Consumer prices in Europe were rising at a rate of more than two percent starting in the summer of 2021. Russia’s attack on Ukraine in February caused additional global inflation by creating a shortage of raw materials. The risk of stagflation – a situation in which inflation reaches high levels and the economic performance of an economy stagnates or even shrinks – has risen.

Why does inflation occur?

Inflation means that the prices of consumer goods rise. Overall price levels in the economy rise.

Rising prices occur if the aggregate demand for goods exceeds the aggregate supply. When consumers realize that the products they want are in short supply, they are willing to pay a higher price.

There are two causes of price-increasing excess demand: an increase in aggregate demand or a decline in the supply of goods. Both have identical consequences for overall price levels but different effects on real gross domestic product (GDP).

Demand-driven inflation increases real GDP

To study the economic effects of changes in demand and supply, a simple graphical analysis tool is used, a price-quantity graph. It works with two central assumptions:

  1. Consumers demand fewer consumer goods when the price they have to pay increases. In a price-quantity graph, the aggregate demand curve has a downward slope.
  2. Companies increase their supply of goods when they receive a higher price for their products. The aggregate supply curve has an upward slope.

However, consumer demand depends not only on prices but also on disposable income for example: If consumers have a higher income, they can afford more goods. In a price-quantity graph, the demand curve is shifted to the right.

Such an increase in aggregate demand for goods has two key economic consequences:

  1. The overall price level in the economy rises, which means that demand-driven inflation
  2. When demand for consumer goods rises, companies adapt to it. They increase their production. The real GDP of the economy is growing.

graph: inflation

Supply-driven inflation lowers real GDP

The supply of goods by companies also depends on more factors than just the prices they receive for their products. If, for example, companies’ costs of production rise, it becomes less attractive for them to offer their products if the market price remains unchanged. They hence reduce their supply of goods.

In a price-quantity graph, the aggregate supply curve for goods is shifted to the left. Again, this results in an increase in the aggregate price level. Real GDP, however, declines.

graph: supply driven inflation

What are the current causes of inflation in Europe?

Three phases can be distinguished in the development of the overall economic price level in Europe since the start of the corona pandemic (and the same applies to the US):

  1. With the outbreak of the corona pandemic in Spring 2020, lockdowns occurred all over the world. Consumers reduced their demand for consumer goods. Low demand meant low prices. In Europe, inflation rates were close to zero or even negative.
  2. As vaccinations increased and the number of infections decreased, economic recovery Consumers demanded more goods. Rising demand has caused prices to rise since 2021. This was the phase of primarily demand-driven inflation but exacerbated by supply shortages due to global interruptions in the supply chains. What’s more, the monthly price increases in 2021 were also partly just a reaction to the low prices or price declines in 2020, so it’s a one-off level effect in 2021 that brings prices back to the previous year’s level.
  3. With the outbreak of the Ukraine war, supply shortages arose in Europe, especially for agricultural products and fossil fuels such as natural gas, oil and coal. The associated price increases are supply-driven inflation – with negative effects on real GDP.

graph: monthly consumer prices

What is the economic outlook?

At the moment, everything indicates that the supply shortages in the area of agricultural products and fossil energy in Europe will last longer. Europe can replace part of the shortfall in food and energy with imports from other countries. But because of the great importance of Russia and Ukraine for the global supply of natural gas and wheat, these shortfalls cannot be completely replaced.

And even if there is a substitute on the world market, Europe will pay higher prices because of the global supply shortage. At the same time, Europe is hit harder by energy price increases than the US, for example, because Europe has no domestic fossil fuel production while the US has and can even export energy to Europe.

Given the demand behavior outlined above, consumers will reduce their demand if the price of a product rises. However, this is difficult for essential products – people need a certain supply of food, electricity and energy. The same applies to companies which cannot produce without energy.

The current situation is made even more difficult now that China is again facing extensive lockdowns due to the corona pandemic. For Europe, this means the absence of urgently needed inputs and end products – in other words, an additional shortage of supply.

