Revisiting Inflation Theories:
Limitations and Prospects for Forecasting Contemporary Inflation Trends
Anushka V. Bagde
ECN 497
Professor Terzi
June 12, 2023
Abstract
This paper aims to assess the adequacy of current inflation theories in explaining and
predicting modern inflationary trends. The introduction begins with an overview of the present
state of inflation following the COVID-19 pandemic, emphasizing its impact on the economy
and living standards. It also discusses the measures taken by central banks in response to this
situation. The theoretical framework examines various theories of inflation, particularly focusing
on the monetarist and New Keynesian perspectives. The methodology incorporates Weber's
influential concept of systemically significant prices to analyze the limitations of traditional
frameworks in addressing inflation in the current context, emphasizing the need for consideration
of additional factors. The primary objective of this research paper is to evaluate existing inflation
theories, propose novel perspectives, and enhance our comprehension and management of
inflation in the contemporary economy.
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In the aftermath of the COVID-19 pandemic, inflation has emerged as a dominant
economic force, capturing headlines and eliciting significant concern among individuals,
businesses, and governments globally. This phenomenon is at its highest levels since the 1980s
and has plunged several countries into prolonged periods of instability, raising fears of a
recession and prompting a concerted effort to address its underlying causes and mitigate its
impact (IMF).
Inflation, as defined by the Federal Reserve, refers to the "general increase in the overall
price level of goods and services in the economy," and is widely regarded as a "cost of living
crisis." This is because inflation leads to a rise in the cost of essential goods and services, thereby
eroding the standard of living (Investopedia).
Due to the significant impact of inflation, several countries have made numerous attempts
to mitigate its effects. The most common or widespread response by central banks is to raise
interest rates, in order to dampen or slow down the economy (IMF). The Federal Reserve alters
the range of the federal funds target rate depending on the economic situation, done to fulfill
their dual mandate of maintaining stable prices and achieving maximum employment levels. To
achieve this, the Fed raises interest rates when inflation becomes too high due to an overheated
economy, and lowers them when the economy appears weak, resulting in high unemployment
rates (Forbes). Currently, the US central bank is increasing interest rates at a gradual and careful
pace. In March, they raised the benchmark borrowing rate by 0.25%, which resulted in a new
target range of 4.75-5%. This is the first time interest rates have reached this level since the
mid-2000s (Bankrate). The ECB similarly has upped its main rate up to 3.5% (The Guardian).
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Despite these efforts, inflation continues to pose a formidable challenge as many have
failed in anticipating inflation trends, thereby necessitating a critical evaluation of the adequacy
of prevailing theories used to measure and address this phenomenon. For example, Fed Chair
Jerome Powell consistently referred to the current inflation period as "transitory" in its early
stages, asserting an expected drop in inflation by the end of 2021 (Forbes). Similar claims were
made by other central banks, such as ECB board member Fabio Panetta, who stated, "the current
inflation spike is temporary and driven largely by supply factors." He further emphasized the
importance for central banks to exercise patience and look past these effects (Reuters). These
claims can be seen to be clearly wrong now, as inflation in the US remained around 5.3%
through September 2021, before surging to over 7% by December, and eventually reaching a
four-decade high of approximately 9% six months later.
This paper will evaluate the adequacy of prevailing inflation theories in accounting for
and forecasting inflation trends in the contemporary economy, arguing that existing theories are
insufficient in comprehensively elucidating and anticipating inflation patterns. The paper will
emphasize the need to adopt fresh perspectives and novel approaches to overcome this limitation,
specifically from Isabella Weber’s paper on measuring systemically significant prices from an
input-output perspective.
In order to accomplish this objective, this research paper is structured into multiple
sections that seek to investigate and assess the existing dominant hypotheses of inflation,
specifically in the aftermath of the pandemic. The segment on theoretical framework will
scrutinize two major theories of inflation: the monetarist approach and the new Keynesian
Phillips curve. The section on analysis will introduce Weber's notion of systemically significant
prices as a determinant of inflation, while the discussion section will emphasize Weber's ideas
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and propose why conventional frameworks for addressing inflation are constrained in the present
circumstances, necessitating the consideration of supplementary factors.
