Inflation is difficult to control, and its cause can be even more challenging to pinpoint. The surge in prices that accompanied the COVID-19 pandemic was often blamed on shortages in the supply chain. But new research by MIT Sloan experts shows that, mathematically, the overwhelming driver of that burst of inflation was federal spending.
The left panel in the figure below illustrates synchronized increases in global inflation during and immediately after the COVID-19 pandemic, with most of the acceleration coming from commodity price shocks (including oil prices, the Russian invasion of Ukraine, and the spike in food costs caused by tight labor markets and supply chain bottlenecks) and sectoral price spikes related to the sudden reopening of services sectors like tourism and hospitality. Moreover, these price shocks were likely transmitted across economies via shifts in the way firms and consumers interact with each other, amplifying relative price shocks and transmitting them to overall inflation, converting them into generalized inflation shocks.
Some of these shocks were transitory, meaning they will not last—the economic principle of supply and demand explains why: as the demand for a good or service goes up, so too do the prices that people are willing to pay for it. But there is also the risk of a spiral: when prices go up, workers demand higher wages to afford those prices. That can in turn lead to more prices going up, and so on. To avoid this danger, governments and central banks often increase their interest rates, which slows the economy and reduces inflation.
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