As vaccines are distributed and the end of the COVID-19 era seems more certain, the debate over how the pandemic will affect the general price level has become more prevalent among economists. Could the pandemic put an end to years of low inflation?

First, monetarist theory argues that given the vast amounts of monetary stimulus from government debt, inflation is inevitable. Government debt in the UK has increased by almost a fifth of GDP, the greatest annual increase in the supply of money in the post-war period. However, many do not see this increase in money as an issue, pointing to periods of low inflation after large monetary stimulus from the 2008 financial crisis. However, the global financial crisis was also followed by a credit crunch which effectively restricted the supply of money in the economy. By contrast, this crisis has had the reverse effect on bank lending: in 2020 annual corporate loans increased by 11% year on year. Such free availability of credit for consumers and firms combined with staggeringly large purchases of government bonds risk a high level of inflation.

Second, as well as creating numerous short-run supply disruptions, hysteresis effects mean that COVID-19 will have a several negative impacts on the long-run aggregate supply of economies. The vast losses in revenue incurred by businesses during the pandemic mean that many will not recover. Overall, the outbreak’s damage is expected to increase the number of corporate insolvencies by 26%. It will take time for these suppliers to be replaced. In the meantime, the economy will experience a reduced supply output which will result in fewer goods and services being produced than are demanded, causing an increase in the price level.

Another impact on the long-run supply output of the economy will be a significant loss of productivity. The deskilling of workers due to unemployment will reduce labour productivity. Layoffs to counteract revenue losses have resulted in a 1.2% decrease in unemployment from the previous year. Short-term unemployment shocks like this often cause a permanent loss of skill, especially if workers cannot quickly obtain new jobs which will likely be in short supply, meaning the effects of the shock persist for a long time after. Ultimately, this degradation of skill will result in reduced potential output for labour in the economy.

Additionally, there will be a reduction in overall productivity due to reduced investment. A shortage of cash due to lost revenues means that business investments in the UK are 19% lower than usual, reducing scope for innovation. Until they can recoup losses incurred during the pandemic, firms will not have the liquidity to invest in developing more efficient production technology or training new workers. As a result, the total factor productivity is likely to be much lower than it would be without the pandemic, reducing potential supply output.

The reduction in supply output of the economy means that if aggregate demand were to rebound, it would be accompanied by a rise in the general price level. Although the pandemic has resulted in extremely low demand, most of these shocks are temporary. As countries recover from the pandemic, rebounds in consumption and investment, as well as high public spending mean that aggregate demand will increase from its current lows. First, as vaccines are implemented and restrictions lifted, consumers making up for lost time may cause a temporary boom in consumption. The Arousal Theory of Motivation suggests that individuals who suffer a deficit of “psychological arousal” seek forms of stimulus. In the context of the pandemic this means that having suffered lockdowns, consumers will be more likely to spend, as they will have “a higher tendency of sensation seeking”. Moreover, vast government expenditure through financial support for households and businesses, which already totals £140bn, will keep demand high. Lastly, as the uncertainty caused by the pandemic subsides, business investment should return to normal levels, and is expected to increase by 9.3% in 2022, sustaining the rebound in aggregate demand, thus putting upward pressure on inflation. By contrast, one of the ways in which it may seem COVID-19 will be disinflationary is a rise in technological progress that has resulted from it.

Despite tremendous efforts to stimulate demand in the form of quantitative easing and interest cuts, inflation has remained low for many years. Many see technology growth as one of the reasons why prices have hardly increased. Greater production efficiency from better technology has dramatically lowered costs, thus keeping prices low. COVID-19 will act as a driving force behind the acceleration in technology – the exposure of vulnerabilities in labour mean that over two thirds of firms have accelerated development in AI and automation. Additionally, much of the increase in remote working will be permanent – surveys suggest that the proportion of employees working three to five days a week at home will increase by 16 percentage points as a result of the pandemic. This long-term increase in remote working means that fewer companies will need to pay for travel expenses or office rent, lowering operating costs. COVID-19 will also result in a permanent increase in online retailing: over 50% of consumers say they will continue their increased rate of online shopping after the pandemic. The increase in the exchange of online goods and services, which are on average 4% less than prices in store, is likely to further reduce average prices. Overall, while these effects all point to lower average prices, they will likely be minimal due to shortage of cash mentioned earlier. Moreover, because of the deskilling of workers and the lack of cash to retrain them, the cost of labour will increase. Although firms will increasingly seek to replace expensive labour with cheaper capital, human input will still be required in the production of most goods and services for the foreseeable future. Overall, this means that prices are unlikely to fall despite technological development.

Another key factor in determining inflation is the expectation for the economy. Inflation expectations are self-fulfilling: when the real value of money is expected to decrease, consumption and investment go up. Current expectations are low in the UK – a survey conducted in September 2020 shows that more people are pessimistic than not about an economic recovery in the UK. Since economic activity and inflation tend to be mutually reinforcing, this would imply low expectations of future inflation. Moreover, this pessimism could in itself slow economic recovery, as households, fearing a prolonged recession, become more willing to save than spend. Many also fear that years of unmet inflation targets could render any attempt at monetary expansion ineffective, since, having lost faith in inflation targets, households and firms continue to save, and banks give out fewer loans.

Although unemployment may make costs higher in the long run, the Short-Run Phillips Curve (SRPC) suggests that the unemployment caused by it will be disinflationary. It is argued that this is because there will be fewer jobs in supply than demanded, resulting in little or no nominal change in wages. This disinflationary effect will be augmented due to furlough schemes, which remove the incentive to seek new work, thereby reducing the short-term supply of labour. Moreover, the long-lasting effects of labour shocks on unemployment mean that the economy will experience a negative output gap for a long time, also implying low inflation.

However, the disinflationary effect of spare capacity may not be as strong as one might expect for two reasons. First, contrary to traditional representations, the Phillips curve is non-linear: data from the UK, US, and Canada show that the SRPC is convex. Since inflation is not directly proportional to unemployment levels, the disinflationary effect caused by vast increases in unemployment from COVID-19 is only marginally greater than if the increase in unemployment was much smaller. Secondly, the effect will be diminished by nominal price rigidity. If firms perceive the demand shock from COVID-19 to be temporary, they will prefer to keep prices the same, as it is often expensive to change them. Vaccines offer some hope that normalcy will soon return, making this price stickiness even more likely.

Overall, COVID-19 has resulted in monetary expansion on an unprecedented scale as well as long-term supply reductions. And its demand effects, while large, will likely only be temporary. Lastly, disinflationary effects from increased automation and unemployment will be minimal at best. However, it is important to note that the inflationary outcome of COVID-19 greatly depends on how well governments respond to the virus through vaccine distribution and effective lockdown measures, as well as the future of the virus, which remains largely unpredictable. A turn for the worse could exacerbate low expectations, discouraging consumption and investment. By contrast, price rises as a result of Brexit could mean that the true inflationary nature of the pandemic may never be determined. Ultimately, the pandemic’s end is inevitable, at which point the likely resurgence of demand will make inflation the most probable outcome.