Inflation Comes From the Demand Side

On the Very Serious podcast, economist Jason Furman explains why prices are rising so quickly and what can be done about it

Dear readers,

It’s Thursday, and we have a new episode of the Very Serious podcast for you. It’s about inflation.

There’s a talking point about inflation you’ve probably heard fairly often: ‘Yes, inflation is x, and x is a lot. But a lot of x is because the semiconductor shortage is pushing up the price of new cars, used cars, and rental cars; and because of global forces that push up the price of gasoline and maybe agricultural products. Those price increases alone add up to inflation of a, and if the factors driving them weren’t happening, inflation would be x - a.’

This line of thinking is wrong for two reasons.

One: inflation is never totally even across the whole economy. Some things go up in price more than others and some things get cheaper. It’s always the case that, if you excluded the categories where prices are rising fastest, you’d calculate a lower inflation number.

Two: prices don’t move in a vacuum. If car prices weren’t so high, consumers would have more money left over after buying cars, and they’d go out and try to buy more goods and services. That would increase inflationary pressure in all the non-car parts of the economy. In other words, you don’t actually get to subtract a from x.

Roughly, you get inflation when the amount of money people want to spend expands faster than the productive capacity of the economy does. And that has happened extensively in the last two years, as the US and other rich-country governments have provided emergency financial support to businesses and individuals, even as output remained constrained by all sorts of real factors. The US has provided especially generous fiscal support compared to other countries, which is a reason we’ve had an especially large burst of inflation.

That doesn’t mean the supportive policies were a mistake. This pandemic was going to cause major economic problems under any policy course. If the government had spent less and the Federal Reserve had been less accommodative, we would probably have lower inflation, but we would also probably have lower employment and lower real economic growth. Life is trade-offs, and we made reasonable ones.

But that still leaves the issue of what to do now.

We can argue about whether the American Rescue Plan was too big, but the money has already gone out. We can’t go back and change it. Congress could push back on inflation with a deficit-reduction package. The president can make some moves like cutting tariffs that would help with inflation a little bit. But the primary responsibility lies with the Federal Reserve to bring inflation down by raising interest rates. And that will involve unfortunate trade-offs, too, like higher mortgage rates.

Those are all matters I talked about with Jason Furman, the former chairman of President Obama’s Council of Economic Advisers, who co-teaches the introductory economics course for Harvard undergraduates. Jason and I had a really interesting talk about where inflation comes from, what we can do about it, and how elected officials should talk about it.

We also updated the Federal Reserve’s report card, 16 months on from my New York profile of Jerome Powell. And we took a look at President Biden’s nominees to the Federal Reserve Board — where they are well suited (monetary policy) and where they could face some pitfalls (climate).

I encourage you to follow the podcast on Apple Podcasts, Spotify, or wherever you listen. And please email if you have thoughts or comments.

Very Seriously,

Josh