Supply and Demand Driven Inflation

Under economic theory inflation and deflationary periods arise from shocks to aggregated demand or supply in the economy. Shocks can arise through a wide range of generally unexpected factors. On an on-going basis shocks typically arise from technology innovations changing the cost of supply, and preferences and tastes changing demand. However, recent events such as the COVID19 pandemic, trade wars and international politics, have significantly affected both supply and demand.

Demand and supply shocks often necessitate different policy responses, both in terms of whether the shock is likely to be permanent or transitory and whether interest rates or other tax and policy responses are necessary. The following presents an approach to understanding the source and sectors driving inflation. The analysis utilises the price and quantity trends of expenditure by Australian households across 27 key categories.

Contribution to Inflation

Trends in the decomposition of inflation into supply and demand shocks highlight the two periods of significant negative demand during the GFC and COVID19 pandemic as well as the demand spike in 2023. Persistent supply constraints were significant contributors to inflation in the lead up to the GFC.

This analysis uses the seasonally adjusted current price and constant price (chain volume) quarterly series of the Australian Household Final Consumption Expenditure (HFCE) from the Australian National Accounts. The difference between the current price and chain volume series implies the price changes, the chain volume series implies the quantity changes. A 10 year rolling Vector Autoregression model with 4 quarterly lags is applied to isolate structural and seasonal price and quantity chages; the residuals represent the price and quantity shocks. HFCE differs from CPI in using quarterly expenditure weights, where CPI is approximately annually re-weighted which prohibits assessing the impact of quarterly quantity along side price changes. Other measurement differences are summarised by the Australian Bureau of Statistics.

Methodology

Under an upward sloping supply curve and a downward sloping demand curve, for any sector i the relationships between quantity () and price () are given by the simultaneous equation:

In a time series vector autoregression, using quarterly data and with 4 quarterly lags representing auto- and cross correlations as well as a constant:

From this relationship, , the regression residual, represents the price or quantity shock after adjusting for structural pricing and production lags in the market for each category. If:

The probabilistic decomposition of contribution to overall inflation from the shock in a sector, is then:

where is the expenditure share of category i, is the quarterly inflation in category i, represent the probabilistic thresholds for strong, weak and ambiguous supply and demand shocks. The demand shock probability is derived parametrically from the standardised normal distribution quantile of the product of the quantity and price regression shocks.

Expenditure Category Contributions

A good example for understanding the mechanism for supply/demand decomposition of inflation is to review the supply and demand shocks for individual sectors. The recent experiences of price and quantities for the accommodation services sector follows a easy to understand classic pricing cycle:

1. Negative demand shock: Starting in 2020, COVID19 lockdowns introduce travel restrictions, both the price of accommodation as well as the quantity of accommodation declined significantly during the lockdowns .
2. Positive demand shock: From 2022, after the COVID19 restrictions are lifted, travel increased rapidly, the price of accommodation increased rapidly in response as the surge .
3. Positive supply shock: After some quarters of high prices additional suppliers of accommodation services entered the market, for example new hotels are built, additonal homes or rooms become available for short term rental, the addition accommodation reduces prices .
4. Negative supply shocks: From 2026 new tax policies reduce benefits from short term rentals, reducing the quantity of available accommodation services and pushing up prices .