Overall, this paper aims to provide a comprehensive analysis of inflation theory and its
limitations in the contemporary economy. By examining various inflation theories and their
shortcomings, this paper seeks to provide insights for policymakers, researchers, and
practitioners in the field of macroeconomics. It is hoped that this paper will contribute to the
ongoing debate on inflation theory and encourage new approaches to the study of inflation.
Theoretical Framework
The literature review section of the paper analyzes different theories of inflation,
beginning with an exploration of the monetarist perspective, particularly the quantity theory of
money, along with the corresponding policy implications. Furthermore, the review examines the
New Keynesian approach, specifically focusing on the 3-equation model.
When discussing the causes of inflation, it is important to understand two terms:
cost-push inflation and demand-pull inflation. Cost-push inflation occurs when prices rise due to
increased costs of wages and raw materials. This leads to a decrease in the overall supply of
goods and services while the demand remains the same. As a result, the increased production
costs are passed on to consumers, resulting in cost-push inflation (Investopedia). On the other
hand, demand-pull inflation happens when prices increase due to a shortage in the supply of
goods. This is often described as a situation where there are "too many dollars chasing too few
goods." Essentially, when there is more demand for goods and services than what is available,
prices tend to rise (Investopedia).
4
The core belief in economics is that inflation is primarily influenced by monetary factors.
This suggests that inflation is ultimately a result of how monetary policy is conducted. The
monetarist theory, popularized by Milton Friedman in his influential book co-written with Anna
Schwartz A Monetary History of the United States, highlights the crucial role of the money
supply as a primary determinant of price levels and inflation and asserts that an excess money
supply leads to an increase in aggregate demand, ultimately resulting in inflation. This aligns
with the concept of demand-pull inflation.
This theory finds its roots in the Quantity Theory of Money (QTM), which establishes a
direct relationship between the money supply and the general price level of goods and services.
According to the QTM, there is a direct proportionality between the general price level of goods
and services and the money supply in an economy. In simpler terms, if the money supply
doubles, assuming all other factors remain constant, price levels will also double. The underlying
rationale for this relationship lies in the role of money as a medium of exchange. Money acts as a
means for facilitating transactions in an economy. When there is an increase in the money supply,
more money is available to be used in exchange for goods and services. However, if the quantity
of money becomes relatively larger compared to the amount of goods and services available, it
can lead to an imbalance in the economy. With an excess supply of money relative to the
available goods and services, individuals and businesses have more money to spend. This
increased demand for goods and services can drive up prices, resulting in inflation.
To mathematically express this relationship, economists use the Fisher Equation
(MV=PQ) to express the relationship between the money supply, price levels, and the quantity of
goods and services produced in an economy. Proposed by Irving Fisher, an American economist
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in the early 20th century, this equation provides a formal representation of the connection
between these variables.
The equation states that the money supply (M) multiplied by the velocity of circulation
(V) is equal to the price level (P) multiplied by the quantity of goods and services produced (Q).
The money supply (M) represents the total amount of money available in the economy, including
physical currency and demand deposits in banks. The velocity of circulation (V) refers to the
speed at which money changes hands and measures the frequency of transactions involving
money. The price level (P) reflects the average prices of goods and services in the economy,
indicating the purchasing power of money. The quantity of goods and services produced (Q)
represents the total value of all final goods and services produced within a specific time period
and is influenced by factors such as labor productivity, technology, and resource availability.
The Fisher Equation assumes that the velocity of money and the quantity of goods and
services produced remain relatively stable in the long run. This assumption allows economists to
focus on the relationship between the money supply and the price level. Changes in the money
supply are believed to primarily impact the price level rather than the real output of the economy.
When it comes to policy making, the Quantity Theory of Money (QTM) suggests that
central banks should regulate the money supply to ensure stable inflation levels. In the past,
central banks placed significant emphasis on monetary aggregates when formulating monetary
policies. A notable example is the German Bundesbank, which effectively tackled inflationary
pressures resulting from the oil price shocks of the 1970s by using monetary targets. Similarly,
the U.S. Federal Reserve, under Chairman Paul Volcker in 1979, highlighted the role of
monetary aggregates to overcome the great inflation in the United States (Beck).
