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Context:

Currently, many central banks and authorities are implementing monetary policies to do monetary tightening in response to current inflation and expectations of even higher inflation in the short term. Core inflation is moving up in many countries so many countries are following by tightening their monetary policies to avoid inflation becoming entrenched in their economies.

In US, economic activities have moderated, but labour market is still tight. China and many other countries still face challenges from the pandemic shutdowns, and commodity prices have been volatile where some have moderated, while others like natural gas have increased in price. In Canada, the economy is operating in excess demand and labour market is still tight. The Canadian GDP has grown by 3.3% in the second quarter which was weaker than projected and domestic demand has been strong. Consumption has grown by 9.5% and business investments were close to 12%. There was unsustainable growth during the pandemic in the housing market, but with higher mortgage rates, it's pulling back as anticipated.

The Bank continues to expect the economy to moderate in the second half of this year, as global demand weakens and tighter monetary policy in Canada begins to bring demand more in line with supply.

QUESTION:

If growth has dampened across the world and in Canada, why is there such high inflation?

My thoughts:

  • the increase in consumption has pushed up the aggregate demand in the country and businesses have made more investments given lower borrowing rates during the pandemic and their expectations of increased demand in the future due to the increase in consumption. The current supply is unable to meet this increase in consumption due to disruptions in the supply chain during the pandemic. Because the current supply is unable to meet the consumption increase, prices are starting to go up because of buyer competition. So, the increase in the aggregate demand is starting to create more inflation and this is expected to continue for the short term.
  • the increase in prices and inflation might strengthen the speed at which transactions occur, but the increase in prices does not reflect an increase in the real value of the items and the increase in transactions does not reflect real growth. So, real growth is not growing despite the inflation. Because it's not growing, there are fewer goods and services on the market with more buyers, so prices continue to rise in response and inflation grows.
  • monetary tightening is expected to slow down demand and thus slow down inflation to make demand meet the current supply and stabilize prices until real growth occurs.

All feedback is appreciated. I'm not sure if my above logic is correct, and I think I need clarity on why real growth is not occurring despite price increases. If there are other ways to think about this, please do share.

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    $\begingroup$ The main drivers of inflation are energy costs (pushed up by the war in the Ukraine) and supply chain issues (mainly a result of COVID measures and the aftermath). $\endgroup$
    – Alex
    Sep 16, 2022 at 19:18

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That is because long-term economic growth is actually deflationary. Hence more economic growth means less inflation and less economic growth more inflation ceteris paribus.

You need to be careful here and distinguish between:

  • [long-run] economic growth. Economic growth means real output is increasing over time thanks to expansion of society's production possibility frontier over time.
  • Business cycle fluctuations, specifically expansion/boom or you could call it short run growth.

What is inflationary is when economy operates above its potential real output due to business cycle fluctuations. A New Keynesian Philips curve is given by

$$\pi = \beta E[\pi] + \kappa (Y - Y^*)$$

Where $\pi$ is inflation, $E[\pi]$ expected inflation, $Y$ real output and real potential output $Y^*$.

When economy experience real sustained economic growth (increase in $Y^*$) there are deflationary pressures. What is inflationary (in short-run) is when $Y$ goes above potential output (due to boom part of a business cycle, which would be the shift in AD to the right).

What happens right now does not look like decrease in $Y$ (fall in aggregate demand/short run growth). Rather it looks like fall in potential of the economy to produce goods and services $Y^*$ (restrictions on energy due to war and push for decarbonization, breakdown of supply chains and trade relationships etc). A fall in the long-run growth will be inflationary.

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  • $\begingroup$ +1 for the distinction between growth and business cycle fluctuations. $\endgroup$
    – erik
    Sep 17, 2022 at 2:06
  • $\begingroup$ Just to make sure, a fall in $Y^*$ is a decline in the long-run output potential, which leads to inflation? This is because $k(Y-Y^*)$ will be larger will a fall in $Y^*$, so inflation will be higher? (Sorry, I'm having a hard time fully understanding the logic of why a fall in $Y^*$ is inflationary, is there a way to understand the relations in the equation in a more general/logic sense?) $\endgroup$
    – eddie
    Sep 23, 2022 at 4:08
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    $\begingroup$ @eddie yes larger (positive) difference between Y and Y^* implies higher inflation and lower Y^* makes the difference larger. The intuition behind this I guess can be best understood by QTM by QTM MV=PY^* where M is the amount of money V velocity of that money P price level and Y^* equilibrium output. The equation says that the effective amount of money in economy MV must be equal to the value of everything economy produces. This should make intuitive sense since money exist just to purchase goods and services. So when there is less goods and services which means the same amount $\endgroup$
    – 1muflon1 ♦
    Sep 23, 2022 at 7:24
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    $\begingroup$ Of money chases less goods and services price level (and hence inflation) increases. When there is more goods and services that means the same amount of money chases more goods and services so P must fall (and hence lower inflation). Production of real goods and services is always deflationary. The reason why business cycle expansion is inflationary is that when the aggregate demand goes beyond the number of goods and services that can be sustainable produced so then the prices have to increase. $\endgroup$
    – 1muflon1 ♦
    Sep 23, 2022 at 7:27

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