Unmasking Inflation: Demand, Not Supply

A recent research paper argues that the primary driver of post-pandemic inflation in both the U.S. and Europe was demand, not supply.

At the European Central Bank’s annual gathering in Sintra, Portugal, economists Domenico Giannone of the International Monetary Fund and Giorgio Primiceri of Northwestern University challenged the prevailing view that supply-chain disruptions were the main cause of inflation. “This popular narrative is difficult to square with all the evidence,” they stated in their presentation, held at the same conference where Federal Reserve Chair Jerome Powell is set to speak.

The economists explained that both the U.S. Federal Reserve and the European Central Bank are effective inflation targeters, resulting in a flat aggregate demand curve. They argued that for inflation to rise, the demand curve must shift upwards due to demand shocks or deviations from previous monetary policy.


Their analysis showed that in the U.S., more than half of the rise and fall in inflation could be attributed to demand disturbances. In Europe, while supply factors significantly impacted GDP, demand shocks played a larger role in inflation.


The researchers maintained their findings held true across various models and measures, including energy prices and monetary variables. They also referenced a separate study by former Fed Chairman Ben Bernanke and former International Monetary Fund chief economist Olivier Blanchard, which emphasized the impact of food and energy prices on inflation.

Giannone and Primiceri noted that their conclusions were not contradictory, as energy prices are influenced by fluctuations in aggregate demand.

The study simulated the potential impact of stricter ECB policies. If the ECB had neutralized all demand shocks, inflation would have peaked at 3%, but GDP would have suffered a cumulative loss of 4%. Raising interest rates earlier would have resulted in a 6% inflation peak with a 1% output loss. The researchers did not conduct a similar analysis for U.S. monetary policy.

In the current economic context, their model predicts an “easy last kilometer” in reducing inflation. They found that the ECB has not suffered significant damage or loss of credibility from its pandemic policies, with public perception returning to pre-Covid norms.

Eurostat’s recent data showed annual inflation easing to 2.5% in June from 2.6% in May, meeting economist estimates. The ECB made its first interest rate cut of the cycle in June.

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