# A method to decompose supply and demand inflation

It is a key Market Monetarist position that there is good and bad deflation and therefore also good and bad inflation. (For a discussion of this see Scott Sumner’s and David Beckworth’s posts here and here). Basically one can say that bad inflation/deflation is a result of demand shocks, while good inflation/deflation is a result of supply shocks. Demand inflation is determined by monetary policy, while supply inflation is independent of whatever happens to monetary policy.
The problem is that the only thing that normally can be observed is “headline” inflation, which of course mostly is a result of both supply shocks and changes in monetary policy. However, inspired by David Eagle’s work on Quasi-Real Indexing (QRI) I will here suggest a method to decompose monetary policy induced changes in consumer prices from supply shock driven changes in consumer prices. I use US data since 1960 to illustrate the method.

**Eagle’s simple equation of exchange**David Eagle in a number of his papers QRI starts out with the equation of exchange: (1) M*V=P*Y Eagle rewrites this to what he calls a simple equation of exchange: (2) N=P*Y where N=M*V This can be rewritten to (3) P=N/Y (3) Shows that consumer prices (P) are determined by the relationship between nominal GDP (N), which is determined by monetary policy (M*V) and by supply factors (Y, real GDP). We can rewrite as growth rates: (4) p=n-y Where p is US headline inflation, n is nominal GDP growth and y is real GDP growth.**Introducing supply shocks**If we assume that we can separate underlining trend growth in y from supply shocks then we can rewrite (4): (5) p=n-(yp+yt) Where yp is the*permanent*growth in productivity and yt is*transitory*(shocks) changes in productivity.**Defining demand and supply inflation**We can then use (5) to define demand inflation pd: (6) pd=n- yp And supply inflation, ps, can then be defined as (7) ps=p-pd (so p= ps+pd) Below is shown the decomposition of US inflation since 1960. In the calculation of demand inflation I have assumed a constant growth rate in yp around 3% y/y (or 0.7% q/q). More advanced methods could of course be used to estimate yp (which is unlikely to be constant over time), but it seems like the long-term growth rate of GDP has been pretty stable around 3% of the last couple of decade. Furthermore, slightly higher or lower trend growth in RGDP does not really change the overall results. We can of course go back from growth rates to the level and define a price index for demand prices as a Quasi-Real Price Index (QRPI). This is the price index that the monetary authorities can control. The graph illustrates the development in demand inflation and supply inflation. There graph reveals a lot of insights to US monetary policy – for example that the increase in inflation in the 1970s was driven by demand inflation and hence caused by the Federal Reserve rather than by an increase in oil prices. Second and most interesting from today’s perspective demand inflation already started to ease in 2006 and in 2008 we saw a historically sharp drop in the Quasi-Real Price Index. Hence, it is very clear from our measure of the Quasi-Real Price Index that US monetary policy turning strongly deflationary already in early 2008 – and before (!) the collapse of Lehman Brothers.**Lets target a 2% growth path for QRPI**It is clear that many people (including many economists) have a hard time comprehending NGDP level targeting. However, I am pretty certain that most people would agree that the central bank should target something it can actually directly influence. The Quasi-Real Price Index is just another modified price index (in the same way as for example core inflation) so why should the Federal Reserve not want to target a path level for QRPI with a growth path of 2%? (the clever reader will of course realise that will be exactly the same as a NGDP path level target of 5% - under an assumption of long term growth of RGDP of 3%). In the coming days I will have a look at the QRPI and US monetary history since the 1960s through the lens of the decomposition of inflation between supply inflation and demand inflation.
2011-12-17