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However, the importance of monetary aggregates has diminished in central bank
strategies since then. The U.S. Federal Reserve, for instance, began reducing the significance of
monetary aggregates in the early 1990s, primarily due to empirical challenges rather than new
theoretical frameworks. Presently, no central bank follows a monetary targeting strategy, and the
Bundesbank also faced difficulties in meeting short-term monetary growth targets during the
1990s (Beck).
This is where the New Keynesian school comes in. In contrast to QTM from the
monetarists, New Keynesians attribute the causes of inflation to factors beyond changes in the
money supply alone. While their views draw inspiration from monetarists, they believe that
inflation can emerge due to a range of factors, encompassing both demand-pull and cost-push
influences (Carlin). Building upon the principles of John Maynard Keynes, modern monetary
macroeconomics relies on what is commonly referred to as the 3-equation model known as
IS-MP-PC. This model consists of the IS curve, interest rate-based monetary policy rule, and
Phillips curve.
The IS curve, which forms the foundation of the model, illustrates the intricate
relationship between aggregate output and the interest rate. It highlights the interplay between
investment and saving decisions, which significantly shape a country's overall economic activity.
Specifically, the IS curve demonstrates that higher interest rates lead to lower output levels. It is
worth noting that the IS curve focuses on the connection between output and real interest rates
rather than nominal rates. Real interest rates account for the impact of inflation by subtracting it
from the headline (nominal) interest rate. Ultimately, it is the real interest rate that influences
consumers' perception of the attractiveness of saving versus spending. When real interest rates
increase, borrowing becomes more expensive, discouraging businesses from investing.
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Consequently, this reduction in investment spending ripples through the economy, leading to an
overall decline in output. Higher interest rates also affect consumption patterns. As the real
interest rate rises, the cost of borrowing for households increases, making it more expensive to
finance purchases through credit. Consequently, consumers may choose to save more and reduce
their spending, further contributing to the decrease in aggregate demand and output. Thus, the IS
curve captures the equilibrium relationship between aggregate output and the real interest rate,
representing the various combinations of output and interest rates at which the goods and
services market is in balance.
Secondly, the Phillips curve (PC) illustrates the trade-off between inflation and
unemployment, suggesting that policymakers face a choice between these two variables in the
short run. This curve, originating from A.W. Phillips' 1958 study at LSE, played a crucial role in
the early development of macroeconomics. Phillips observed a strong negative correlation
between wage inflation and unemployment, and subsequent research by MIT economists Robert
Solow and Paul Samuelson confirmed this relationship for both wage and price inflation in the
United States. The Phillips curve is a macroeconomic concept that describes the relationship
between inflation, inflation expectations, and the output gap. It provides a framework for
understanding the tradeoff between unemployment and inflation in an economy. The curve
suggests that there is a positive relationship between inflation and the output gap (figure 1),
which represents the difference between actual output and the "natural" level of output associated
with full employment or the so-called natural rate of unemployment. The Phillips curve quickly
became a foundation for macroeconomic policy discussions, with economists advising
governments to consider the tradeoff between achieving lower unemployment and the potential
for higher inflation.
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Figure 1: The Phillips Curve
The last component, monetary policy (MP), refers to the actions taken by a country's
central bank to control the money supply and interest rates in order to influence economic
conditions. It plays a crucial role in the modern monetary macroeconomics framework. The
interest rate-based monetary policy rule represents the central bank's strategy for adjusting
interest rates in response to changes in economic conditions. In this framework, the central bank
adjusts the nominal interest rate upwards when inflation goes up and downwards when inflation
goes down and it does so in a way that means when inflation equals a target chosen by the central
bank, real interest rates will be equal to their natural level. The central bank adjusts the target
interest rate based on its assessment of the current state of the economy and its desired policy
objectives. The monetary policy rule is a significant component of the IS-MP-PC model because
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it helps determine the position of the aggregate demand curve. Changes in the interest rate can
affect investment and consumption decisions, which, in turn, influence aggregate demand and
output levels. When the central bank raises interest rates, it aims to reduce aggregate demand and
inflationary pressures
The 3-equation model has gained prominence in the field of monetary economics and has
significantly influenced contemporary central bank policies. This model advises policymakers to
determine short-term interest rates, which serve as the primary policy tool for central banks,
based on inflation forecasts and output gaps. By emphasizing the importance of these factors, the
model reduces the significance of monetary aggregates derived from Friedman's monetarist
perspectives, as these aggregates do not directly affect the transmission of monetary policy to
output and inflation in the New-Keynesian model. Instead, monetary policy decisions are made
in consideration of the nominal interest rate, which indirectly affects the real interest rate due to
the inflexibility and delayed adjustment of some prices.
