Yes, but not in the way that most people assume.
Brian Albrecht has a very good post criticizing ad hoc theories of inflation, such as those that point to a mysterious rise in “collusion”. He favors the traditional supply and demand approach to prices:
The important part is that while supply and demand is overly flexible, the issue is worse with other models. Any story that relies on implicit agreements, folk theorems, and coordination failure arguments is likely unfalsifiable. There is no way to tell when firms move prices together due to collusion or due to normal supply and demand. The two outcomes are “observationally equivalent.”
Why did collusion start when it did? There was a supply shock. But do you know what other theory predicts supply shocks lead to higher prices? Supply and demand.
These models do not show us how a market switches from no collusion (low prices) to collusion (high prices). The folk theorem offers no means for the prediction of future prices.
In my view, there are actually two problems here. Collusion is generally a weak explanation for the rise in the price of a particular product, and changes in individual prices do not explain a change in the overall price level.
Consider the following hypothetical. Suppose there is a 10% fall in the relative price of housing. How would that impact the overall cost of living? At first glance, you might assume that this would reduce the overall price level. After all, housing has a weight of nearly 30% in the CPI. But this is to confuse changes in relative prices with changes in the overall price level. The supply and demand model only explains relative prices (with one exception, which we’ll consider momentarily.)
Recall the maxim, “Never reason from a price change”. Why did housing prices fall? Let’s suppose that the decrease was caused by a decline in population growth. With fewer people and a fixed quantity of land, assume the price of housing declines by 5%. But fewer people also represents a negative supply shock, reducing the supply of labor. That sort of shock tends to be inflationary. Suppose non-housing prices rise by 5%. In that case, the relative price of housing will decline by 10%, but the overall CPI will rise (as housing comprises less than 50% of the CPI.) You cannot explain movements in the overall CPI by looking at changes in a single component of prices. You need to consider why prices changed.
So if the relative price of individual goods and services does not explain absolute changes in the overall price level, why do I claim that supply and demand can help us model inflation? It turns out that there is one very important relative price—the price of money. By definition, the price level is the inverse of the relative price of money. Thus a rise in the price level is nothing more than an equivalent fall in the relative price (purchasing power) of money. And S&D theory can explain changes in the value of money. If you double the money supply and the demand for money doesn’t change, then the value of money falls in half. Prices double.
Now let’s use S&D theory to consider the impact of a decline in population. Start with an automatic monetary regime, such as a pure silver standard. In the long run, a lower population would likely lead to a higher price level. With fewer people there would be less demand for coins. Prices rose after Europe was hit by the Black Death around 1348. To be sure, fewer people might also lead to fewer silver discoveries, but the direct effect of a lower population reducing money demand would probably be more significant.
The short run effect of slower population growth is trickier. It might initially lead to lower nominal interest rates. Because the interest rate is the opportunity cost of holding silver coins, this might temporarily increase the demand for silver—pushing the price of goods and services lower. During the gold standard period, prices tended to be lower during periods of low interest rates.
With a fiat money regime, one also needs to account for the response of the central bank. Under NGDP targeting, a lower population would clearly lead to higher prices (as RGDP would fall.) In contrast, if the central bank is targeting interest rates at a fixed level, then a falling population might accidentally trigger tighter money by pushing the equilibrium interest rate to a level below the policy rate. This could at least partly explain what happened to Japan after the early 1990s.
There are no easy answers here. But if we evaluate inflation using a model of the supply and demand for money, we can at least think about the problem in a coherent fashion. In contrast, looking at the supply and demand for individual goods is of no help at all when trying to explain changes in the overall price level. The S&D model can only explain relative prices. And the price level reflects the relative price of only one good—money.
READER COMMENTS
Alex S.
Sep 18 2023 at 8:37pm
Thought I might flag these two items, ICYMI:
Supply-Side Expansion Has Driven the Decline in Inflation by Mike Konczal
. At first glance I was skeptical but I agree with his findings/conclusion.
