Traditional economic wisdom holds that demand surges during business cycle booms generate inflation. Demand rises more quickly than capacity during booms; in turn, this excess demand produces "tight" labor and product markets and therefore rising wages and prices. While this wisdom is widely accepted by economists, the press and policymakers, its empirical foundations are questionable, as many recent studies show that rates of wage and price inflation are uncorrelated or even negatively correlated with the business cycle. It is the investigator's opinion that these recent studies fail to address the question of whether demand surges generate wage and price inflation. The correlation between inflation and the business cycle reflects the influence of both supply and demand factors. Adverse supply shocks, such as the oil price increases of 1973 and 1979, cause prices to rise and output to fall; such shocks can cause prices to appear negatively correlated with the business cycle even if demand shocks generate wage-price inflation. Studies examining only the correlation between inflation and the business cycle are thus not useful to policymakers attempting to determine the potential inflationary effects of fiscal or monetary policies designed to stimulate short-run output growth. This research will implement a new methodology for addressing the relationship between demand shocks and wage-price inflation. Information from input-output tables published by the Bureau of Labor Statistics will be used to identify the actual sources of demand for disaggregated industries. This information makes the estimation of the responses of industry wages and prices to observable industry demand shocks possible. For instance, if input-output tables indicate that most lumber is used for construction purposes, the response of lumber wages and prices to movements in construction industry output will be investigated. By examining the relationship between price and industry demand, rather than the mere correlation between price and industry output, the influence of supply shocks on industry activity will be effectively controlled. These results will therefore be more useful than existing research for examining the potential inflationary impact of fiscal and monetary policies designed to stimulate aggregate demand.
