Demand, Supply, Both, or Neither?

One way current debates over inflation sometimes get framed is whether it’s driven by supply or demand. Critics of the ARPA and other stimulus measures point to various lines of evidence to suggest that rising prices are coming from the demand side, not the supply side; and of course you can find the opposite arguments among its defenders. This sometimes gets conflated with the question of how persistent inflation is likely to be, with a preference for supply-side explanations putting you on “team transitory.”

In my opinion, the question in this form is not well specified. It makes no sense to ask if price rises are driven by supply or by demand. A mismatch between aggregate demand and aggregate supply is one explanation for inflation. To say “inflation would be lower if aggregate demand were lower” is exactly the same statement as “inflation would be lower  if aggregate supply were higher.” This story is about the difference between the two.

The first step, then, is to think about how we can reframe the question in a meaningful way. The issue of specific indicators is downstream from this, as is the question of how long one might expect higher inflation to last. 

Here are some quick thoughts on how we might clarify this debate. 

1. Insofar as we are explaining price changes in terms of aggregate demand and aggregate supply (or potential output) this is a story about an imbalance between the two of them. If we are using this framework, any change in inflation is fully explained by supply *and* fully explained by demand. To turn this into an either-or question, we have to pose an explicit counterfactual. For example, we might say that current spending levels would have led to no (or less) rise in inflation if it weren’t for pandemic. Or we might say that the disruptions of the pandemic would have led to no (or less) rise in inflation if it weren’t for the stimulus bills. The problem is, these aren’t alternatives — both  might very well be true!

2. If the question is specifically whether current aggregate demand in the US would be inflationary even without the pandemic and Ukraine war, it seems to me that the answer is unequivocally No. The fact that real GDP is no higher than trend is, to me, absolutely decisive here. Suppose we thought that two years from now, the economy operating at normal capacity will be capable of producing a certain quantity of cars, houses, tv shows, haircuts, etc. Now suppose two years pass, and we find that people are in fact buying exactly the quantity of cars, houses, tv shows, haircuts, etc. that we had predicted,. If inflation has nonetheless risen, the only possible explanation, within the supply-vs-demand framework, is that the productive capacity of the economy is less than we expected. If buying a certain quantity of stuff is not inflationary in one year, but is inflationary in a later year, then (within this framework) by definition that means that potential output is lower.

Of course it may be true in this scenario that the nominal value of spending will be higher. But this precisely because prices have risen. Suggesting that higher nominal expenditure explains higher inflation is arguing in a circle — it is using the rise in prices to explain that same rise in prices.

To put it another way, aggregate supply or potential output are describing the quantity of stuff we can produce. It makes no sense to say that the potential output of the US economy is $22 trillion dollars. People who look at nominal expenditure in this context are just confused.

(It’s also worth noting that nominal GDP was below pre-pandemic trend until the last quarter of 2021, at which point inflation had been above target and accelerating for a year already. So this story fails on the basis of timing as well as logic.)

So in this specific sense, I think the supply story is simply right, and the demand story is simply wrong. There is no reason to think that the aggregate quantity of goods and services people are trying to purchase today would be beyond normal capacity limits in the absence of the pandemic.

3. Again, though, it all depends on the counterfactual. It does not contradict the preceding point to say that if the ARPA had been smaller, inflation would be lower. Given a fall in the economy’s productive capacity, you are going to see some combination of lower output and income, and higher inflation, with the mix depending on the extent to which demand also falls. Again, demand and supply are two sides of the same story. It’s perfectly consistent to say that in the absence of the pandemic, today’s level of spending would not have caused any rise in inflation, and that if we had allowed spending to fall in line with the fall in potential, the supply disruptions would not have caused any rise in inflation. 

This means the question of whether ARPA was too big is not really a question about inflation as such. It is not going to resolved by any data on whether inflation is limited to a few sectors or is broader, or whether inflation peaked at the end of 2021 or at some later date. The answer to this question depends on how we weigh the relative costs of rising prices versus lost income and output. The more socially costly you think inflation is, the more you are going to think that ARPA was too big. The more socially costly you think unemployment and the associated loss of income is, the more you are going to think the ARPA was the right size, or too small. It seems to me that this is what a lot of the debate over “supply” versus “demand” stories of inflation are really about.

4. So far, I’ve been using an aggregate supply and aggregate demand framework, which is how people usually talk about inflation. But as readers of this blog will know, I am generally skeptical that rising prices are best thought of at the aggregate level. If we don’t like the aggregate framework, we might tell micro stories. There are several flavors of these, any or all of which which could be true. 

First, there is there’s a story about changes in the composition of demand. It’s easy for a business or industry produce less than it usually does, but hard to produce more — especially in a hurry. So sectors of the economy that face reduced demand are likely to respond with lower output, while sectors that face increased demand are likely to respond in some large part with higher prices, especially if the increase is large and rapid. That means we should expect rapid shifts in demand to be associated with higher inflation, even if the total volume of demand is unchanged. 

That’s one micro story. Another is that when certain sectors of the economy face supply constraints, it may be hard to substitute elsewhere. If demand for the sectors facing bottlenecks is very inelastic, and/or they are important inputs for other sectors, then the fall in capacity in those sectors may have a larger effect on prices than a similar across-the-board fall in productive capacity would.  

Another, simpler micro story is that there is no useful information in the aggregate price level at all. If prices are rising for particular goods and services, that is best understood in terms of production conditions and demand for those particular things.

