equation suitable for economic analysis. In particular, we will assume that the velocity and the actual output are independent of the money supply. This is not always true. Many economic recessions can be partially explained by a sudden decline in V, which means a sudden increase in liquidity demand. However, this is often a good guess for short to medium-driven predictions.
The dynamic equation of exchange is more effective, which is the same formula expressed in growth rate: gM + gV = gP + gQ. First, note that when discussing Level Among these variables, we multiply them, but when discussing Growth rate, We add them. This will be important later. Second, the dynamic version tells us directly what inflation (GP) is happening. This is why this version of the equation is so helpful.
One possible explanation for inflation is declining productivity. We are less good at converting inputs into outputs. In the dynamic equation of exchange, it will show as a sudden fall in gQ. The economy does not have to shrink. It grows more slowly than before. Assuming that the rate and speed of growth of the money supply remains unchanged, the GP must increase, which means that inflation will increase.
Theoretically, it makes sense. But why is productivity declining? There are several explanations for the continued production disruption from the epidemic, as well as the war in Ukraine. A quick look at the data shows that real income and productivity are increasing, but a bit slower than before. This probably contributes to inflation. But magnitude has no meaning as a primary explanation.
Covid post-war and the Ukraine war
These important events demand more thorough treatment. Again, both are admirable, but we should be careful.
It has been more than two years since the epidemic began. Does it really take so long to solve Covid’s interruptions and attendant supply-chain problems? And even if they are not completely resolved, the problems today are expected to be less serious. Yet inflation is rising.
How about the war in Ukraine? As many commentators have noted, prices began to rise a year before the Russian invasion. President Biden’s repeated line about “Putin’s price hike” is a bad attempt at political rotation. However, it is reasonable to assume that important values such as food and energy have been affected by the conflict. But are they the leading factor? Probably not.
We can compare US inflation with inflation in other countries to better understand what is happening. The push of the above supply has affected all the countries to different extent. For example, the invasion of Ukraine has hit Europe much harder than the United States. According to Jason Furman, who served on President Obama’s Economic Advisory Council, skyrocketing natural gas prices have played a major role in European inflation. He added that core inflation – which excludes food and energy prices – was significantly higher in the United States (6.5 percent) than in Europe (3.8 percent). It goes without saying that supply disruptions are not contributing to the rise in U.S. prices. But we clearly need something else to explain the level of inflation in the United States.
Casual observations suggest that rising government spending is the cause of inflation. But casual observations are often wrong. Expenditure does not necessarily increase total expenditure. It may crowd out personal expenses. Uncle Sam takes a large slice of pie, but no more or less pie is available at all.
Whether government spending increases total spending depends, in large part, on whether it shifts with loose monetary policy. So the impact of government spending on inflation is indirect.
Starting in 2020, Congress ran extraordinary deficits: about $ 3.1 trillion and $ 2.8 trillion in 2020 and 2021, respectively. As a share of GDP, it is 15 percent and 12 percent. It covers these deficits by issuing bonds, adding national debt. And many of those bonds have found their way into the Fed’s balance sheet.
Between 2020 and 2022, the Fed bought about 3 3.3 trillion in government debt. That’s about 55 percent of the deficit in those years. It is difficult to avoid the conclusion that the Fed has indirectly financed large budget deficits through money laundering. All that new liquidity contributes to our current inflation phase.
Money mischief is ultimately the Fed’s fault. But financial inconsistencies have played a helpful role. Undoubtedly, fiscal policymakers have felt the pressure to be wary of the wind and to backstop huge revenue expansion. We never know how much pressure politicians put on technocrats behind the scenes, but we don’t need to. Cooperation between fiscal and fiscal policymakers explains the upward trend in overall demand, which we can see in the overall spending growth above the trend.
A cautious conclusion
We need both supply and demand to explain inflation. At the moment, there seems to be a demand for driver’s seats. But that may change. We will know more after finding out whether the actual output growth in 2022Q2 was positive. Real-time assessment of overall supply and overall demand on inflation is quite difficult. Nevertheless, we have enough information to put an end to policy mistakes, especially in terms of demand, which can go a long way in explaining today’s inflation.