Friedman and Schwartz (1963, 489-90, footnote):
“The wage-price spiral or price-wage spiral is often stated as if the existence of strong unions or strong producer monopolies were sufficient to set in motion autonomous forces raising wages and prices. This is wrong and involves the confusion between ‘high’ and ‘rising’ that is so common a fallacy in reasoning about economic matters. Strong unions and strong producer monopolies simply imply high wages for the unionized labor and high prices for the commodities monopolized relative to the wages of other labor and the prices of other commodities; they do not imply a continuous tendency for those wages and prices to be forced still higher. Such autonomous upward pressure is to be expected only form increasingly strong unions, and increasingly strong monopoly groups in the process of raising their wages and prices to level consistent with their newly acquired monopoly power.”
Scott Sumner
Sep 19 2023 at 1:48am
Yes, I agree with Friedman and Schwartz.
Andrew_FL
Sep 19 2023 at 9:41am
Making any kind of inference about the implications for the over all level of prices from the movement of prices of one class of goods in particular requires making assumptions about how the resultant change in expenditure on one class of goods in particular will effect overall budgets-which is just another way of saying that the change in the over all price level can only be predicted on the basis of the total stream of money payments.
If the demand for gasoline decreases and the price of gasoline falls, less money is being spent on gasoline. If we assume over all expenditures remain constant, we are assuming the demand for everything other than gasoline increases-so the price of everything else goes up. The impact on the over all level of prices is zero-the effect on prices excluding gasoline is positive. If we instead assume that expenditures on all other things remain constant, then total expenditures fall by the amount expenditures on gasoline fall. Demand for all other things was unchanged so the prices of all other things don’t need to change. The effect on over all prices is negative-but only because over all prices include gasoline. I think the latter kind of scenario is what a lot of people implicitly assume when they think the change of the price of one class of good in particular will change the over all price level.
But notice that the price of gasoline has no explanatory power here. The assumption about total expenditures is what is actually doing all the predictive work.
Thomas L Hutcheson
Sep 20 2023 at 12:22pm
Changes in individual markets do not drive inflation; it must be mediated by the Fed. It is that case, however, that the Fed will take account of large shocks in deciding how much inflation to shoot for. I large enough increase in the price of, say, petroleum because of a change in international prices would be grounds for the Fed to allow above-target inflation temporarily (“flexibly”) in order to facilitate changes in relative prices when some prices are not downwardly flexible. So the exogenous change plus the Fed’s optimal response will give the impression of the exogenous change driving inflation. I think this is the source of much of the confusion.
Andrew_FL
Sep 20 2023 at 10:19pm
Try to reason about and understand how changes in individual markets would effect or not the overall level of prices in institutional contexts other than the present day United States.
What you are implicitly saying is that what happens to the total stream of payments is determined by the Fed, in the context of the present day US.
steve
Sep 19 2023 at 1:36pm
Suppose that an economy was highly reliant upon external inputs for what it produces, including what we think of as services. Then suppose that those inputs are cut in half. Is there some percentage of reliance upon those external inputs would be high enough that a big supply shock would in and of itself cut production so severely prices would rise? This seems pretty intuitive to me and it looks very much like wha that happened through history.
Steve
Jon Murphy
Sep 19 2023 at 7:42pm
You can get supply shocks (or demand shocks) that cause inflation in the short run. But they shouldn’t lead to sustained inflation. We should expect deflation to set in once the shock passed and return to zero inflation, all else held equal. Scott can correct me if I am wrong, but I think his point is that:
1) supply and demand explain relative price shifts, not absolute price shifts
2) to get sustained (ie more than a month or two) inflation, you need a change in money
Scott Sumner
Sep 20 2023 at 12:29am
It’s certainly plausible that a negative supply shock could increase the price level—it depends on monetary policy. I’d put it this way. The effect of supply shocks on the price level can best be evaluated by looking at how they impact the supply and demand for money, not how they impact the relative price of a given commodity.
