What Does It Mean to Say that Inflation Is Caused by Demand?

There has been a lot of debate about whether the high inflation of 2021-2022 has been due mainly to supply or demand factors. Joe Stiglitz and Ira Regmi have a new paper from Roosevelt making the case for supply disruptions as the decisive factor. It’s the most thorough version of that case that I’ve seen, and I agree with almost all of it. I highly recommend reading it. 

What I want to do in this post is something different. I want to clarify what it would mean, if inflation were in fact driven by demand. Because there are two quite distinct stories here that I think tend to get mixed up.

In the textbook story, production takes place with constant returns to scale and labor as the only input. (We could introduce other inputs like land or imports without affecting the logic.) Firms have market power, so price are set as a positive markup over unit costs. The markup depends on various things (regulations, market structure, etc.) but not on the current level of output. With constant output per worker, this means that the real wage and wage share are also constant. 

The nominal wage, however, depends on the state of the labor market. The lower the unemployment rate, and the more bargaining power workers have, the higher the wage they will be in a position to demand. (We can think of this as an expected real wage, or as a rate of change from current wages.) When unemployment falls, workers command higher wages; but given markup pricing, these higher wages are simply passed on to higher prices. If we think of wages as a decreasing function of unemployment, there will be a unique level of unemployment where wage growth is equal to productivity growth plus the target inflation rate.

You can change this in various ways without losing the fundamental logic. If there are non-labor costs, then rising nominal wages can be passed less than one for one, and tight labor markets may result in faster real wage growth along with higher inflation. But there will still be a unique level of wage growth, and underlying labor-market conditions, that is consistent with the central bank’s target.  This is the so-called NAIRU or natural rate of unemployment. You don’t hear that term as much as you used to, but the logic is very present in modern textbooks and the Fed’s communications.

There’s a different way of thinking about demand and inflation, though, that you hear a lot in popular discussions — variations on “too much money chasing too few goods.” In this story, rather than production being perfectly elastic at a given cost, production is perfectly inelastic — the amount of output is treated as fixed. (That’s what it means to talk about “too few goods”.) In this case, there is no relationship between costs of production and prices. Instead, the price ends up at  the level where demand is just equal to the fixed quantity of goods.

In this story, there is no relationship between wages and prices — or at least, the former has no influence on the latter. Profit maximizing businesses will set their price as high as they can and still sell their available stocks, regardless of what it cost to produce them. 

In the first story, the fundamental scarcity is inputs, meaning basically labor. In the second, what is scarce is final goods. Both of these are stories about how an increase in the flow of spending can cause prices to rise. But the mechanism is different. In the first case, transmission happens through the labor market. In the second, labor market conditions are at best an indicator of broader scarcities. In the first story, the inflation barrier is mediated by all sorts of institutional factors that can change the market power of businesses and the bargaining power of workers. In the second story it comes straightforwardly from the quantity of stuff available for purchase. 

Once concrete difference between the stories is that only in the first one is there a tight quantitive relationship between wages and prices. When you say “wage growth consistent with price stability,” as Powell has in almost all of his recent press conferences, you are evidently thinking of wages as a cost. If we are thinking of wages as a source of demand, or an indicator of broader supply constraints, we might expect a positive relationship between wages and inflation but not the sort of exact quantitive relationship that this kind of language implies.

in any case, what we don’t want to do at this point is to say that one of these stories is right and the other is wrong. Our goal is simply to clarify what people are saying. Substantively, both could be wrong.

Or, both could be right, but in different contexts. 

If we imagine cost curves as highly convex, it’s very natural to think of these two cases as describing two different situations or regimes or time scales in the same economy.¹ Imagine something like the figure below. At a point like c, marginal costs are basically constant, and shifts in demand simply result in changes in output. At a point like b, on the other hand, output is very inelastic, and shifts in demand result almost entirely in changes in price.

Note that we can still have price equal to marginal cost, or a fixed markup to it, in both cases. It’s just that in the steeply upward-sloping section, price determines cost rather than vice versa.

Another point here is that once we are facing quantity constraints, the markup over average cost (which is all that we can normally observe) is going to rise. But this doesn’t necessarily reflect an increase in the  markup over (unobservable) marginal cost, or any change in producers’ market power or pricing decisions.

We might think of this at the level of a firm, an industry or the economy as a whole. Normally, production is at a point like a — capitalists will invest to the point where capacity is a bit greater than normal levels of output. As long as production is taking place within the normal level of utilization, marginal costs are constant. But once normal capacity is exceeded by more than some reasonable margin, costs rise rapidly. 

This framework does a couple of things. First, it clarifies that demand can lead to higher prices in two different ways. First, it shifts the demand curve (not shown here, but you can imagine a downward-sloping diagonal line) up and to the right. Second, insofar as it raises wages, it shifts the cost curve upward. The first effect does not matter for prices as long production is within normal capacity limits. The second effect does not matter once production has exceeded those limits. 

Second, it helps explain why shifts in the composition of output led to a rise in the overall price level. Imagine a situation where most industries were at a position like a, operating at normal capacity levels. A big change in the mix of demand would shift some to b and others to c. The first would see lower output at their old prices, while the latter would see little increase in output but a big rise in prices. This has nothing to do with price stickiness or anything like that. It simply reflects the fact that it’s easy to produce at less than full capacity and very hard to produce much above it.

ETA: One of the striking features of the current disinflation is that it is happening without any noticeable weakening of the labor market. We could see that as just one more piece of evidence for the Stiglitz-Regmi position that it was transitory supply problems all along. But if you really want to credit the Fed, you could use the framework here to do it. Something like this:

In a sustained situation of strong demand, businesses will expect to be able to sell more in the future, and will invest enough to raise capacity in line with output. So the cost curve will shift outward as demand rises, and production will remain In the normal capacity, constant marginal cost range. In this situation, the way that demand is raising prices is via wages. (Unlike business capacity, the labor force does not, in this story, respond to demand.) Rising wages raise costs even at normal utilization levels, so the only way that policy can slow process growth is via weaker labor markets that reduce wage growth. But, when demand rises rapidly and unexpectedly, capacity will not be able to keep up in the short run, and we’ll end up on the righthand, steeply upward sloping part of the cost curve. At this point, price increases are not coming from wages or the cost side in general. Businesses cannot meaningful increase output in the short run, so prices are determined from the demand side rather than as a markup. In this context, price stability calls for policy to reduce desired purchases to what business can currently produce (presumably by reducing aggregate income). In principle this can happen without higher unemployment or slower wage growth.

I personally am not inclined to credit the Fed with a soft landing, even if all the inflation news is good from here on out. But if you do want to tell that story, convex supply curves are something you might like to have in your toolkit.

1. I prefer the term cost curve rather than supply curve, because in a setting of constant or declining marginal costs, the conventional definition of a supply curve – the most that will be offered at a given price – does not make sense.