Demand-Driven Inflation

Post-covid inflation was predominantly driven by unexpectedly strong demand forces---both in the United States and in the Euro Area. We establish this result using a sequence of structural VARs with progressively richer specifications, interpret it through the lens of standard AD-AS analysis and an estimated DSGE model, and provide independent support for this conclusion using survey forecasts and real-time data. These demand forces reflected a combination of surprisingly robust pent-up demand following the pandemic restrictions, stronger-than-expected expansionary fiscal policies, and an unusually accommodative monetary stance. Together, they mitigated the recessionary effects of adverse supply shocks and supported the recovery, albeit at the cost of higher inflation. The economic intuition is simple: When a central bank responds forcefully to inflationary pressures, as the Fed and the ECB have done in recent decades, the aggregate demand curve is relatively flat, so supply disturbances move real activity much more than inflation. A large inflation surge, therefore, requires a shift or rotation of the aggregate demand curve.