Overall, the 3-equation model has emerged as the leading approach in the realm of
monetary economics, guiding central bank policies by focusing on inflation forecasts, output
gaps, and short-term interest rates.
Methodology
This section introduces a forward-looking approach to policy responses to inflation,
based on Isabella Weber's influential working paper titled "Inflation in Times of Overlapping
Emergencies: Systemically Significant Prices from an Input-output Perspective," published in
2022. It has been mentioned in the mainstream including Bloomberg, The New Yorker, the
Financial Times. The key points of Weber's paper, including the utilization of the Leontif price
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model, the definition of systemically significant prices, and her empirical findings, will be
described. By adopting Weber's perspective on inflation, this research aims to assess the
limitations and gaps in the standard inflation theories within the context of the contemporary
economy.
Weber's paper becomes increasingly significant in light of the ever-changing
circumstances brought about by the COVID-19 pandemic. These times are unparalleled, both for
the world as a whole and for the global economy. Initially, price surges were primarily
concentrated within specific sectors before permeating the broader economy. The aftermath of
the pandemic has revealed that these sector-specific price increases can be attributed to various
factors, including disruptions in the supply chain and volatility in global commodity markets,
which were further amplified by the ongoing conflict in Ukraine (Bank of International
Settlement, 2022). In an era characterized by overlapping global emergencies, it is reasonable to
anticipate more frequent shocks specific to certain sectors. This raises the question of how these
shocks impact overall price stability and whether specific sectors play a more substantial role in
maintaining such stability. Weber's paper introduces an innovative approach to targeting micro
policies that can complement existing macroeconomic stabilization efforts.
Weber begins by defining the concept of "systemically significant prices." This term,
borrowed from the Financial Stability Board's definition of systemically important financial
institutions based on their potential to disrupt the wider financial system and economic activity,
is extended by Hockett and Omarova to include non-financial prices that can acquire systemic
significance. Building upon this idea, Weber argues that systemically significant prices are not
only crucial for financial stability but also for monetary stability.
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To operationalize the notion of systemic significance and identify prices that have the
most impact on inflation, Weber employs the Leontief price model. She conducts simulations of
price shocks to a single industry in a single period within the Leontief price model. The resulting
change in the synthetic Consumer Price Index (CPI) when the price of a specific industry is
shocked by a certain amount is referred to as the inflation impact. In Weber's framework, the
most systemically significant prices are those that exert the greatest influence on the general
price level as measured by the CPI. By identifying the most vulnerable points in the price
system, she argues that they possess the potential to acquire systemic significance for overall
monetary stability. These vulnerable points are often found in the most pervasive industries,
those whose output holds the utmost importance for the entire economic system in terms of
direct and indirect input value.
In examining the significance of specific industries for overall monetary stability, Weber
focuses not only on the structural importance of an industry, as indicated by the ubiquity of its
products, but also on the degree of price fluctuation within that industry. Price volatility varies
significantly across different sectors. Hence, an industry that produces a widely used input but
experiences minimal price fluctuations may have a lesser impact on overall monetary stability
compared to a less prevalent industry with higher price volatility. Instead of excluding goods
with high price volatility from the core CPI, as is commonly done in economic analysis, Weber
considers the systemwide implications of price volatility transmitted through input-output
relationships within her simulation-based approach.
