Where Inflation Comes From: Too Much Demand or Too Little Supply

What this means

An economy-wide price rise is not the same thing as one product getting expensive. If concert tickets get pricier because a popular artist tours, that is a relative price change, and money that goes to tickets is money not going somewhere else. InflationAn increase in the average price level across the economy, not a rise in the price of a single good. means the average is moving, which requires something acting on the whole economy at once.

Two things can do that. The first is a rise in aggregate demandThe total quantity of goods and services that households, firms, government, and foreign buyers want to purchase at each price level.: spending across the economy increases. The sources vary. Households may spend more because incomes rose, credit got cheaper, or confidence improved. Government may spend more. The money supply may expand, giving people more to spend with. Foreign buyers may want more of what this economy produces.

Now hold the productive side still. Suppose the economy is already running near capacity, so factories, workers, and equipment are close to fully used and the quantity of goods and services available cannot easily grow. More spending arrives and meets the same quantity of stuff. Buyers who want it must outbid other buyers, and the price level rises. This is demand-pull inflationInflation caused by an increase in total spending pressing against a quantity of goods and services that cannot expand to match it., and the phrase used to describe it, too much money chasing too few goods, is a fair summary of the mechanism.

The second engine runs the other way. A fall in aggregate supplyThe total quantity of goods and services that producers in an economy are willing and able to supply at each price level. means the economy can produce less than before. A war or disaster destroys productive capacity. A key input becomes scarce or expensive. A shipping network breaks. Spending need not rise at all; if the quantity of goods shrinks while spending holds steady, the same dollars chase fewer goods and prices rise anyway.

Here is the diagnostic that separates them, and it is worth memorizing. Both engines raise the price level, but they move outputThe total quantity of goods and services an economy actually produces. in opposite directions. Demand-pull inflation comes with rising output and falling unemployment, because the extra spending pulls production up as far as capacity allows. Supply-driven inflation comes with falling output and rising unemployment, because there is less being produced. Prices alone cannot tell you which you are looking at. Prices plus output can.

That second combination, rising prices alongside falling output, is uncomfortable enough to have its own name: stagflationThe combination of a rising price level and falling or stagnant output, typically with rising unemployment.. It is difficult to respond to because the usual tools for fighting inflation slow the economy further, and the usual tools for fighting a slowdown push prices higher.

Why it matters

Every policy fight about inflation is, underneath, a disagreement about which engine is running. If prices are rising because spending outran capacity, the remedy involves cooling spending, through higher interest rates or tighter budgets. If prices are rising because supply collapsed, cooling spending does little about the shortage and costs jobs on top of it, and the useful responses are the slow ones: rebuilding capacity, unclogging supply routes, finding substitute inputs.

This also explains something people find counterintuitive: policies that hand money to buyers in a market with fixed supply mostly raise prices rather than helping buyers. A subsidy for something that cannot be produced in greater quantity in the short run gets absorbed into the price. Housing in a supply-constrained city is the case you will meet most often, but the logic is general and applies to anything where quantity cannot respond quickly.

Try it

1. Set up the core scenario in a form you can manipulate. Imagine a small economy that produces exactly 1,000 identical goods this year and cannot produce more, and where total spending is 10,000 dollars. Compute the average price.
2. Hold the quantity at 1,000 and raise total spending to 12,000 dollars. Compute the new average price and the percent change. State in one sentence what happened to the number of goods available.
3. Answer the central question in writing: if people attempt to increase their spending but the quantity of goods and services stays the same, what happens, and what does not happen? Your answer must name both the price level and the quantity of output.
4. Now run the other engine. Return spending to 10,000 dollars but cut the quantity of goods to 800. Compute the average price. Compare it to your answer in step 2 and note that the price outcome can look similar while the cause is opposite.
5. Build the diagnostic table. Rows: demand-pull, supply-driven. Columns: what happens to the price level, what happens to output, what happens to unemployment. Fill all six cells.
6. Collect real data. From FRED, pull the CPI inflation rate and the civilian unemployment rate for the last fifty years and chart them together.
7. Identify one period where inflation was elevated and unemployment was low, and one period where both were elevated at the same time. Record the approximate years for each.
8. For each period you identified, use your table from step 5 to argue which engine was the more likely driver. State what additional evidence would strengthen your case, such as data on output, on production of a key input, or on the money supply.
9. Apply it to a policy. Choose a market where supply cannot expand quickly, such as housing in a growing city. Predict what happens to prices if the government gives every buyer a large purchase subsidy while nothing is done about the quantity supplied. Then predict what happens if instead the constraint on new construction is loosened. Explain the difference using the two engines.

Check yourself