With inflation occupying the headlines, one can often read arguments that high inflation will cause a decrease in the aggregate demand and potentially a recession. What does basic macroeconomics have to say about this argument? The simple answer is that such reasoning is faulty, but the more complicated answer is that in current situation it might hold a grain of truth.
Start
with the basic AS-AD model, which has the total output on the horizontal axis
and the price level on the vertical one.[1]
In this space, the aggregate demand is a downward sloping curve, with higher price
level resulting in lower total output demanded. Meanwhile, the aggregate supply
is upward sloping curve, capturing that higher price level means higher total
output supplied.
On
the first (very brief) look it might seem that inflation can indeed cause
decrease in aggregate demand, but one should quickly realize that this
reasoning is faulty: while the total output demanded will decrease when price
level increases, the curve capturing the relationship between output demanded
and price level is the same. In other words, this is a macroeconomic analogy of
the mistake made by first year students of microeconomics, who struggle to
distinguish between decrease in quantity demanded caused by higher price, and decrease
in demand caused by some other factor. Since only the change in (aggregate) demand
or supply can change the equilibrium price (level), then arguing that higher
price (level) leads to lower (aggregate) demand is confusing causes with consequences:
the price (level) is an equilibrium outcome of the model, and not a driving
force of changes in the equilibrium. As one of my favorite bloggers says, an economist
should never argue from a price change!
At
this point one could feel that this is just semantics – economists often say that
higher price means lower demand, knowing full well that it is really quantity
demanded what they have in mind. They do this because they speak to general population
that did not go through basis economic course and hence would not understand the
terminology of “change in quantity demanded” vs. “change in demand”.
However,
the problem is that in many situations the writers are not using this as a
shorthand terminology, which then leads to problematic lines of reasoning. In
case of inflation and aggregate demand, the problematic reasoning goes like
this: we are currently seeing high inflation, which will cause a decrease in
aggregate demand, and hence we are in danger of economy going into recession.
In
this reasoning, the high inflation is what is driving the economy into
recession. This reasoning is problematic because high inflation is a response
of the model to some shock, not source of shock. To see this consider a scenario
in which current inflation is caused by large increase in aggregate demand. In
such situation, the AS-AD model tells us that output should increase and so
should price level, both of which we observed. Is there a reason to worry about
decreasing aggregate demand and recession? No, because we started with increase
in aggregate demand!
What
about the situation when the higher prices are cause by decrease in aggregate
supply, say because of an supply bottlenecks? Here, we will indeed observe decrease
in output – a recession – and inflation. However, it is not inflation causing
the decline in output, it is the supply shock and corresponding decrease in
supply. Worrying about inflation is double-counting: there is no further
decrease in output because of the high inflation, all of the decrease is due to
the supply shock.
The faulty
reasoning can go even one step further: if inflation will cause decrease in
aggregate demand, then, some argue, this is all good, because lower aggregate
demand will lead to lower prices/inflation, which is what we need. Of course,
one then can wonder whether lower prices will not cause higher aggregate demand,
which will cause higher inflation… and so on and so on.[2],[3]
Overall,
we are left with the conclusion that in basic macro saying “inflation will
cause decrease in aggregate demand” is a nonsense. Does it mean the
argument belongs to garbage bin? Or could we find support for it if we leave
the world of basic macro? Every now and then I catch myself being annoyed with
some argument which is a bad economics, but that captures some more complicated
story that is valid, and I think this is the case here.
To
see this, consider abandoning the notion of homogenous output, and considering
heterogenous outputs. Large part of the European inflation right now is driven
by jump in energy costs, reflecting the combination of diminished supply and revived
(global) demand. While the diminished supply in AS-AD world would amount to concurrent
decrease in aggregate supply and increase in aggregate demand, resulting in inflation,
the AS-AD world is maybe not very suitable for the present situation. Instead, we
could think about things in terms economy with two sectors, energy sector and
all the rest, and assume that energy is supplied by foreign country. In such
situation, increase in price of energy will lead to a decrease in aggregate demand
in the rest of the economy, and hence inflation will indeed cause something
which is akin to decrease in aggregate demand.
What
about savings, not present in basic static macroeconomics, could those create
link between inflation and aggregate demand? Inflation clearly leads to
decrease in value of savings, so it might seem that inflation will cause
decrease in savings, which will cause decrease in aggregate demand. However, this
story is not fully satisfying from macroeconomic perspective: in general, higher
prices also mean higher profits and higher wages, which should cancel the
effect on aggregate demand. But it might be the case that the higher prices are
indeed driving decrease in aggregate demand, if we either consider
heterogeneity of households or some form of myopic behavior. In case of heterogenous
households, it might be that the distribution of costs of higher prices and benefits
of higher prices is such that it shifts money towards households who will spend
less. In case of myopic households, it might be that higher households are
spending for as long as they have money in their accounts, but once they draw down
these balances, they stop spending.
So,
there, we have it. In general, the argument “inflation will cause decrease in
aggregate demand” rings hollow, but it might not be always the case if the
inflation is either heterogenous in terms of its source, coming from decrease in
supply in particular sector of the economy, or heterogenous in terms of distribution
of impacts on households. I don’t think that’s what the pundits have in mind,
though.
P.S.:
Note the microeconomics equivalent of this blogpost is a blogpost about “Do
higher car prices cause lower demand for cars?”. The answer is yes, if one
means decrease in quantity demanded, but no, if one means that people will not
want to buy cars anymore and that car makers should be worried: as soon as
price of cars will go back down, quantity demanded will again increase.
[1] One
could re-formulate the model so that we have (surprise) inflation on the
horizontal axis instead of price level.
[2]
The is again analogical to microeconomics, where you will see students in an endless
loop of reasoning: higher price means lower demand, which means lower price,
which means higher demand, which mean higher price, which means lower demand, …
[3] This
last point points towards a way one could salvage the argument that inflation
will lead to decrease in aggregate demand. Maybe, it could be an argument about
disequilibrium and dynamics. Maybe, the decrease in aggregate supply was not
matched by decrease in aggregate output demanded yet, and hence decrease in
output is to be expected in due course. It does not take the form of shift in
the curve, but rather movement from disequilibrium position to position back on
the curve.
However, this does not solve the puzzle fully: the already
observed higher prices mean that we have moved, so current inflation should not
cause further decline in output demanded in future. Moreover, in economics it
is typically the prices that adjust faster than quantities. After all, the
decrease in supply means that we are not able to produce the same quantities as
before, so it is hard to see how it is the prices that adjusted first and
quantities will adjust later.
