Productivity and Price Inflation

In my last two posts, I discussed the factors of price inflation and the possibility of price inflation with excess reserves remaining high.  I wrote that price inflation is primarily determined by the supply and demand of money.

There is another factor in price inflation and that is productivity.  While this would not usually cause significant price swings in the short run like the supply and demand of money can, productivity does have an effect, especially over the long run.

To be clear, this has little to do with the pricing of individual products.  Prices of certain goods and services can go up and down based on the supply and demand.  For instance, if there are really cold temperatures in Florida which cause orange trees to be destroyed, we would expect for orange prices to go up because of a lower supply.

For this discussion, the focus is on the overall general price level.  For the sake of discussion, let’s assume that the supply and demand for money remains constant and we have a free market economy.

It is obvious that a farmer using a tractor can and will be more productive than a farmer using hand tools to do all of the work.  If country A has many farmers who use tractors and country B has farmers that mostly use hand tools, then we can expect food production to be higher in country A.  If not, then country B would be expending a lot more resources in the form of labor to match the food production of country B.  Either way, we can expect food prices to be lower in country A.

This is because of capital investment and technology.  Some farmers have tractors to use because they have prior savings that could be used to buy a tractor.  The savings do not even necessarily have to be from the farmer.  He may borrow money that someone else saved and promise to pay back the loan with the food he is able to produce with the use of his tractor.

The point is that you need capital investment and increases in technology in most cases to significantly increase production.  This will happen to a higher degree in a more free market economy.  If there are productivity gains throughout a society, it will actually lead to noticeably lower prices.  If the same amount of money is chasing a larger number of goods, then prices will go down.

We can see this in the electronics industry where computers and televisions get cheaper every year.  If they don’t get cheaper, then you are getting more for you money in terms of chip speed, storage space, quality, etc.  This is in spite of the Fed’s monetary inflation and an overall positive CPI.  If only healthcare and education could be more like the electronics industry, where we see things getting constantly better and cheaper at the same time.

Price deflation is not a bad thing if it is due to an increase in productivity.  There is nothing to fear in that case.  It is a good thing.  It means that our standard of living is increasing.  It means that we can purchase more goods and services with the money we have.

While we don’t want to see deflationary situations due to failing banks and boom and bust cycles caused by the Fed, we shouldn’t let that scare us about having falling prices.  We should cheer on falling prices that are due to productivity gains and increasing technology.  We should be thankful that we still have a free enough economy that some sectors see productivity gains.