What these stories suggest is that the aggregate supply/demand framework is less useful when there are large, rapid shifts in the composition of spending or production. That framework may be reasonable when we are talking about an economy undergoing steady growth and want to know if somewhat faster growth (spurred perhaps by across the board easier credit) would lead to higher inflation. But it’s not very useful when the economy is undergoing major qualitative changes. It’s not even clear how the concept of aggregate supply is defined when we are seeing big shifts in the composition of output. 

To be clear, none of these micro stories are necessarily arguments for a “supply side” explanation of inflation. Rather, they are reasons why the supply versus demand framework might not be helpful. 

5. Another story about inflation that often gets conflated with aggregate demand but should not be is the extent to which higher wages are driving inflation. In the standard textbook story, the mechanism by which higher demand raises prices is through higher wages. In the textbook story — this is totally mainstream — there are no constraints on the supply side except the supply of labor. The reason higher demand leads to higher inflation is that lower unemployment leads workers to obtain higher wages, which then get passed on to prices. We know this is the theory the Fed is working with. And people like Krugman are saying that there’s no way to have lower inflation without “getting wage growth down considerably.” 

But even though these two things are linked in the textbook story, they are logically distinct. When we talk about a demand-side story of inflation, we need to be clear whether and to what extent this is a story about wages specifically. And as Krugman emphasizes in the linked piece, the question of whether reducing inflation will require slower wage growth is logically independent of the question of whether higher wages are what has driven rising inflation so far.

6. So what is actually at stake here? Before we start talking about who is on what team, we should be sure we know what game they are playing, and where the goals are.

It seems to me that, operationally, the big question people are arguing about is: if real activity — and in particular the labor market — remains on its current trend, will inflation eventually come down on its own? Or if not, can interventions in specific sectors reduce it? Or is a significant slowing of activity across the board required? This forward-looking question is what the fighting is really about. 

There is some relationship between these questions and the causes of inflation, but they are not the same. For example, it is certainly more plausible that resolving a small number of bottlenecks would bring prices down when the price increases are concentrated in a few sectors. But one might also believe — as I and others have long argued — that we underestimate the flexibility of the supply side of the economy in general. If you believe in hysteresis, then even a general overheating might over time lead to faster growth of potential output, as more people are drawn into the labor force and businesses invest and raise productivity. So unless you start from the premise that potential output is normally fixed, “inflation is widespread, therefore we need less demand” is a non sequitur.

(In this light, it would be worth systematically revisiting the arguments about hysteresis made by Lawrence Summers and others during the 2010s.)

7. The question of whether reducing inflation requires lower demand and weaker labor markets is inextricable from your political program and broader worldview. At this moment, we are on the verge of seeing a major new public investment bill that is being presented as a way of bringing down inflation and creating good jobs. This is a huge vindication for arguments that progressives have been putting forward for years. It would be odd if we now turned around and said, “no no, investing in clean energy won’t help with inflation. And we don’t want more jobs, there’s too much demand in the economy already.” If you think that the clean energy investments in the IRA will in fact bring down prices over time, you need an understanding of inflation that’s consistent with that. And if your view of inflation implies that we would be better off not making those investments at this time, then you need to own that position.

(Some people will say the bill is anti-inflationary because it lowers the deficit. First of all, it seems unlikely that the specific tax increases in the IRA will have much if any dampening effect on demand, while the spending components certainly will boost it. Second, even if you thought the bill as a whole will reduce inflation, you still need to have a view on whether the energy provisions specifically will do so.)

I’m not saying you should just make the economic arguments that support your political program. It’s very important to only say things that are supported by logic and evidence! But presumably, you have the worldview you do because it captures important things you think are true about the world. If your analysis of inflation is not consistent with other things that you strongly believe, that suggests that there might be something wrong with your analysis. 

For example, you might believe that potential employment in the US is much higher than conventional estimates of unemployment or the labor force suggest. You could arrive at this belief on the basis of statistical evidence and also from other beliefs that you are strongly committed to — for example, that women and non-white people are just as capable of useful work as white men are. This argument runs directly against claims that the US is currently facing hard supply constraints, so that the only way the growth in wages and prices will moderate is via lower demand. If the conventional unemployment rate vastly understated the number of people available for work in 2015, presumably it still does today. You can’t just ignore those earlier arguments when talking about current inflation.

Similarly, you might believe that business investment and productivity growth depend on demand. Or you might think they depend on decisions made at the firm level — that corporations face a choice between long-term growth and short-term returns to shareholders, which they will make differently in different institutional and legal environments. These long-standing arguments are relevant to the question of whether it’s plausible that corporate profiteering is contributing to current price rises, and whether changes to taxes and regulation could bring down inflation without any need to reduce demand. They are also relevant to the question of whether given sustained strong demand, supply will eventually catch up, via higher investment and faster productivity growth. This Gavin Wright paper argues that scarce labor and rising wages drove the acceleration of productivity growth in the late 1990s. How convincing you find that argument should be relevant to your assessment of inflation today.

Or again, the question of whether conventional monetary policy should be the go-to response to inflation is not (only) a question about inflation. You could have a fully “demand side” account of rising rents — that they are entirely driven by rising incomes, and not by any change in the housing supply — and yet also believe that higher interest rates, by discouraging housing construction, will only make the problem worse. 

It’s a big mistake, in my opinion, to debate inflation in isolation, or to think that debates over inflation are going to be resolved with statistical tests. We first need to step back and think carefully about what question we are trying to answer, and about what account of inflation is consistent with our broader intellectual commitments. The reason I disagree with someone like Jason Furman about inflation isn’t because I have a different read on this or that data series. (I like his empirical work!) We see inflation differently because we have different ideas about how the world works.