Disrupted supply chains during the pandemic and the shortage of energy and food in the wake of the Ukraine conflict: The global economy has twice had to contend with events in the past three years that have led to sudden supply shortages. In the widely accepted standard model of neo-Keynesianism, however, such supply shocks have no long-term consequences for the economy. The inflation that we are currently experiencing, is in the models, only a side effect during an acute period of shortage and disappears again as soon as supply can be increased. 

Scarring after severe crises

"Various empirical studies have actually already shown that this is not so simple," says Dr. Martin Wolf of the Swiss Institute for International Economics and Applied Economic Research (SIAW-HSG) at the University of St.Gallen. According to these studies, short-term, severe supply crises can also have negative effects on the economy far beyond their immediate impact horizon. In order to investigate the inflationary consequences of such crises, an economic model should be consulted that traces this mechanism of action. Dr. Martin Wolf and his colleague Dr. Luca Fornaro from the University Pompeu Fabra in Barcelona dedicated themselves to this task. 

Investments decline

In the model of the two researchers, supply shocks lead directly to a drop in investment in the economy as a whole: "If, for example, energy becomes more expensive, as is currently the case in the wake of the Ukraine war, companies cut back on their production, invest less and it shrinks as a result," explains Martin Wolf. According to the model, this abrupt contraction process also has a negative impact on production and thus on supply in the long term: Once the acute phase of the shock is over, companies may reduce their investments to the pre-crisis level, for example to a total of 10 percent of gross domestic product. But this is not enough to make up for the lost investments of the crisis years. "To really get back to the pre-crisis trend in supply, there would actually have to be more investment in percentage terms than before," says Martin Wolf. 

Stubborn inflation

This persistent drop in supply now amplifies the shock's immediate impact on inflation. Consequently, in the two researchers' model, inflation remains above the central bank's target for several years, even if the shock is short-lived. "We are now a little less optimistic that inflation will disappear quickly," says Martin Wolf. 

Counterproductive monetary policy

Central banks often try to counter inflationary phases such as the one currently occurring with a restrictive monetary policy. As the study shows, however, this behavior could have a counterproductive effect in the medium term. If central banks raise their key interest rates in order to reduce the money supply, this will also make loans more expensive, which companies actually need for their investments in productivity increases. This keeps supply low, which supports inflation in the medium term. 

Create fiscal incentives

"Our model helps to understand why inflation was so persistent in the wake of the oil price shock in the 1970s," says Martin Wolf. For him, the study also makes clear that the one-sided fight against inflation via central banks should be questioned after supply shocks: "In addition to monetary policy measures, companies should also be encouraged to invest more in such crises, for example via tax policy. This is the only way to prevent a tightening of monetary policy from preventing important investments, which would further reduce supply and increase inflation in the medium term."

Image: Adobe Stock / MAK