OFR Creates Model Justifying Long-held View About Inflation Determinants
Published: April 20, 2023
Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the OFR or Treasury.
Greg Phelan is a Senior Economist with the Office of Financial Research. Jean-Paul L’Huillier is a Senior Economist with the Federal Reserve Bank of Cleveland and an Assistant Professor of Economics at Brandeis University.
In the new OFR working paper “Can Supply Shocks be Inflationary with a Flat Phillips Curve?” we present a new model for explaining how a longstanding theory about inflation just might be correct. That theory is simple: supply shocks cause inflation, demand shocks don’t. While these relationships are widely accepted, economists haven’t yet created a model that simultaneously yields both facts. The authors explain why and then provide a model in which prices are sticky with respect to demand shocks but flexible with respect to supply shocks. Their analysis has implications for optimal monetary policy.
Economists have documented that the relationship between inflation and demand—known as the Phillips curve—has been incredibly flat for decades, with almost no relationship between the two variables. Put simply, the Phillips curve is the measure that tells economists that demand shocks don’t cause inflation. This view that demand and inflation are not closely related has led many economists to suggest that inflation is instead caused by shocks to supply. On the other hand, standard macro models calibrated to have a very flat Phillips curve haven’t been able to produce inflation without resorting to implausible changes in supply.
In our working paper, we present a model and theory that simultaneously produces both a flat Phillips curve with respect to demand disturbances and significant inflation in response to realistic supply disturbances. This model is based on the strategic price-setting decisions of firms.
As we know, inflation is a continuing increase in prices, and prices are set by firms. In choosing their prices, firms, in part, consider how information about the state of the economy gets conveyed to consumers and whether or how they (the firms) would like to convey such information to maximize profits.
When demand shocks are not so volatile, firms strategically choose sticky prices that do not fluctuate in response to demand—meaning there is no inflation as a result of demand shocks. But firms have no strategic incentive to choose prices that do not fluctuate in response to marginal costs, so they will always set prices that respond flexibly to changes in their costs. Thus, because supply shocks increase firms’ costs, supply shocks also automatically affect the prices firms charge their customers—leading to inflation.
What Does This Mean for Monetary Policy?
Creating a model to show why this long-held view might be correct may not appear to have any immediate benefit. After all, there is consensus that a major cause of inflation in the 1970s was supply shocks. There is also consensus that, despite the demand shocks exhibited in 2020–21, a significant portion of the current inflation has supply-driven sources. Nevertheless, the authors contend that understanding what type of firm-pricing decisions underlie this consensus view could have crucial implications for optimal monetary policy.
In this setting, with asymmetric price rigidity, monetary policy should respond very differently to economic fluctuations caused by demand shocks compared to fluctuations caused by supply shocks. The authors’ model suggests that the conventional approach to demand shocks is correct, but supply shocks may require different responses. Standard monetary policy responses might not be effective at bringing down inflation, and more research is needed to understand these possible implications.