A recent New York Times poll finds that Americans disagree about the cause(s) of inflation. The poll lists several supply-chain explanations, including supply-chain disruptions, COVID-19, and the Russian invasion of Ukraine. On the surface, these supply-chain explanations seem plausible. When goods become more scarce, their prices rise. But there are at least two problems with the supply-chain narrative.
The first problem with the view that inflation is largely a consequence of supply-chain issues concerns the timing of inflation. The pandemic and corresponding stay-at-home orders began in early 2020. Prices remained below trend until February 2021. If the COVID-19 contraction increased prices, it did so with a considerable lag. Adverse supply shocks typically push prices up more quickly than that.
The second problem concerns the way in which prices have (and are projected to) evolve. Supply shocks tend to be temporary and, hence, have a temporary effect on prices. When supplies return to normal, so do prices. Even though some of the supply disturbances experienced early in the pandemic have since been resolved, the general level of prices remains elevated and, indeed, continues to grow more rapidly than usual. Federal Reserve officials project that, although inflation will eventually return to 2 percent, it will not fall below 2 percent—meaning prices will remain permanently elevated. That’s inconsistent with the standard supply-chain narrative.
Given the shortcomings of the conventional supply-chain narrative, it makes sense to consider an alternative explanation: loose monetary policy. Monetary policy is too loose if the central bank (1) increases the money supply too rapidly or (2) fails to reduce the growth rate of money sufficiently when velocity growth picks up. In either case, nominal spending will grow more rapidly.
The dynamic equation of exchange offers a convenient framework for comparing these two conflicting narratives. The dynamic equation of exchange is the conventional equation of exchange expressed in terms of growth rates. Specifically, it says that gPt = gNt – gYt, where gPt is the growth rate of the price level (or, inflation rate) at time t, gNt is the growth rate of nominal spending at time t, and gY is the growth rate of real (or, inflation adjusted) output at time t.
A straightforward extension of the equation of exchange reveals that gPt – gPt-1 = (gNt – gNt-1) – (gYt – gYt-1). Hence, if inflation rises from time t-1 to t, it is either because (1) nominal spending growth is higher, (2) real output growth is lower, or (3) a combination of the two.
Consider first the plot below. The solid line depicts nominal spending (NGDP), the dashed-line is the NGDP trend, and the green bars represent the NGDP gap (measured in the right axis). This plot shows that NGDP fell below its trend at the beginning of the pandemic. Then, at some point in 2021, NGDP rose above its trend.
Let’s look now at a more complete series. The table below shows the inflation rate, growth rate of NGDP, and percent change of real GDP.
| 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | |
| gP | 1.7 | 1.9 | 1.9 | 1.7 | 1.3 | 5.8 |
| gNGDP | 2.7 | 4.2 | 5.4 | 4.1 | -2.2 | 10.1 |
| gY | 1.7 | 2.3 | 2.9 | 2.3 | -3.4 | 5.6 |
I want to highlight two implications of the data in the table. First, it is clear that a negative real shock took place in 2020, with a recovery following in 2021. Real GDP growth was -3.4 percent in 2020 and 5.6 percent in 2021. The negative real-shock certainly affected inflation in 2020. But the recovery means it contributes much less to the inflation observed in late 2021 and 2022.
Second, there was a sharp increase in the growth rate of NGDP in 2021. Nominal spending averaged around 4.1 percent in the four years prior to the pandemic. In 2021, it was 10.1 percent. This huge increase in nominal spending accounts for much of the inflation observed over the last year.
Monetary policy and supply-chain issues can both push prices up. However, the recent inflation appears to be largely due to monetary policy. Nominal spending has surged. Supply disturbances have largely worked their way out.
Inflation can be a serious problem, especially if it becomes persistent. Yet, the willingness of politicians to blame supply disturbances and corporations rather than acknowledging that loose monetary policy is largely responsible for today’s inflation is even more worrisome. Political maturity calls for owning and solving policy errors.
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