The Sectoral Anatomy of Inflation
Why a single instrument aimed at demand cannot reach multifaceted inflation dynamics.
“Inflation is always and everywhere
a monetaryan excess demand phenomenon”
Friedman’s famous quote is a rehash of the old quantity theory of money adage, that inflation is too much money chasing too few goods. For what mechanism could possibly make the creation of new money a danger to price stability, other than the fact that it is spent? The monetary story to which Friedman was a major contributor was always an excess-demand story. And even after monetarism’s prescriptions had failed, this story remains the founding principle of the modern monetary policy regime, which applies variable demand to an assumed context in which supply is exogenously determined.
One aggregate cause needs only one kind of lever. The framework establishes a policy rate that targets aggregate demand, and the monetary authority’s expanded toolkit supports the same mechanism that it was originally assigned to deploy. Monetary tightening is meant to raise the cost of borrowing, cool spending, and lower demand and inflation.
But the mechanism implicitly assumes that one of two things must be true. Either every price is set overwhelmingly by demand, so that shifting demand shifts all of them. Or, where prices are not sensitive to demand, demand can be suppressed sufficiently in the demand-sensitive sectors to compensate for the unresponsiveness of insensitive sectors.
