Jean-Paul L’Huillier (Brandeis University)

Why Do Supply Disruptions Lead to Inflation?

Abstract: According to anecdotal accounts, firms tend to justify price increases as a need to cover cost increases. Standard pricing models imply that firms do not only adjust to cost increases, but also to changes in spending (such as pent-up demand). We present a model where this is not necessarily the case. Our framework relies on an asymmetry between firms and consumers, where firms have more precise information about aggregate shocks. This leads to a novel microfoundation for price stickiness. There is differential adjustment depending on the type of shock, with supply shocks triggering more adjustment than demand shocks. We discipline the model using a survey of firms during the post-pandemic reopening of the German economy in March 2021. Consistent with the model, firms report increasing prices as a reaction to higher costs resulting from strenuous hygiene and social distancing regulations. On the other hand, in an effort to avoid upsetting customers, firms report not reacting to pent-up demand (despite equilibrium rationing). In a calibrated version of the model, despite both large demand and supply shocks, supply shocks are responsible for most of the upward adjustment of prices.