The Inflation Mystery That Wasn't

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As a result of our work here at Economic Forces, Brian and I are often referred to as the “supply and demand guys” by people we see at conferences or people who reference us on social media. In some sense, this is a badge of honor. It is a sign that the reach of Economic Forces is growing. On the other hand, it is somewhat of an odd moniker. After all, every economist that we know understands supply and demand. What have we done to deserve the moniker?

After giving it some thought, I think the moniker has more to do with the rest of the profession and less to do with us. What I mean by this is that it seems like there is a lot of focus elsewhere on creative or clever answers to problems. For some, this means using fancy econometric tools that allow them to simply focus “on the data” (whatever that means). For others, this means that complicated or difficult questions require complex models.

Yet, if you take price theory seriously, you realize that price theory is the tool that you need. Sure, sometimes price theoretic models are more complex than others. But the important point is that the lessons you learn from studying price theory are always there. In some sense, true mastery of price theory allows one to distill complicated questions into straightforward answers (my own mastery is more aspirational, but that is part of what Economic Forces is about).

This is why I like to tell the (possibly apocryphal) story of a young assistant professor asking Armen Alchian what he taught in his graduate course. Alchian is said to have replied, “I teach the theory of demand.” For Alchian, there was always more to explore. There was always another string to pull on when it came to thinking about demand.

Here at Economic Forces, we take that seriously. We try to see how well supply and demand can explain the world.

In terms of my own writing here, I tend to write a lot about money and financial markets. Some see these topics as a departure from price theory, but there is a rich tradition of people like Alchian and Ben Klein and Earl Thompson and Milton Friedman and many others who used price theory to generate insights about money and financial markets.

Nonetheless, it is understandable that people miss this connection. In finance, it is popular to assume that people are irrational and have various cognitive biases that require moving past traditional models. In modern macroeconomics, although there was a push for more microeconomic foundations, the monetary policy wing of macroeconomics just sort of retrofitted old Keynesian ideas into models with optimizing agents (and some rather ad hoc assumptions). Perhaps macroeconomics needs more of a price theoretic foundation.

These points are important. Price theory helps us to understand the world, including macroeconomic outcomes. The recent experience of inflation is one such example. Most pundits and policymakers predicted that any inflation coming out of the pandemic would be temporary, largely driven by supply shocks. In reality, inflation increased persistently throughout 2021 and remained high throughout 2022. My conjecture is that if the profession had greater price theoretic foundations with respect to macroeconomic questions, perhaps it would not have been caught so flat-footed with respect to inflation following the pandemic.