A Recent New York Times Poll Americans do not agree on the cause (s) of inflation. The poll lists several supply-chain explanations, including supply-chain disruptions, COVID-19 and the Russian invasion of Ukraine. On the surface, these supply-chain explanations seem admirable. When products become more scarce, their prices go up. But there are at least two problems with the supply-chain narrative.
The first problem with this approach is that inflation is essentially a consequence of supply-chain problems that concern the timing of inflation. Outbreaks appear to be exacerbated during the early 2020s Prices were below trend till February 2021 If the price rises due to the contraction of COVID-19, it did so at a considerable distance Adverse shocks to supply usually push up prices faster than that.
The second problem concerns the way prices develop (and are estimated). The supply push tends to be temporary and, therefore, has a temporary effect on prices. When supply is normal, so is price. Although some supply disruptions have been resolved in the early days of the epidemic, the general level of prices has risen and, in fact, continues to rise faster than usual. Federal Reserve officials predict that while inflation will return to 2 percent, it will not fall below 2 percent – meaning prices will remain permanently higher. This is inconsistent with the standard supply-chain description.
Given the shortcomings of the conventional supply-chain narrative, it is understandable to consider an alternative explanation: loose monetary policy. Monetary policy is very weak if the central bank (1) raises money supply too fast or (2) fails to reduce the growth rate of money considerably when the speed increases. In either case, the nominal cost will increase even faster.
The dynamic equations of exchange provide a convenient framework for comparing these two conflicting descriptions. The dynamic equation of exchange is the conventional equation of exchange expressed in terms of growth rate. In particular, it says that GPt = gNt – YestWhere GPt The rate of increase in the price level (or, the rate of inflation) at t, gNt The nominal cost growth rate at t and gY is the growth rate of actual (or, inflation compatible) output at t.
A simple extension of the exchange equation reveals that GPt – GPt-1 = (gNt – GNt-1) – (GYYt – Yest-1) Therefore, if inflation increases from t-1 to t, it is due to (1) higher nominal cost increase, (2) lower actual production growth, or (3) a combination of the two.
Consider the plot below first. The solid line represents the nominal cost (NGDP), the dash-line represents the NGDP trend, and the green bars represent the NGDP gap (measured on the right axis). This plot shows that at the beginning of the epidemic the NGDP fell below its trend. Then, at some point in 2021, the NGDP rose above its trend.
Let’s see more complete series now. The table below shows the rate of change of inflation rate, growth rate of NGDP and percentage of actual GDP.
I want to highlight two effects of data on the table. First, it is clear that there was a negative real push in 2020, after the recovery in 2021. Actual GDP growth was -3.4 percent in 2020 and 5.6 percent in 2021. Negative real-shocks will certainly affect inflation in 2020. But recovery means it contributes much less to the inflation observed in 2021 and the end of 2022.
Second, there was a sharp increase in the growth rate of NGDP in 2021. In the four years before the epidemic, nominal expenditure averaged about 4.1 percent. In 2021, it was 10.1 percent. This huge increase in nominal spending is responsible for much of last year’s inflation.
Both monetary policy and supply-chain problems can drive up prices. However, the recent rise in inflation seems to have been largely due to monetary policy. Nominal costs have increased. Supply disruption has basically worked their way.
Inflation can be a serious problem, especially if it persists. Yet, instead of acknowledging that loose monetary policy is largely responsible for today’s inflation, politicians are more concerned about supply disruptions and the desire to blame corporations. Political maturity calls for ownership and resolution of policy errors.