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I've heard numerous times that the current inflation problem is caused by supply-side issues including supply chain disruption, lower productivity from fewer people working, impacts from trade restrictions, and higher energy prices.

Yet, many folks are blaming government spending which, if I understand correctly, would be a demand-based inflation.

Isn't it well established that demand-caused inflation (larger amounts of currency in the economy) is very different from supply-caused inflation (lower supplies) or are the two really considered the same since it is still too much demand pursuing too few goods?

Not being an expert, I can see the arguments for either case but am very interested if there is a consensus from economists on this question. Intuitively, it seems to be that there is a difference. Raising interest rates would seem to be a classic solution to demand-caused inflation. Raising interest rates would seem to me to make inflation worse for supply-caused inflation since this will ultimately raise production costs of suppliers who need short term loans to cover costs.

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Is supply-caused inflation different from demand-caused inflation

Trivially there is difference, "supply-side" (properly known as cost-push) inflation occurs when there is drop in aggregate supply, and "demand-side" (properly known as demand-pull) inflation is result of shift in aggregate demand (see visualization below). Note the graph has $P$ on $y$-axis which is the price level and increase in price level is inflation, so whenever you see LARS and AD to intersect at higher $P$ there is more inflation and vice versa.

Other than that there is no difference inflation is inflation as you said there is still too much money chasing too little goods regardless of whether people demand more goods or whether there is less goods.

enter image description hereenter image description here

Raising interest rates would seem to be a classic solution to demand-caused inflation. Raising interest rates would seem to me to make inflation worse for supply-caused inflation since this will ultimately raise production costs of suppliers who need short term loans to cover costs.

No rising interest rate works regardless whether we talk about cost-push or demand pull inflation. If central bank raises interest rates then that suppresses aggregate demand and reduces price level (i.e. there will be lower inflation) regardless of whether we are talking about cost-push or demand-pull. Your assumption about interest rates is fallacious, interest rates don't affect long-run aggregate supply, which is determined by the production capacity of the economy.

This is not to say that from welfare perspective, depressing aggregate demand in an economy suffering from supply shock further to reduce inflation is necessarily optimal public policy, but it would reduce inflation. An example, is visualized below.

enter image description here

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  • $\begingroup$ Thanks very much! This is a great answer that gives me the technical terms and lots to think about! $\endgroup$ Jun 11 at 19:54
  • $\begingroup$ "Your assumption about interest rates is fallacious, interest rates don't affect long-run aggregate supply, which is determined by the production capacity of the economy." @1muflon1 Could you say a little more about that? Surely if higher interest rates depress investment in gross captial formation this will impact the long run productive capacity. $\endgroup$
    – Food
    Jun 12 at 12:13
  • $\begingroup$ @Food investment by definition is always equal to saving. Higher interest rate makes loans more expensive but also makes people save more. In long run interest rate is orthogonal on productive capacity of an economy. For example, suppose production function is given by $F = 10K^{0.5}L^{0.5}$ with such technology and with capital and labor endowment $K=L=100$ economy would in long run produce output equal to 1000 regardless whether interest rate is 2% or 10% $\endgroup$
    – 1muflon1
    Jun 12 at 12:17
  • $\begingroup$ Thanks Muflon. So if output is always 1000, regardless of interest rate, my conclusion from what you say is that interest rate policy is pointless - which I assume is wrong. Or is "long run" the key word here and interest rate changes cause deviation from the long run path? $\endgroup$
    – Food
    Jun 13 at 6:32
  • $\begingroup$ @Food the long run is key here, in short run it has effect but also mainly via demand not supply $\endgroup$
    – 1muflon1
    Jun 13 at 6:34
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Inflation can be caused by a significant increase in money supply and credit expansion. If this increase is not accompanied by a corresponding increase in the supply of goods in the market, the prices of goods will inevitably rise. This can happen directly, by increasing the amount of money issued by the competent state authorities (central bank). It is done indirectly through the issuance of government bonds or other bonds and their sale to the banks, which use these securities to raise money from the central bank. Monetary expansion can also be caused by the multiplier operation of the banking system. Inflation can also result from a strong increase in active demand. In this case, price increases are a result of increased demand relative to supply in an economy, especially because supply has very little or no elasticity, due to the full employment of available means of production and technology. The more inelastic the supply, the higher the inflation.

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The increase in M2 in the last 2 years caused by the Fed appears to be one of the main causes of the current inflation in the U.S. There should be a third option central-bank-caused-inflation (which in turned is caused by a central bank's intervention policy for recessions).

In the U.S. the banks have trillions in excess reserves because of all the QE, so the fractional banking multiplier is irrelevant to whether the banks make loans. Instead it is determined by leverage constraints and the opportunity cost of the holdings in excess reserves (which are earning the interest which the Fed began paying from 2008). This allows the Fed to control the money supply M2 despite all the QE.

Indeed in March 2020 the Fed dropped the interest rate on excess reserves down to nearly zero (see FRED IOER), inspiring the banks to lend much more (see the very large spike in M2 in March and April 2020 in FRED M2).

The total reserves (a liability on the Fed's balance sheet) changes when the Fed buys and sells financial assets, it doesn't tend to change when banks lend money. Putting it another way, the total reserves on its own doesn't tell you how much money is actually in circulation. That explains how it's possible for all the QE in the last 12 years to have elevated prices of financial assets through increased demand without substantially inflating the amount of money in circulation.

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