At least in the coming months, Europe will experience supply-driven inflation – with the negative effects on real GDP and the labor market outlined above. There is a threat of a combination of high inflation rates and stagnating economic output, i.e., stagflation.

What can economic policy do?

Neither governments nor central banks can remedy the cause of stagflation – i.e. the lack of energy, food and intermediate inputs. However, if economic weakness results from a supply shortage, limited economic policy options exist.

Especially in the short term, i.e., in the next 12 months, governments can somewhat increase supply.

  • One option is to release strategic energy reserves. However, these reserves are limited. In Germany, this reserve covers 90 days of demand. The supply-increasing effect of this measure, however, is small.
  • In addition, governments can try to enter into agreements with new supplier countries. However, since all resource-poor countries will follow this process and the change in supplier relationships takes time, this approach cannot completely eliminate the supply shortage in the short term.

Hence, at least in the short term, Europe will have to deal with the consequences of supply-driven inflation. The main issue here is to avoid social hardship. This may arise if consumers can no longer afford essential products or if companies have to shut down production.

Limiting price increases by means of government-set maximum prices is not a sensible option in this context. A low price means high demand, so the excess demand in the economy is not reduced. Moreover, given the supply behavior of companies outlined above, a price cap means that they do not expand their supply – so scarcity remains. Finally, this instrument also benefits high-income households that can get by without government support.

Needs-oriented transfer payments to relieve the burden on low-income households would be better. This would also take pressure off wage policy.

What must be avoided is a wage-price spiral which means the following:

  • Rising consumer prices reduce the purchasing power of labor income. Employees, therefore, demand higher nominal wages.
  • Higher wages increase companies’ cost of production. They have to increase the prices of goods to avoid lower profits or even losses.
  • A cost-induced price increase, in turn, means a loss of purchasing power for private individuals. Again, higher wages lead to higher prices via rising costs of production. The wage-price spiral turns faster and faster. Prices rise, but real GDP stagnates.

graph: wage-price spiral

Conclusion and outlook

If an economy suffers a slump due to a decline in aggregate demand, central banks and governments can stimulate aggregate demand – primarily by cutting interest rates and increasing government spending on goods and services.

The options for action in the event of an economic downturn due to a supply shortage, on the other hand, are limited. The government has few options to increase the supply of goods in the short term. Then stagflation looms: If consumers curtail their consumption demand due to higher consumer prices, companies will reduce production. Real GDP and employment will decline.

The government can compensate for this shortfall in demand by increasing public spending. Against the background of the current supply bottlenecks, this should focus primarily on low-energy products, e.g., services in the education sector. Other useful areas for higher government spending are the expansion of renewable energies, including solar, wind and hydropower and the development of the hydrogen economy.

At least in the short term, however, the dilemma remains that such demand stimuli have an inflation-increasing effect. To prevent this, the overall productivity of the economy must be increased. If that succeeds, more goods and services can be produced with a given quantity of factors of production. Inflationary pressure is hence reduced by an expansion of the supply of goods. However, productivity increases take time.

At least there is also a ray of hope: The abrupt shortage of raw materials led to a sharp rise in the corresponding prices in the first days and weeks of the Ukraine war. For example, the price of a barrel of crude oil rose from around $90 at the beginning of February 2022 to almost $125 at the beginning of March. Since then, however, „…, it has fallen somewhat and was slightly below 115 dollars in mid-May“.

graph: annual inflation

Thus, it could be that the outbreak of the Ukraine war will lead to a noticeable level effect in commodity prices and prices will remain at the current level but will not rise further. For monthly consumer prices, this means the following: The monthly rates of change in prices will remain at the levels now reached until the beginning of 2023. After that, however, inflation rates will normalize. This is also the expectation of the International Monetary Fund in its World Economic Outlook of April 2022. If these expectations are met, stagflation could be prevented.

About the author

Thieß Petersen is Senior Advisor at the Bertelsmann Stiftung, specializing in macro-economic studies and economics. His focus lies on the causes and effects of financial and economic crises as well as the chances and risks of globalization. Most recently, he worked on the effects of carbon pricing and the benefits of a potential global climate club.

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