The core model employed by Weber is the Leontief price model, which rests on the
fundamental premise that the entire economy constitutes an extensive intersectoral network of
cost-price connections. This implies an "interdependence among wage rates, profits earned, and
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taxes paid per unit of output in each of the many separate industries on the one hand and the
prices of all different kinds of goods and services sold by these industries on the other" (Leontief,
1947). By modeling prices as interconnected, Weber is able to simulate how an increase in a
specific price "is transmitted to the rest of the economy step by step via the chain of transactions
that links the whole system together" (Leontief, 1951), ultimately resulting in a rise in the
general price level. In essence, this allows Weber to simulate cost-push inflation. When the price
of any input rises, it directly affects the prices of industries utilizing that input, as well as
indirectly impacts the costs of other industries reliant on the output of the directly affected
sectors. It is important to note that Weber's model assumes constant wages and profits in nominal
terms. This implies that real wages and the profit share in total output of each sector decline as
prices increase due to a cost shock. By abstracting from nominal wage and profit adjustments in
the baseline model, Weber isolates the cost-push impact of systemically significant prices from
phenomena such as profiteering or wage-price spirals.
Weber then presents the results of her simulations of price shocks. She simulates shocks
to each of the 71 industries in the input-output table published by the U.S. Bureau of Economic
Analysis, identifying the industries that have the greatest total inflation impact and are thus
systemically significant for price stability. She utilizes the magnitudes of average price
volatilities between 2000 and 2019 as shocks in the simulation to identify latent systemically
significant prices in the two decades prior to the current inflation context. Subsequently, she
compares these latent systemically significant prices with the sectors that acquire systemic
significance when the price shocks are applied based on the post-shutdown inflation and the
context of the war in Ukraine.
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The magnitude of the price shocks to each industry, represented by a green dot, reflects
the average annual price change of each industry between 2000 and 2019, which is referred to as
the "sectoral price volatility." Figures 2.2 and 2.3 illustrate the annual price changes of each
industry between 2020-Q4 and 2021-Q4 (post-pandemic context) and between 2021-Q2 and
2022-Q2 (Ukraine war context), respectively. The yellow share indicates the direct inflation
impact, while the purple share represents the indirect inflation impact. The direct inflation impact
depends solely on the weight in the CPI and the magnitude of the price shock. On the other hand,
the indirect inflation impact captures an industry's position in the input-output network,
measured by the number of forward linkages. The combined length of the purple and yellow bars
reflects the total inflation impact on a synthetic CPI generated by a price shock to each industry.
Figure 2.1 Sectoral Price Volatility 2000-2019
The inflation impact varies widely, with certain industries exerting a more significant
influence than others. Notably, the "Petroleum and coal products" industry stands out, with a
latent inflation impact of 0.42 percent, more than twice as large as the next most important
industry. This industry alone accounts for almost one-quarter of the Fed's target interest rate.
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Following this industry, the next eight industries in the ranking of inflation impact form a distinct
group with a notably greater impact than the industries further down the list. In contrast, the rest
of the ranking shows less segmentation. This suggests the presence of a group of industries that
possess a distinctly high level of latent systemic significance.
Figure 2.2 Yearly Price Change from 2020 Q4 to 2021 Q4
In the analysis of the post-shutdown inflation impact, it is observed that the magnitude of
the total inflation impact has tripled compared to the latent inflation impact calculation from
2000 to 2019. However, the sectors that have the most significant impact on inflation remain
largely the same. Except for the "Motor vehicle and part dealers" industry, which experienced a
pandemic-related price increase of almost 40%, the other eight industries in the top nine most
significant prices were also identified as having latent systemic significance. Once again, the
"Petroleum and coal products" industry stands out as the most potent industry for price stability,
with an inflation impact of 1.48%, resulting from a substantial price increase of 75.66%. The
next most important industry has about half the impact of the petroleum industry.
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Additionally, the relative importance of each industry has shifted slightly compared to the
latent inflation impact analysis. One notable change is the rise of the "Wholesale trade" sector,
which has become the third most important industry for total inflation. The pandemic-induced
supply chain issues presented opportunities for wholesale traders to increase their prices
significantly, with an annual price increase of 9.56%, more than five times the average price
volatility of the previous two decades. The "Chemical products" industry has also risen to rank 4
in terms of total inflation impact, with prices increasing by an astonishing 18.13%, almost four
times the average volatility.