Thomas L Hutcheson
Sep 20 2023 at 12:25pm
Exactly! Under a FAIT policy, the Fed will allow inflation to temporarily exceed target.
Thomas L Hutcheson
Sep 19 2023 at 11:03pm
Money supply and demand is actually a pretty good way of thinking about the optimal rate of inflation. The downside is that it is easy to confuse people that some monetary aggregates is a proper target or even a unique instrument.
Jon Murphy
Sep 20 2023 at 1:39pm
Could you expand on that? It’s not obvious to me that money supply and money demand tell us anything about an optimal rate of inflation given they are static items and inflation is a growth rate.
Thomas L Hutcheson
Sep 21 2023 at 8:17am
I mean changes in “M.”
Maybe the metaphor does not work for everyone but in a toy model with only M as a policy instrument, the central bank detects a real shock (above some background level of shocks) that will require actors in the economy to react to/relative prices to change. But since some prices cannot fall, relative price change requires that other rise. The central bank supplies (just) enough additional M to allow the relative price change and then it’s back to the target rate of M change to restore the target level of inflation which is optimized to allow the relative price changes needed to deal with the background level of shocks. [The extra injection of M is like a drop of All-in-One on a rusty gearbox.] Since ex-post relative prices have continuously adjusted no unemployment of any good or service developed.To “outsiders,” who do not see the changes in M as central bank actions, it appears that the shock caused a temporary increase in inflation.
Jon Murphy
Sep 21 2023 at 2:48pm
Ok, that makes sense. Thanks for the clarification!
spencer
Sep 20 2023 at 10:13am
Only price increases generated by DEMAND, irrespective of changes in SUPPLY, provide evidence of inflation.
There must be an increase in aggregate monetary purchasing power, AD, which can come about only as a consequence of an increase in the volume and/or transactions’ velocity of money.
Jon Murphy
Sep 20 2023 at 1:42pm
Prima facie, that statement is incorrect. If there is a decrease in Aggregate supply, then the price level will rise (inflation) assuming AD does not change.
Further, if AD increases and AS does as well, the price level can rise (inflation) stay the same, or even fall (deflation). It depends on the relative magnitudes of the shift.
So, just by simple Econ 102 logic, changes in supply do matter.
Andrew_FL
Sep 20 2023 at 2:33pm
To be fair, in practice, supply in general only decreases over time in very dysfunctional countries
Brian Albrecht
Sep 20 2023 at 3:13pm
All very good responses and qualifications. I should have said more on these points.
I did a better job explaining this idea in an oped with Alex Salter https://thehill.com/opinion/finance/594098-lina-khan-wont-solve-inflation/
To see the difference, suppose prices started out at $1 for an apple and $1 for a banana and that each consumer spends $10 to buy apples and bananas.
Suddenly, apple producers conspire to raise the price of an apple to $2. It’s tempting to believe this collusion will generate inflation; after all, the price rose. Sen. Warren pursued this line of argument in Federal Reserve Chair Jerome Powell’s re-confirmation hearing. But since the consumer only has $10 to spend, any price rise in the apple market will drive down prices in the banana market. Often prices rise and fall in proportion to each other. That’s not the same thing as inflation.
Always and everywhere, inflation results from too much purchasing power chasing too few goods. Right now, we’ve got both. Surging demand amid flagging supply is the best explanation for inflation. Contrary to the claims of antitrust enthusiasts, corporate greed doesn’t get us economy-wide price hikes.
Collusion, when it happens, does drive up prices. When firms strike deals in restraint of trade, the quantity of goods falls while prices rise. This is why proponents of antitrust focus on collusion.
But that doesn’t explain the broad inflation of the entire market. For collusion to be the cause, it would require collusion in nearly every sector of the economy. Furthermore, the collusion theory predicts declines in the output of goods, which causes price hikes. But that’s not what has happened. Over the last year, inflation and output have increased together. That tells us that the inflation we’re seeing has a major demand-side component. Even at its most effective, antitrust regulates the supply side only.
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