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Inflation: Old Wine in New Bottles

Inflation: Old Wine in New Bottles

Inflation is rapidly rising at present across most of the world. This happens in the aftermath of a first pandemic year during in which the fears of deflation that have characterised the decade following the 2008 financial crisis resurfaced in earnest. The new inflation wave is commonly blamed on the pandemic supply shock to global supply chains, as well as on the negative effect of Russia’s war in Ukraine, particularly with regard to grain prices. These aggregate supply rationales are real and correct as far as they go, but insufficient to explain the phenomenon. The pandemic affected both supply and demand, whence sustained efforts in large consumer-driven economies such as the United States to preserve the latter. Less financially constrained consumers accumulated large cash balances at the height of the pandemic which have been reinjected into the economy since the most draconian restrictions have been gradually lifted. And excessively cautious monetary policies, oriented towards recovering lost growth from years past, have reinforced the inflationary effect of post-pandemic spending.

Inflation is one of the most controversial topics in economic theory as well as an object of economic policy of crucial importance and great public impact. The up and down movements of the inflation rate have repercussions and reverberations throughout the whole economic system, often in poorly understood ways because of its complexity. Complexity refers to the aggregate interaction of the unobserved decisions of millions, even billions, of actors (consumers, producers, traders, savers, investors and so on), which take place more or less simultaneously and in partial knowledge of each other. No single person can know for certain beforehand the outcome of his actions and is, to an even lesser extent, able to differentiate between his actions and his reactions to the decisions of others. Consequently, analysts and policymakers only have aggregate observations of the individual interactions from which to map out the course of events and discern the phenomena in question. Not surprisingly, emotions can run high and misconceptions abound among experts and laymen alike.

The theoretical controversy over inflation involves its very essence. While virtually all economists agree that inflation is defined as a general rise in the prices of goods and services, what exact causes this rise in prices is still hotly debated. “The price of goods and services” is the key to the unsolved mystery. Inflation movements eminently involve both the real economy (physical production of stuff) and the monetary economy (disbursement of money, cash or credit), which makes it very difficult to distinguish the cause from the effect. “Too much money can chase too few goods”, as the proverbial wisdom goes, but the reverse statement – i.e., “Too few goods are chased by too much money” – is equally valid. This simple but very consequential insight is incorporated in a standard toolkit economists call the Aggregate Demand/Aggregate Supply Model (AS/AD). 

On the ordinate or y axis is the price level P, while on the abscissa or x axis is real GDP. A shift inward of the aggregate supply AS curve on the Cartesian plane denotes a scarcity of goods, commonly described as a supply shock, which leads to a rise in the price level P and a lower real GDP equilibrium, describing a recession already materialized due to higher costs. The higher price level in this situation represents what most economists used to call “cost-push inflation”. 

A very different situation arises when the AD curve shifts outwards in the Cartesian plane. Higher demand for goods and services also leads to a higher price level P, but real GDP expands as producers sell inventory and increase production to capacity. In this case, the economy is said to be overheated and inflation is “demand-pulled”. 

Since the economy is a complex system in which many things happen at the same time, often before people fully grasp their significance, the two situations determining a rise in the general price level of goods and services need not be exclusive. The economy can suffer from both scarcity, due to various supply shocks, and excess demand, due to increased consumer spending. 

The above figure sketches out this unusual case which best captures the present situation. A shift of the AS curve inwards, due to supply chains disruptions, leads to a new price and production steady state equilibrium E', with a lower GDP on the x axis and a higher P on the y axis, while a shift of the AD curve outwards, following the lifting of health restrictions as people got vaccinated and the pandemic subsided, leads to a new equilibrium E' with a higher GDP level on the abscissa and a higher P on the ordinate (in the actual course of events, chronologically the AD curve first shifted inwards during the pandemic, in tandem with the AS curve, as locked-down consumers increased their precautionary savings, exacerbating the fall in GDP and giving rise to the short-lived fear of deflation from spring 2020 to spring 2021). The combined effect of the inwards shift of the AS curve and the – second period – outward shift of the AD curve is represented by the price and production equilibrium point E''. In this point, inflation represented by the P level on the y axis is much higher, due to scarcity generated by war and supply chain disruptions as well as more consumer spending following pandemic stimulus measures and forced quarantine savings, while the real GDP level is maintained and even expands despite higher cost pressures for producers, which are generated by the two crises as well as by structural changes in commercial, energy and regulatory policies announced before or during the pandemic.