Figure 2.3 Yearly Price Change from 2021 Q2 and 2022 Q2
The results of the inflation impact analysis following the war in Ukraine closely resemble
those of the post-shutdown phase. The "Petroleum and coal products" industry remains the most
important sector by a significant margin, reflecting its latent importance in the global energy
crisis. The price increase in the "Utilities" sector further climbed to 26.81%, placing it at rank
four in terms of total inflation impact. "Wholesale trade" climbed to the second rank due to a
substantial annual price increase of 10.97%. The "Housing" sector became even more important,
ranking third in terms of inflation impact, with prices continuing to rise in a heated housing
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market, reaching an annual increase of 5.24%. The "Farms" sector experienced a price increase
of 25.92% due to the war in Ukraine's impact on global food markets, placing it at rank seven in
terms of inflation impact. The "Chemical products" sector's prices eased somewhat, leading to a
fall to rank nine. Two new sectors joined the top ten ranks: "Food services and drinking places"
at rank eight, reflecting high food prices and the return of eating out after COVID-19 shutdowns,
and "Truck transportation" at rank ten, likely influenced by high fuel prices.
Isabella Weber's paper presents a groundbreaking approach to identifying prices that have
significant implications for price stability. Her findings demonstrate that the sectors that are most
important in this regard remain consistent when considering both pre-pandemic average price
volatilities and the price shocks experienced during the current inflation period. However, the
overall impact of inflation has significantly increased during the post-shutdown and Ukraine war
inflation, approximately tripling in magnitude compared to latent inflation impact simulations. In
essence, the pre-pandemic economy's latent systemic significance has materialized in the form of
post-shutdown and Ukraine war inflation.
Several sectors have been identified as having systemic significance, including
"Petroleum and coal products," "Oil and gas extraction," "Farms," "Food and beverage and
tobacco products," "Chemical products," "Housing," "Utilities," and "Wholesale trade." Notably,
these sectors that gained systemic significance during the post-shutdown period and in the
aftermath of the Ukraine war align with those identified as systemically significant in
simulations using average price volatilities from 2000 to 2019. This observation suggests that
had appropriate institutions and policies been in place to stabilize these prices of systemic
importance, the current inflation crisis could have been proactively managed.
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Discussion
To address inflation effectively in the current context, it is necessary to move beyond
traditional frameworks and consider additional factors. Most economists have traditionally
viewed inflation as a macroeconomic phenomenon, with monetarists attributing it to "too much
money chasing too few goods" and New Keynesians linking it to the relationship between
aggregate demand and capacity utilization. These traditional approaches focus on controlling
macroeconomic variables such as the quantity of money and government spending. However,
recent inflationary pressures have revealed the limitations of these approaches, especially in
dealing with commodity-specific price shocks, energy crises, input shortages, and environmental
shocks.
Central banks, responsible for maintaining monetary stability, have struggled to address
these challenges, as acknowledged by Federal Reserve Chair Powell during a Congressional
Hearing in 2022. Consequently, policymakers have implemented reactive measures like windfall
profit taxes, anti-trust measures, price gouging policies, and direct price stabilization. However,
these measures have been ad hoc and often implemented only when inflation reaches
unprecedented levels. Considering the likelihood of more systemic shocks and overlapping
emergencies, there is a need for economic disaster preparedness to protect against vulnerabilities
that could destabilize monetary stability beyond the current inflationary environment.
Responding to significant price shocks before they trigger broader inflation dynamics is crucial.
Examining historical examples, the use of price controls during World War II in the
United States emerged as an effective strategy when inflation rates were close to two percent.
Industry-specific price controls prevented companies from raising prices above certain levels,
containing consumer costs while encouraging companies to increase sales volume to boost
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profits. This approach limited inflation without resorting to layoffs and wage cuts. Comparing
the economic conditions of the forties to the present, similarities like high consumer demand,
record corporate profits, and production bottlenecks suggest that strategies like price controls
from the wartime period could be relevant and effective today.
Contrasting with the conventional tactic of raising interest rates, which could harm
employment and industrial activity during wartime, industry-specific price controls manage
consumer costs while enabling companies to maintain profitability through increased sales
volume. Therefore, policymakers can explore the implementation of industry-specific price
controls, considering the historical success of price controls and recognizing the similarities
between past and present economic conditions, to contain inflation while supporting economic
stability.
