Supply and demand explain why we are probably headed for stagflation

Inflation has made its appearance both in developed economies and developing economies after many decades and thus is now at the centre of debates for citizens and policymakers all over the globe.

Though all economies suffer from inflation, there are significant differences in how the countries experience it. In each country, each region, and each sector, inflation is created in a different way, so its effects on the economy, the financial markets, interest rates, and currency needs to be evaluated in a different way. Therefore, in order to deal with it, policymakers of each country are required to provide different solutions for dealing with it.

As a general rule, inflation is a condition that can be caused by a decrease in supply, that is, a decrease in the ability of an economy to provide goods and services, as well as an increase in the demand for goods and services. Or from a combination of the two above, which is the situation the world economy is currently experiencing.

Decrease in supply

The reduction in supply, which led to increased inflation, was initially caused by the shutdown of business activity due to COVID-19. The closure of borders disrupted the supply chain and thus has reduced the supply of goods and services at a global level. 

Moreover, supply was reduced because the continuous lockdowns due to the pandemic for about two years reduced labour supply. In fact, many people who lost their jobs due to the significantly reduced supply in certain job sectors changed their professional orientation, while others who were close to retirement opted for early retirement. , Also, due to the pandemic, migration in search of work in some industries and countries has decreased significantly, and therefore their participation in the labour force in these industries and countries has also decreased.

The unfavourable situation created by the pandemic intensified even more after the Russian invasion of Ukraine, as the war has greatly affected supply chains and the supply of essential goods such as oil, gas, agricultural products, wheat and corn also fertilizers since these two countries have a large share of these goods in the global production. The reduction and disruption of the supply chain of essential commodities by these two countries led to a rapid rise in commodity prices and, consequently, a rise in inflation.

Furthermore, a critical parameter concerns the fact that in the emerging economies, the transition to conditions of low inflation and low-interest rates in the last decades was incomplete, with the result that the disruption of the supply chain led to a rapid rise in interest rates, and a consequent reduction in the production capacity of these countries and thus reducing the supply of products on world markets from these countries.

Increase in demand

Economic policymakers since the onset of the pandemic in their effort to support households and businesses in 2020 and 2021 implemented expansionary fiscal policy. This policy, combined with the capital surplus created by the reduction in investment and consumption during the pandemic period, later led to an explosion in demand for goods and services.

The increase in demand has also been contributed by the easing of monetary policy since in some countries central banks lowered interest rates to stimulate economic growth. Indeed, low-interest rates have acted as an important driver for strengthening demand in the last years.

Determining prices and growth

Let us now see by illustrating the economic model of supply and demand the way in which the above two indicators worked to determine prices and growth in the economy and the market.

The figure below shows the supply and demand curves for the entire economy (GDP). The demand curve slopes downward because lower prices encourage more spending and output while higher prices reduce spending and output. The supply curve is upward sloping because higher prices induce more production while lower prices discourage production. The vertical axis measures the price level and thus the increase or decrease of inflation while the horizontal axis measures real GDP and therefore the growth of the economy.

The increase in demand (shown in green), is indicated by the shift in the demand curve from 2019 [solid line] to 2022 [dashed line] on the right side of the diagram. This shift of the demand curve to the right side of the diagram would indicate an increase in real GDP if it were accompanied by an increase in supply and, therefore, a corresponding shift of the supply curve (shown in orange) also to the right side of the diagram. That, if there had been a rightward shift in the dotted line defining the Optimum Supply Curve (shown in brown). However, this did not happen. Instead, the supply curve (shown in orange) shifted to the left from 2019 [solid line] to 2022 [dashed line] as supply, for the reasons discussed above, decreased, resulting in the rising price level and thus inflation and the decline in real GDP.

Heading into stagflation 

The supply shock is negative in all economies of the world. Due to the war in Ukraine, the countries and regions that will face the biggest challenges in supplying goods to them are the countries of Europe. In addition, developing world countries due to supply chain disruption will likely face a food crisis, while borrowing costs for developing countries will remain high.

The biggest challenge for developed economies and especially Europe will be the energy transition from fossil fuels to clean energy. However, this will take time and lead to higher prices for the metals and minerals that will be required for this transition.

In the UK, Brexit through greater trade restrictions and costs will slow economic growth and increase inflation.

A possible reduction in energy supply from Russia next winter will reduce the production of goods and thus shift the supply curve to the left. This, combined with the impending tightening of monetary policy by central banks, creates demand-reducing effects and shifts the demand curve also to the left, (tending towards the 2019 level). This combination can create pressure conditions on real GDP, while inflation will remain high. Such a scenario makes stagflation conditions inevitable and its maintenance at least in the medium term.