Cost-push inflation can be mitigated through regulatory policies. The market structure of the various national economies that make up the world economy is often responsible for the phenomenon or, in any case, responsible for making it worse. Monopolies, oligopolies, cartels, high trade barriers and costly licences ignite the inflation rate particularly when a shortage of goods and services arises for whatever reason. The current bout of cost-push inflation is primarily blamed on bottlenecks in the global supply chains of many firms following various health restrictions across the world and is consequently deemed transitory. But the adverse pandemic shock to global supply chains coincided with growing calls in many Western countries for the reshoring of production from countries such as China, in particular, which makes the transient aspect of the issue less convincing and the regulatory policy a determinant of “transient inflation” rather than a cure. A less integrated world economy reduces contagion risks to individual economies and may increase their geopolitical resilience, but it also raises their cost structure. Nevertheless, concerted government policy can still have a leading role in addressing the rapid rise in grain prices and, to a less extent, energy prices, due to the war in Ukraine, which is, along with sanctions-hit Russia, one of the world’s leading exporters of cereals. The urgent focus at present is on identifying diplomatic and logistic solutions for the export of Ukraine’s harvest in the face of ongoing fighting and a naval blockade on its remaining Black Sea ports, such as by using neighbouring Romanian ports, or on reducing European dependency on Russian hydrocarbons, most notably by interconnecting the continent’s energy infrastructure. However, the secular trend of rising agricultural prices, for instance (generated by demographic pressures in emergent countries, soil erosion and shrinking farm land), was accelerated long before Russia’s war in Ukraine by contradictory climate policies. These policies led to a poorly-thought partial diversion of cereal production from the food industry to other industries such as transportation, in the hope of obtaining more environmentally friendly products, which can now be reconsidered.

Adjusting fiscal policy, by unwinding pandemic stimulus measures, is the first step in combating demand-pulled inflation. This is often easier said than done, particularly where the health crisis stimulus measures morphed into quasi-structural policies as is the case most notably with the European Recovery and Resilience Facility. Its role was to create fiscal space for European Union countries with chronic, even dangerous, fiscal deficits through a one-time disbursement of collectively-guaranteed low-interest loans in order to finance a host of public investments in the Member States, but it is doubtful that most beneficiary-countries will now use this money to reduce budget spending on other chapters. Although, on the basis of emergency powers, some price fixing schemes have been adopted here and there, alongside more indirect measures such as subsidies or distribution of state reserves, particularly with regard to the rising retail cost of electricity, heating and fuel during the last pandemic winter, a revival of large scale administrative policies of price controls remains unthinkable and would most likely exacerbate the problem. This leaves fiscal policy with little room to manoeuvre just as consumer goods price pressures have begun to spill over into the wage-setting process, unhinging expectations regarding the future and risking an uncontrolled wage-price spiral. This makes monetary policy once more the ultimate arbiter of inflation.

The theoretical disputes regarding the cause of inflation are fiercer than those regarding the capacity of monetary policy to control it. Since inflation represents a rise in the general price level and modern central banks control the supply of money which go into all prices, monetary policy is effective against both cost-push and demand-pulled inflation. However, there are some significant differences in the way monetary policy impacts the two sources of inflation. In both cases, central banks must chart a course between the desired price level (P) and the desired growth rate (GDP/P) of the economy when making use of their policy instruments, such as interest rate setting or open market operations with financial papers. In the first case, where inflation is the result of scarcity in the goods market, the central bank must decide whether to ratify the shortage-induced higher price level in the hope of a softer fall in real GDP, due to the capture of producers’ rents in imperfect markets, or whether to defend the price level and risk a much deeper fall in growth, due to the squeeze suffered by consumers’ surplus when faced with downwardly rigid prices. In the second case, that of excessive demand, the central bank must decide how fast and by how much to slow the above-growth potential GDP rate in order to stop the rise in the price level P. But the two cases can rarely be found separately, since often supply shocks amplify demand shocks and vice versa, which makes the job of “fine tuning” monetary policy as much of an art as a science. Nevertheless, a clear and credible statement regarding the course ahead on behalf of monetary policymakers is the first step towards resolving the trade-off, which involves re-anchoring price expectations and stabilizing the real growth rate.

The current world-wide inflation wave is the result of cumulative factors, short term as well as medium term, on the demand as well as on the supply side. A striking piece of evidence in favour of this observation is that not all countries are in the same position on the inflation curve. Countries such as Romania for instance, where inflation is almost twice the rate in the United States of America as well as the Eurozone at the moment, experienced overheated economies several years before the pandemic amplified the effects of government overspending and lax monetary policies, whereas highly efficient advanced economies such as Japan remain besieged by mild deflation or zero-rate inflation due to the countervailing effect of aging on consumer spending. The size of the economy is as relevant as its structure for the inflation rate. Lower income countries are more affected by the increase in the price of food than by increases in the price of fuel or used cars, for instance, because of important compositional differences in the basket of consumer goods that enters into the computation of the former’s price level compared to higher income economies. This fact can lead to an underestimation/overestimation of the effective inflation rate across countries and may generate international disagreements regarding the relative importance of the various inflationary channels at play. 

Photo source: PxHere.



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