Additionally, relying solely on raising interest rates can make borrowing more
challenging for businesses, potentially leading to cost-cutting measures like layoffs. Larry
Summers, former United States Secretary of the Treasury, even proposed aiming for a
ten-percent unemployment rate, resulting in sixteen million people losing their jobs. However,
this approach is considered painful. Comparing the pandemic relief spending of the United States
to that of Japan, it becomes evident that excessive government spending is not the sole cause of
inflation. Japan experienced inflation peaking at only 4.3 percent despite significant spending.
This challenges the assumption that excessive government spending always leads to high
inflation. Moreover, if excessive household wealth were the primary driver, one would expect a
uniform rise in prices across all consumer goods. However, inflationary pressure has mostly
originated from specific products and commodities, such as natural gas, which have experienced
significant price spikes. This observation challenges the notion that households are directing all
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their stimulus checks towards raising thermostat settings or increasing consumption across the
board.
By questioning the proposed solution of inducing mass layoffs and considering these
counterpoints, a more nuanced understanding of inflation drivers emerges. Factors like specific
supply and demand dynamics for certain products and commodities play a significant role. In
highly concentrated industries, companies have demonstrated the ability to prioritize price
increases over changes in volume, even in situations where demand is declining. The
understanding that competitors are likely to adopt similar pricing measures to protect their profit
margins further incentivizes coordinated pricing behavior. This has led firms across various
industries to inflate prices during the chaotic pandemic circumstances, exploiting customers who
were already expecting price hikes due to disruptions. This phenomenon, termed "sellers'
inflation," contrasts with the traditional model of inflation where excess consumer purchasing
power is typically seen as the cause.
Additionally, Weber highlights that disruptions occurring further upstream in the supply
chain have a more significant impact on consumers. For instance, if the price of electricity or oil
rises, it becomes harder to produce or transport various goods. The same principle applies to
essential commodities like chemicals, metals, and lumber, which are necessary for
manufacturing more complex products. Preventing these crucial component prices from spiraling
out of control could help mitigate inflationary pressures.
Considering the likelihood of more systemic shocks and overlapping emergencies, there
is a need for economic disaster preparedness to protect against vulnerabilities that could
destabilize monetary stability beyond the current inflationary environment. Weber suggests
targeting micro policies that complement macroeconomic stabilization efforts. She argues that
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vulnerabilities for price stability existed before the pandemic, and actual inflation involves not
only a change in the average price level but also a change in relative prices. Cost increases in
certain sectors lead to price increases through input-output relationships. This aligns with
Keynes's view that inflation involves far-reaching redistribution, with unequal incidence of price
level shifts.
Swift implementation of targeted measures is crucial to prevent price shocks from
propagating and contributing to inflationary pressures. This requires monitoring systemically
significant prices and having contingency plans for price stabilization, enhanced oversight, and
regulation in these sectors to discourage drastic price increases. Price stabilization policies can
take various forms, including strict price gouging legislation, automatic taxes on windfall profits
for systemically significant prices during emergencies, or strategic price caps. Regulations on
financial speculation and anti-trust legislation can also play important roles in stabilizing prices
in systemically significant sectors.
The specific mechanisms and forms of price stabilization measures should be tailored to
the realities of each sector, considering physical, institutional, and social factors. For instance,
(international) buyer stocks and central bank-style open market operations have been suggested
for important commodities. Investment encouragement programs may be necessary in
underinvested areas, and measures to enhance supply chain resilience, such as minimum
inventory requirements for systemically important goods, can help mitigate supply shocks.
In conclusion, understanding inflation as a multifaceted dynamic involving economic and
psychological factors reveals the mechanisms behind coordinated pricing behaviors.
Policymakers have resorted to ad hoc price stabilization measures, but swift implementation is
crucial to prevent price shocks from driving up inflation. Effective price stabilization policies
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should be tailored to systemically significant sectors and complemented by enhanced oversight,
regulation, and contingency plans. Further research is needed to refine these policies and develop
a comprehensive framework for addressing inflationary challenges.
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