Supply Shocks and the Summer of our Inflation Discontent

This post started out as a short Twitter thread discussing the role of supply shocks in our current burst of inflation. The thread was triggered by Skanda Aramanth’s tweet arguing that, within a traditional aggregate-demand/aggregate-supply framework, a negative supply shock would have an effect sufficiently inflationary to cause the rate of NGDP growth to rise even with an unchanged monetary policy if the aggregate-demand curve is highly inelastic.

Skanda received some pushback on his contention from those, e.g., George Selgin, who dismissed the assumption of an inelastic aggregate demand as an implausible explanation of recent experience.

Here are the tweets by Skanda and George.

Without weighing in on the plausibility of the inelastic aggregate demand curve assumption, not being very enamored of the aggregate demand/aggregate supply paradigm, which strikes me as a mishmash of inconsistent partial-equilibrium and general-equilibrium reasoning based on a static model with inflationary expectations uneasily attached, I offered the following alternative account of our recent inflationary experience.

There were two supply shocks. The first was the pandemic, in 2020-21. That was followed in late 2021 by the prelude to Putin’s war which sent oil prices up from $50/barrel in early 2021 to nearly $100/barrel by the end of 2021.

The first supply shock required income support for basic consumption during the pandemic resulting in a buildup of purchasing power in the form of cash balances or other liquid assets for which there was no immediate outlet during the pandemic.

The buildup of unused purchasing power implied that the end of the pandemic would involve a positive but transitory shock to aggregate demand when the economy (production and consumption patterns) returned to normal as the limitations imposed by the pandemic began to ease.

The alternative to allowing the positive but transitory shock to aggregate demand would have been to adopt a restrictive policy as the pandemic was easing, which made neither economic or political sense. The optimal policy was to accept temporary inflation during the recovery, rather than impose a deflationary policy to suppress transitory inflation.

The transitory inflation was exacerbated by various supply bottlenecks and shortages of workers and other productive resources, which were reflected the difficulties of ramping up production quickly after lengthy production shutdowns or curtailments during the height of the pandemic.

These transitory difficulties would have likely worked themselves out by the end of 2021 had it not been for the second supply shock associated with the months long buildup to Putin’s war which was anticipated for months before it actually started in February 2022,  causing a second increase in inflation just when the first burst of inflation in the second half of 2021 would have tapered off.

No doubt, it would have been better for the Fed to have started tightening earlier so keep the NGDP from increasing so rapidly at the end of 2021 and the start of 2022, but the scare talk about unanchoring inflation expectations has been overdone.

Financial markets clearly reflect expectations that the Fed is going to rein in aggregate demand so that the excess growth in NGDP in 2021 will have little long-term effect. Even with the continuing potential that Putin’s War will cause further supply disruptions with short-term inflationary effects, the current and likely future conditions seem far better than result than that would have produced by the Volcker 2.0 policy for which Larry Summers et al. are still pining.


5 Responses to “Supply Shocks and the Summer of our Inflation Discontent”

  1. 1 Benjamin Cole the Tin-Foil Hat Economist July 19, 2022 at 4:52 pm

    I agree with this post.

    In addition, hindsight is perfect.

    Another troubling situation: what many people call “tight labor markets” have been a pathway to higher wages for tens of millions of Americans.


  2. 2 Frank Restly July 21, 2022 at 12:01 pm

    So basically everything that predated the pandemic and Putin’s war had no impact on supply or demand?


    1. Trump tariffs and Chinese counter tariffs?
    2. Slowing US population growth?
    3. Increasing US defense expenditures under Trump?

    “The alternative to allowing the positive but transitory shock to aggregate demand would have been to adopt a restrictive policy as the pandemic was easing, which made neither economic or political sense.”

    The alternative would have been to take a more targeted approach to federal expenditures (see means testing, identity verification, etc.) rather than opening the flood gates.

    “Financial markets clearly reflect expectations that the Fed is going to rein in aggregate demand so that the excess growth in NGDP in 2021 will have little long-term effect.”

    Financial markets clearly reflected expectations of 8-9% inflation right now? Financial markets clearly reflected expectations of a housing bust in 2008-2009?


  3. 3 Frank Restly July 21, 2022 at 12:12 pm

    Financial markets clearly reflect expectations that no matter what side of a trade a market participant may take, he / she is going to be bailed out when the bet goes the wrong way (see Greenspan put / Bank bailouts).

    So it really doesn’t matter what expectations you might infer from markets about inflation, nominal GDP, or any other economic indicator.


  4. 4 David Glasner July 22, 2022 at 8:33 am

    Benjamin, Thanks!

    Frank, I did not say that nothing that happened before Putin’s war affected supply and demand. On the contrary I explained why both supply and demand were affected. But I also explained why those effects were diminishing and would have been transitory with an appropriate adjustment in monetary policy. I of course favored eliminating Former Guy’s tariffs and other nonsensical policies. The pandemic income support policies were not perfect and there was certainly room for improvement along the lines you suggest, but they didn’t imply a permanent increase in inflation. Financial markets reflect expectations of the future, but they are often mistaken. I only said that you can’t argue that inflation expectations are becoming unanchored when expectations of inflation are diminishing.


  1. 1 Jason Furman Hyperventilates about Wages and Inflation | Uneasy Money Trackback on March 20, 2023 at 11:53 am

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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