The Week in Radical Leftism, 05/19/2023

What causes inflation?

At its root, inflation is driven by too much demand relative to supply. More precisely, as former Fed chair Ben Bernanke writes in his macroeconomics textbook with Andrew Abel: “Inflation occurs when the aggregate quantity of goods demanded at any particular price level is rising more quickly than the aggregate quantity of goods supplied at that price level.”

But what causes demand to outpace supply? That can happen for a few different reasons, and to understand them it helps to consider the three pillars of macroeconomics that David Moss describes in his book A Concise Guide to Macroeconomics: What Managers, Executives, and Students Need to Know. Moss structures the book based on output (how much an economy produces), money (how much currency people have or can easily get their hands on), and expectations (what people think will happen next). All three have a role in inflation.

Supply shocks: Inflation often happens because of supply shocks — major disruptions to an important economic input, like energy. For example, if a lot of oil fields stop producing oil because of a war, the price of energy increases. Since energy is a critical input into almost every other good, prices of other things rise, too. This is often called “cost-push inflation.”

In theory, a decrease in the supply of a good should lead to a higher price, fewer buyers, and a new equilibrium. In practice, things are more complicated. A supply shock might set off a sustained increase in prices because there aren’t many good alternatives and so the price keeps getting bid up. Or it might be because there’s uncertainty around when and whether the supply shock will end, or because the initial price increase changes peoples’ expectations about future inflation.

Money supply: Then there’s the demand side of the equation. An increase in the money supply will tend to cause inflation, as Moss explains. “With more cash in their pockets and bank accounts, consumers often find new reasons to buy things,” he writes in the book. “But unless the supply of goods and services has increased in the meantime, the consumers’ mounting demand for products will simply bid up prices, thus stoking inflation. Economists sometimes say that inflation rises when ‘too much money is chasing too few goods.’” This is sometimes referred to as “demand-pull inflation.”

The money supply theory of inflation was popularized by economist Milton Friedman who famously said that “always and everywhere a monetary phenomenon.” While it’s true that increases in the money supply can cause inflation, Friedman’s claim was too strong. In fact, if you had to boil the causes of inflation down to one thing, it might be expectations.

Expectations and spirals: In many models of inflation, the cause isn’t an increase in the money supply but an unanticipated increase in the money supply. The intuition is that if everyone knows demand will increase (because there’s more money flowing) then supply will increase to match it. It’s the unexpected increase in demand (or decrease in supply) that sets off inflation.

Along those same lines, how much inflation people expect affects how much inflation we actually get. As prices of goods rise, workers aren’t able to buy as much with their wages. So, if people expect higher inflation, they’ll bargain for higher wages to maintain their living standard. But if businesses expect this wage inflation, they’ll raise prices further, which can cause what’s called a “wage-price spiral” that drives further inflation. Thankfully, wage-price spirals are fairly rare.

Because expectations matter so much, central banks work hard to maintain their credibility on inflation and to keep inflation expectations “anchored.” That basically means they want to convince everyone that they’ll be able to meet their inflation target, so that people don’t worry about month-to-month inflation data and just assume that inflation will rise by whatever the central bank says it will.

It does not appear corporate profits are much of a contributor.

In our case, biden caused the inflation, full stop.