Does Price Reduce Fuel Deflation?

Almost everyone seems to think so, including many economists: when the price rises, it fuels inflation. A respectable magazine The Economist he doesn’t think twice about it. Speaking of Argentina, he writes (“Javier Milei’s Next Move Could Make His Presidency—or Break It,” June 19, 2024):

Monthly inflation may rise in June as electricity prices rise.

I The Wall Street Journal headlined “Rent Hikes Loom, Posing Threat to Inflation Fight,” June 18, 2024. Examples are everywhere.

But if all price increases encourage inflation (a general increase in the price level), then it must be that all price cuts threaten inflation (a general decrease in the price level, which is reflected in a recession). Other things being equal, therefore, every price drop in the market is a threat, as is every price increase. Every price change is a bad omen. Does this weird idea work? No. The error lies in the failure to distinguish between changes in relative prices and changes in the general level of prices, ie across all prices, which is inflation (or deflation).

Assume that there is no inflation or deflation and that the demand for beef increases, all else being equal. As a result, the price of beef increases compared to (say) pork. This is like saying that the economy has moved to its production frontier (PPF) to more beef and less pork, meaning beef is now more expensive than pork. (The chart below shows the typical PPF for a two-goods economy. If good Y is beef and good X is pork, the economy has moved from point B to point A.) Any price index (say, the Consumer Price Index) has changed between the initial state B and and new A in PPF. Whether the index shows an increase or decrease will depend on the exact price of beef and pork because these figures are the weights by which the price index is calculated. It can be a steep climb if it doesn’t change. Thus, we cannot use the change in relative price to conclude that inflation or deflation exists.

Inflation—a general increase in the price level—is a separate phenomenon, caused by the amount of money in the economy.

If there is inflation, the price index captures both changes in relative prices and changes in the general price level. We can’t tell which part of the inflation is related to the change in price, because the recent change is partly due to inflation (the way all prices have gone up)–and partly due to the change in that price relative to (relative) for other values. Energy prices or rents cannot drive inflation (or deflation) because they are partly caused by them. Causality works the other way around.

I’ve written a few EconLog posts on this topic, but my latest article “Rising Commodity Prices Don’t Cause Inflation,” by Ryan Bourne, editor, The Price War (Cato Institute, pp. 19-27) provides a detailed explanation. My post “Guns and Butter” contains another illustration of the PPF concept.

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