Persistent Demand-Pull Inflation is Unlikely in Demand-Led Economies

Capitalist economies are demand led in the sense that both output and growth tend to reflect the behavior of autonomous demand, especially in the long run. Prices, in contrast, tend to be supply determined, reflecting cost. Supply shocks can temporarily dominate demand effects on output (for instance, as the result of war, a pandemic, or an oil shock), just as variations in demand, especially if supply is constricted, can temporarily dominate cost effects on prices. But the normal situation for a capitalist economy is demand-determined output and supply-determined prices.

There are two main factors that make persistent or long-lasting demand-pull inflation unlikely in demand-led economies. The first is that firms have reason to adapt productive capacity (including planned margins of spare capacity) to demand through investment so as to maintain market share. If the economy is already operating near full capacity, the accelerated investment can temporarily add to price pressures (since the demand effect of investment is immediate whereas the capacity effect takes time), but the process also tends to ensure that any instances of excess demand are short-lived. Once new capacity comes on line, and the initial demand impacts of investment have subsided, the economy’s supply potential will have expanded relative to demand.

A second factor is that technical progress is continually reducing labor requirements throughout the economy such that ongoing labor-market slack (evidenced by unemployment and underemployment) is the typical situation. A more or less permanent oversupply of workers makes it possible for firms to adjust both output and capacity to rising demand, drawing upon reserves of labor as needed. This will be true, at least, so long as the economy remains within resource limits.

The two factors reinforce each other. Strong demand growth relative to capacity not only encourages an expansion of productive scale but, especially if markets for labor-power and natural resources are tightening, creates additional impetus for labor-saving and natural-resource-economizing technical innovations. In this way, the adaption of capacity to demand entails not only quantitative changes in physical plant and equipment but qualitative improvements. Conversely, when demand growth is perennially sluggish, the impetus for technical innovation is weakened.

In an economy in which capacity is continually adapting to demand, persistent inflation (in excess of the policy target) is unlikely to originate from the demand side. To occur at all, persistent excessive inflation would likely need to be driven from the supply side, in the form of cost-push inflation. But this would require a capacity on the part of workers and firms to engage in an ongoing “battle of the markups”. For that to be sustained, workers would need an industrial clout that they presently lack, and have lacked for decades, and firms as a whole (and not just a cohort with monopolistic pricing power) would need to be able to escalate prices continually in a context of tepid wages growth.