I tend to take a quite negative stance on the issue of current monetary policy, as those of you who have read my previous writing know. While I stand by those views, which I have elaborated in a previous blog post you can find here, I want the blog to be a forum for discussion and a medium to explore different viewpoints which is why I will this week explain one view of why low rates of inflation proves so stubborn. As the title implies, there are links between technology and inflation and perhaps it is the high rate of technological progress the world currently enjoys which puts a deflationary pressure on price levels. How would that happen? Let’s find out.
In order to explain the relationship between inflation and technology we need to understand what inflation is, what causes it, and what counters it. Inflation is, according to Investopedia “a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period or time”. Or in plain English: the speed at which prices increase. What causes inflation? Well, there are a few schools of thought on the matter. The monetarist school believes, in the words of Milton Friedman himself, that inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in money than in output. Another view is that inflation is primarily determined by previous inflation and expectations about the future, i.e. if last years inflation was 2% and you expect this year’s inflation to be 2% you demand a 2% rise in your pay so that your living standard is constant which on an aggregate scale becomes a self-fulfilling prophecy. The last, and for this blog post most relevant, model of inflation is the so-called cost-push inflation. Cost-push inflation comes about when the inputs in a production process become more expensive to which firms react by raising prices for consumers to preserve their profits.
Now that we’ve explained inflation we can start to examine how technological progress could impact inflation. In a cost-push model inflation is a result of rising production costs which are shifted to end consumers by firms in order to keep profits constant, but what happens if production costs instead of rising start to fall? Well, if this occurs in an uncompetitive market then the producing firm simply get higher profit margins but if this happens in a competitive market then producing firms have to lower their prices to stay competitive. So if technology enables firms to produce their goods and services cheaper than before in a competitive market then prices fall, benefiting consumers because they can buy more for the same money as before. What’s relevant here is the definition of inflation, recall that inflation is the rate at which prices in an economy rise. If prices in an economy fall we end up with deflation, i.e. the inverse of inflation, which is considered dangerous as deflation creates a vicious cycle where people buy as little as possible as their money will, in real terms, be more valuable tomorrow. Therefore, if technology makes production cheaper and easier then that puts a deflationary pressure on the economy as, if it were left to its own devices, the economy would enter deflation as general price levels decline.
So is this the case in reality? Probably, but it depends on which way you believe inflation is created. My views on the subject is that I believe technological progress has a deflationary quality, however that does not excuse the shortcomings of most Western (and Japanese) monetary policy since 2008. Obviously, deflation is bad and should be fought, but there must be a way with less harmful impact on wealth distribution.
What are your thoughts on the matter? Please share your thoughts on Twitter, which is the easiest way to reach me should you want to, and come back next week for another blog post. You can read my other blog posts on economimcs here.
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