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Inflation and relative prices

Summary:
Pierre Lemieux has a post explaining the fallacy of assuming that inflation is caused by changes in relative prices. An increase in the price of used cars cannot generate or “drive” inflation for a simple reason: it works the other way around. Inflation, which is defined as a continuous and sustained increase in the general price level, causes all individual prices (including wages, interest rates, etc.) to rise more or less proportionately, over and above the change in relative prices caused by changes in demand or supply on specific markets. To the extent that used car prices were partially caused by both inflation and a relative price change, they could not be a cause of inflation. Pierre is correct.  Nonetheless, some people might have a nagging doubt about

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Pierre Lemieux has a post explaining the fallacy of assuming that inflation is caused by changes in relative prices.

An increase in the price of used cars cannot generate or “drive” inflation for a simple reason: it works the other way around. Inflation, which is defined as a continuous and sustained increase in the general price level, causes all individual prices (including wages, interest rates, etc.) to rise more or less proportionately, over and above the change in relative prices caused by changes in demand or supply on specific markets. To the extent that used car prices were partially caused by both inflation and a relative price change, they could not be a cause of inflation.

Pierre is correct.  Nonetheless, some people might have a nagging doubt about this issue.  Consider the following thought experiment.  Someone with a crystal ball tells me that the relative price of oil will double in the next three months.  How does that change my forecast for the rise in the CPI?  I don’t know about you, but I’d raise my forecast of next year’s CPI.  So why can’t we say that a rising relative price of oil is inflationary?

Let’s first think about why people often link relative price changes with inflation.  One possibility is that some prices are “sticky”, or slow to adjust, while other prices are quite flexible.  Thus an inflationary monetary policy might cause the price of commodities such as food and energy to rise immediately, while other prices respond with a delay.  To the average person, it looks like rising commodity prices are causing an inflation that is actually caused by an expansionary monetary policy.

Another possibility is that relative price changes are associated with a change in aggregate supply.  Here we can also assume that monetary policy targets something like NGDP (although a “flexible inflation target” that “looks through” supply shocks would also work.) If a disruption in the supply of oil causes real GDP to fall, then it will lead to a one-time increase in the price level under NGDP targeting.  Strictly speaking, it’s not correct to say that rising oil prices “cause” the inflation (that would be reasoning from a price change), rather the rise in the price level is caused by a combination of falling RGDP and a monetary policy that targets NGDP (or core inflation.)  In this particular case, inflation is caused by the thing that causes the relative price of oil to rise.

To summarize, the false belief that rising relative prices cause inflation is due to the correct view that:

1.  Most large and sudden relative price changes are caused by supply shocks.

2.  Central banks tend to target something like NGDP or core inflation rates.

3.  When both #1 and #2 are true, most large and sudden relative price changes will be associated with a one-time movement in the overall CPI in the same direction.

Here it’s important to understand that negative supply shocks only cause even a temporary rise in prices by depressing real GDP.  Because real GDP growth in the 1970s was quite respectable (more than 3%/year), we can conclude that relative price changes for products like food and energy played almost no role in the overall inflation rate during the 1970s.  If NGDP growth had been 5% during 1971-81 instead of 11%, then inflation would have been 2% instead of 8%.  It was easy money that caused the inflation.

At the same time, the inflation rate during the 1971-81 period was not constant, and the Fed’s response to supply shocks led to inflation rates that were higher during periods of depressed oil production than during periods of high oil output.  So it looked to the average person (and perhaps even many economists) as if oil were driving the high inflation of the 1970s.

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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