Prices Respond to Supply and Demand

Matthew Yglesias:

To maybe put the point about inflation in a different way, it’s worth breaking the term down. “Inflation” is what happens when prices rise. And prices rise, as we know, when demand begins to outpace the available supply. For example, suppose we had full employment and full industrial capacity utilization. Then suppose the Fed began printing money and throwing it off a helicopter. Well, folks would pick the money up and go to the store to buy stuff. So shops would start ordering more goods and looking to hire more salespeople. But the helicopter-drop hasn’t made anyone’s work more productive so it’s not actually possible for more goods to be produced in the aggregate or more people to be working in shops. Consequently, prices need to go up since demand for stuff is pushing up against the economy’s ability to supply the stuff. The people who happened to have picked the money up are going to be richer than they were before, but in “real” terms the economy isn’t making any more than it was previously. This is inflation, and in principle it could become a vicious cycle.

But suppose you’re in a different situation. Suppose that unemployment is at 10 percent. And suppose that capacity utilization looks like this:

Now suppose that Ben Bernanke prints up a bunch of money and drops it from a helicopter. Well, people pick the money up and they go to the store to buy stuff. So stores recognize that there’s increased demand and they start hiring more people and ordering more goods from factories. And since there’s this vast supply of idle labor and idle factories, it’s easy to hire more people and buy more goods without offering much in the way of a higher price. After all, if over 25 percent of the country’s industrial capacity is idle what’s going to happen if I’m a factory owner and I try to say “no, I won’t make any more stuff unless you pay me more money?” Well, you’re just going to tell me “fine, keep making what you’re making at the price I’m paying and I’ll find someone else to do the extra work.”

Now obviously labor isn’t perfectly fungible nor is industrial capacity perfectly flexible. You can’t just print money all the way down to four percent unemployment and 95 percent capacity utilization. But as recently as two years ago, eight percent unemployment was considered a frightening and distant prospect. We could print our way down to that, at a minimum. Or we could say we’re going to keep printing until inflation hits the two percent target, and then we’re going to keep interest rates at zero until we regain the long-term price level trend, and then we’re going to worry about inflation. It’s a matter of speculation how low unemployment would get before that became a problem, but it would have to be quite a bit lower than it is right now. At the moment supply of idle labor and production capacity is very high, so it’s not possible for the price of most things to rise.

Posted via email from Jim Nichols