Inflation – all the talk is supply but what about demand?

In simple economics supply and demand are in equilibrium at a particular level of output and price. If something is in short supply the price will go up to cancel out the shortage.

All the talk in the media about supply costs/problems – shipping delays, energy prices, semiconductors shortage, truck drivers in the UK – there seems to be little mention of MP3 (Monetary Policy 3) and the increasing levels of demand.

MP3 is a continuum of coordinated monetary and fiscal policies that vary who gets the money (private sector versus public sector) and how directly that printed money is provided (directly providing “helicopter money” to spenders versus more indirect means of financing spending).

With the COVID-19 crisis governments around the world sought to protect people’s job and businesses by providing a wage subsidy and financial assistance to businesses in the hope of staying afloat. However this creates more demand (wage subsidy / business support) with no increase in supply (companies are closed due to COCVID-19). Supply is struggling to cope with this extra demand. Areas of supply pressure are: raw materials, energy, productive capacity, stock, housing and workers. The graph below the supply of goods is above pre-COVID levels

As economies open up there will be an increasing demand for services – e.g. bars, restaurants etc.
Demand for services is rapidly returning to pre-COVID levels and services employment is lagging, as employers are having trouble finding workers. The latter is a major concern with unemployment at low levels there will be upward pressure on wages to entice workers to work longer hours as well as investment to improve productivity.

Whack-a-mole economics
With so many supply constraints you can fix it in one place but you can’t fix it everywhere. Long-term investment is needed if supply is to close the increasing gap with demand but expansionary policies still remain even if central bank interest rates are going up.

Productive Capacity higher than pre-COVID
Global production has risen above the trend line and with most of the marginal productive capacity coming from China. They have increased their production by 20% with exports 40% higher that at the start of 2020.

World goods price index has increased dramatically since 2020. As a result of trying to keep up with demand, capital investment is at significant highs and although this will put less strain on inflation in the longer term there are still short-term pressures.

With demand outstripping supply everywhere you look, policy makers are unlikely to be able fix shortages across the board. They can open ports for longer, as in the US, or ease environmental regulations, as in China, but in order for supply and demand to clear at levels that don’t lead to sustained price increases, there would need to be a massive investment in productivity for supply to catch up. The gap between demand and supply is now large enough that high inflation is likely to be reasonably sustained, particularly because extremely easy policy is encouraging further demand rather than constricting it.

Source: It’s Mostly a Demand Shock, Not a Supply Shock, and It’s Everywhere


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