There are many bad explanations for inflation. I address some of them here. So let’s explore some better ones. They aren’t iron-clad, but they make sense in terms of basic economic theory.
As always, the place to start is the equation of exchange: MV=PQ, where M is the money supply, V the velocity of circulation (the number of times, on average, the same dollar is spent on goods and services), P is the price level, and Q is real (inflation-adjusted) output. The equation of exchange is an identity. It just tells us that the total amount spent (MV) has to be equal to the nominal value of the expenditures (PY).
In order to make the equation of exchange useful for economic analysis, we need to add some assumptions. In particular, we will assume that velocity and real output are independent of the money supply. This isn’t always true. Many economic downturns can be explained in part by a sudden drop in V, which means a sudden increase in liquidity demand. However, it’s often a good assumption for short- to medium-run predictions.
Even more useful is the dynamic equation of exchange, which is the same formula expressed in growth rates: gM+gV=gP+gQ. First, note that when discussing the level of these variables, we multiply them, but when discussing their growth rates, we add them. This will be important later. Second, the dynamic version tells us what’s happening to inflation (gP) directly. That’s why this version of the equation is so helpful.
One possible explanation for inflation is falling productivity. We’re less good at turning inputs into outputs. In the dynamic equation of exchange, this would show up as a sudden fall in gQ. The economy doesn’t have to shrink. It just grows more slowly than before. Assuming the growth rates of the money supply and velocity remain unchanged, gP must rise, meaning inflation goes up.
Theoretically, this makes sense. But why is productivity falling? There are several explanations, such as continued production bottlenecks from the pandemic, as well as the war in Ukraine. A quick look at the data shows real income and productivity are growing, but slightly more slowly than before. This probably contributes to inflation. But the magnitudes don’t make sense as a primary explanation.
Post-covid bottlenecks and the Ukraine war
These important events deserve a more thorough treatment. Again, both are plausible, but we should be cautious.
It’s been more than two years since the pandemic began. Would it really take this long for the COVID bottlenecks and attendant supply-chain issues to be resolved? And even if they have not been fully resolved, one would still expect the problems to be less severe today. Yet inflation keeps rising.
How about the war in Ukraine? As many commentators have noted, prices started going up a year before Russia’s invasion. President Biden’s oft-repeated line about “Putin’s price hike” is a bad attempt at political spin. Nevertheless, it’s reasonable to suppose that important prices, like food and energy, have been affected by the conflict. But are they the leading factor? Probably not.
We can compare US inflation to that of other countries to get a better sense of what’s going on. The above supply shocks have affected all countries to varying degrees. For example, the invasion of Ukraine has hit Europe much harder than the US. According to Jason Furman, who served on President Obama’s Council of Economic Advisors, skyrocketing natural gas prices have played a much larger role in European inflation. He also notes that core inflation—which excludes food and energy prices—has been significantly higher in the US (6.5 percent) than in Europe (3.8 percent). This is not to say that supply disturbances are not contributing to US price increases. But we clearly need something else to explain the magnitude of inflation in the US.
Casual observation suggests increased government spending causes inflation. But casual observation is frequently wrong. Spending doesn’t necessarily increase total spending. It might crowd out private spending. Uncle Sam takes a bigger slice of the pie, but there is neither more nor less pie available in total.
Whether government spending increases total spending depends, in large part, on whether it is accommodated with loose monetary policy. Hence, the effect of government spending on inflation is indirect.
Starting in 2020, Congress ran phenomenal deficits: about $3.1 trillion and $2.8 trillion in 2020 and 2021, respectively. As a share of GDP, that’s 15 percent and 12 percent. It covered these deficits by issuing bonds, adding to the national debt. And a great many of those bonds found their way onto the Fed’s balance sheet.
Between 2020 and 2022, the Fed purchased about $3.3 trillion in government debt. That amounts to about 55 poercent of the deficits over those years.. While the Fed didn’t buy directly from the Treasury, its support in the secondary market was enough to prop up the primary market. It’s hard to escape the conclusion that the Fed indirectly financed large budget deficits by printing money. All that new liquidity contributes to our current inflationary episode.
Money mischief is ultimately the Fed’s fault. But fiscal follies played a supporting role. Undoubtedly monetary policymakers felt pressured to throw caution to the wind and backstop the massive fiscal expansion. We may never know how much politicians pressured technocrats behind the scene, but we don’t need to. Cooperation between fiscal and monetary policymakers explains the surge in aggregate demand, which we can see in the rise of total spending above trend.
A cautious conclusion
We need both the supply side and the demand side to explain inflation. Right now, it looks like demand is in the driver’s seat. But that could change. We’ll know more when we find out whether real output growth was positive in 2022Q2. Real-time assessments of aggregate supply and aggregate demand on inflation are pretty difficult. Nevertheless, we have enough information to conclude policy mistakes, especially on the demand side, go a long way toward explaining today’s inflation.