Generally speaking, people think about inflation in terms of purchasing power. $1 from 1950 is worth $10 dollars today. It is quite important what that $10 represents, however. For true inflation (real inflation), it would take $10 today to purchase the exact same good for $1 in 1950. That is not always the real world case. Rather, $10 today purchases an enhanced version of the same good as in 1950 (or more likely a good that didn’t exist in 1950).
So what is exactly going on? To understand inflation with respect to the price level, it is necessary to introduce some macrofoundations into the micro analysis (a phrase borrowed from David Glasner). In an economy where there are productivity gains, a steady price level is not the absence of inflation. Productivity means producing the same good for less, and as such, productivity leads to a deflationary state absent an offset in demand. The offset by demand is where the stance of monetary policy comes into play.
If a monetary authority targets a steady price level (or seek 2% growth as is the case with the Fed), they must necessarily counteract deflationary pressures induced by productivity gains. That means, more or less, increasing the money supply so that aggregate demand offsets the downward shift in the aggregate supply curve. This is what George Selgin has called the “productivity norm”.
[Note:Importantly, the situation I have described above is an offsetting of a supply-induced deflation. This must be distinguished between a demand-induced deflation of the price level. If demand is falling, that is an indication (or tautologically equivalent) to national income falling. There may be other reasons (see Great Depression) to think about this situation differently than deflation caused by general increases in productivity.]
The productivity norm, however, does not automatically require inflationary tactics by the Fed. As a society becomes more productive, once-used resources can be redeployed into other income generating activities–a process I will label dynamic growth. Dynamic growth grows the composite basket of goods in the economy and grows national income, as more and more output is produced out of the same stock of capital (which then grows itself). This increase in demand not only alleviates deflationary pressures but it also alters the nature of the price level.
What do I mean by nature of the price level? To be more precise, I mean that a historic price level corresponds to an entirely different basket of goods when compared to a price level in the future. A 1950s car is not the same as a 2016 car, even though their prices may be the same. Furthermore, the price level may incorporate 150 models of cars in 2016 when compared to 5 in 1950 (hypothetical for argument sake). It is difficult to conceptualize a comparative price level, therefore, when the nature of the underlying basket of goods changes so fundamentally.
However, we think of inflation as comparing price levels over time. And our current method of calculating the price level airs on the side of a static state of goods. For purposes of determining the price level, the average car in 2016 with all of its bells and whistles, is considered the same more or less as the average car in 1950. So if a 2016 chevy costs 20k and the 1950 chevy costs 10k, we have a 100% increase in price for purposes of calculating inflation.
This seemingly arbitrary calculation, the difference in price between an entirely different set of goods in different years has real effects on the stance of monetary policy and in turn real effects on the distribution of income. Consider the following three scenarios:
Scenario #1: New product at higher price
This is the scenario I think actually corresponds with a lot of the economic progress we have seen in recent decades. A new product replaces an old one but comes in at the same or at a higher price. Even if it starts at a higher price, there is a minimal impact on the price level as innovation brings the new good down to the original price.
For example, tube tvs were replaced by plasma and lcd tvs. The new plasma tvs were quite expensive when compared to to tube tvs, but they were of a completely different quality. After several years, the price of tvs have come down to the old tube-tv price level. Wheres tube-tvs go for cents on the dollar when compared to 1990 prices.
From the perspective of the monetary authority seeking to maintain a price level, this scenario creates limited problems. The price level may go up initially but returns to the old price quite quickly. Furthermore, the purchasers of tvs are spending more on tvs and less on other goods, which offsets any increase in the aggregate price level.
Imbedded, however, in this scenario is the deflation of the original good. The tube-tv is far less costly than it was before. What is important to see is that the surplus generated is a product of demand and not supply. The tube-tv is not any cheaper to make, but is rather not demanded by any buyers. A surplus only exists for people who buy tube-tvs and who are willing to pay more for tube tvs– in other words a small population.
By substituting plasma tvs for tube tvs in the basket of goods, there is virtually no impact on the price level and therefore no observed inflation or deflation. This is not to say that individuals are not better off, however, as the new tv is certainly better than the old. But for purposes of the monetary authority, their job is accomplished by the mere swap of goods in the CPI basket under the heading TV.
Does this scenario have any impact on income distribution? At the very least it would seem to benefit the bottom-end of the distribution more than the top. Assuming incomes are static, the price of a TV remains the same but the quality of the TV is higher than before. As such, the consumption benefit would be greater (as percentage of income) for the bottom rung of the income distribution.
A new product is developed, it does not substantially replace any existing products in the CPI basket, and it is highly demanded by the public. The laptop computer may fit this description nicely. In the case of the laptop, the introduction of the product will lower the demand for all other goods in the economy, unless the laptop makes everyone that much more richer and productive (unlikely). This will tend to reduce prices (through demand) unless the CPI basket is updated to include the brand new technology, which would likely take a substantial period of time. It took 15 years for the cell phone to be included in the CPI after its invention, as in interesting historical aside. This reduction in demand of other goods, due to the introduction of the laptop, would generally show up as deflation in the CPI index.
As such, the monetary authority, if it intended to maintain a steady price level, would be required to raise inflation to offset the general demand-induced price inflation. Importantly, however, this deflation is not a “real” deflation. It is a measurement error and one that would induce the monetary authority to raise inflation to maintain the price level.
This type of inflation has the desired impact of keeping the prices of all CPI goods at their previous level and to raise the price of the new good. Secondary distributional impacts would occur, however, if inflation is not distributed equally across the economy. And there is good reason to to doubt equal distribution; namely the observed and theoretical winners (creditors/owners of capital assets) and losers (debtors/sticky wage employees) from inflation.
Therefore, a miscalculation of the price level due to new technological progress could induce real, yet generally unobserved inflation AND that inflation could be driving some residual inequality.
An existing product is produced at a much cheaper price. Here there is price deflation that is consistent with the productivity norm. The new price level is lower because the same good is being made at a cheaper cost IF the extra income surplus does not lead to corresponding increase in the price of other goods in the CPI basket.
The potential for estimated deflation is higher when considering scenario #2. Specifically, the extra income from a decrease in one CPI good could be spent on goods not included in the CPI price level. This estimated and potentially real, short-term deflation must be offset by the monetary authority targeting a level price.
Once again, we have deflations offset by inflation and the critical question is whether inflation is distributed evenly throughout the economy. If the answer is no, then we have growing inequality baked into the system due a price level target.
Overall, a steady price level target by the Fed actually produces inflation in one dimension that goes generally unseen by many. Counterintuitively, a steady price level is not the absence of inflation. As George Selgin points out, whenever an economy has productivity growth, the natural price level for specific goods should fall. Maintaining a price level would then require either (1) a corresponding increase in demand (through growth and purchasing other goods) which in turn requires the correct demand elasticity, or (2) growth in the money supply to offset falls in the price level. The latter situation is almost always necessary if an economy is slow to adjust.
As such, the baked-in inflation residual of price-level targeting may have implications for inequality that are generally unaccounted for. There’s also reason to think that future innovation, at least in the areas of software and AI, will correspond more closely with the second or third scenario discussed above. New technologies will be of a different type of product or will make existing products much cheaper in a real-sense. Both of those advances require inflation to maintain a price level for the economy.