Deflation and Economic Growth

Some free market economists, and many from the "Austrian" school, favor supply-side deflation. They believe that a growing, dynamic economy should typically be characterized by gently falling prices of final goods and services.

I believe that many "amateur" Austrians favor this view due to a fallacy of composition. Clearly, I wouldn't accuse a great economist like Hayek of such a simple error. Nor do I think those of my fellow free bankers taking this position--Selgin, White, Horwitz, Garrison, to mention a few--are making any kind of simple error. On the other hand, I do sometimes wonder if they have "priors" based on the simple error I am attributing to the "amateurs."

What is the obvious, common sense, (and wrong) perspective?

An improvement in the technology for producing a single good is traditionally illustrated with a supply and demand diagram by a shift of the supply curve to the right.

The immediate result is a surplus of this good at its initial price. But with the improved technology reducing unit costs, firms are more profitable. By lowering prices, they motivate buyers to expand the real volume of purchases--the law of demand. The firms expand production and while they make less money on each item sold and perhaps less revenue in total, the entire process is one of at least temporary profits, expanding production, and a growing real volume of sales.

The end result is a decrease in the equilibrium price for this good and an increase in the equilibrium quantity. The amount of the product flowing through the market--the amount produced, sold, bought, and consumed--is higher.

If this is taken to be the "typical" market, then clearly the result of a dynamic economy with improving technology will be falling prices and rising output.

In other words, it seems natural that a growing, dynamic economy will be characterized by growing real output and real incomes combined with mild deflation

However, a closer look shows that this simple approach is in error.

In the diagram above, the slope of the demand curve includes both a substitution effect and an income effect. The substitution effect for a single market involves a lower relative price providing a signal and incentive for households to better achieve their goals by shifting away from the consumption of other goods towards the consumption of this good.

The income effect occurs because the lower price of this good increases real income. If the same amount is purchased at a lower price, additional funds are available to purchase other goods. Further, more of this good can be purchased without reducing the purchase of other goods.

If this is a normal good, which means that higher real income leads to greater demand, then the income effect due to the lower price reinforces the substitution effect. Both the substitution effect and the income effect of the lower price lead to increased consumption of this good.

On other hand, if this is an inferior good, which means that higher real income leads to less consumption, then the lower price still raises real income, but paradoxically, being able to afford more leads to fewer purchases. Then, the income effect partially offsets the substitution effect.

If a good makes up a small part of household budgets, then the income effect is going to be small. If a household only spends a little on a particular good, a change in the price of that good will only have a small effect on the household's real income. While this small income effect is included in the slope of the demand curve, the increase in real income, should impact other markets as well. The demands for all normal goods should rise and the demands for all inferior goods should fall. Of course, this diagram doesn't show what is happening to other goods, either the substitution or income effects.

If this is taken to be the "typical" market, so that there are supposedly increases in supply in most, if not all, markets, then the substitution and income effects from the other markets are going to significantly impact this "typical" market.

As for the substitution effect, it is evident that all prices cannot fall relative to all prices. Similarly, it is impossible to substitute away from all goods to all goods. The substitution effect, which is central to understanding the consequences of an increase in supply in a single market, cannot be applied to to all markets. Treating a single market as "typical" fails.

And what of income effects?

The notion that the reduced price only has a small effect on real income no longer makes sense when real income and output is expanding because of increased supplies in most or all markets.

If the "typical" good is normal, so that increased real income results in increased demand, then the impact of growing real income due to an increase in supply in the typical market will be an increase in demand in the typical market.

The impact of an increase in supply in the "typical market" is a matching increase in demand. The relative price of the typical good is unchanged, and the quantity rises. The result, then, is growing real output and real income, and a stable price level.

Of course, it is unlikely that all markets will have exactly the same increase in supply. Improvements in technology may be more significant in some markets, and less significant in others. Further, demands rise more for luxuries and less for necessities, and fall for inferior goods. Rapidly rising demand for a luxury with no significant improvement in technology may pull resources away from its substitutes in production. If there were no improvements in technology in those markets, supplies would decreases there.

The growth process is unlikely to be smooth or simple. It is called "creative destruction" for a reason. But to generalize from a single market with an increase in supply to the economy as a whole is an error--the fallacy of composition. What are small, "secondary" effects when technology improves for a particular good become essential parts of the growth process.

Of course, supply and demand curves are conventionally constructed as showing the relationship between quantities supplied and demanded and relative prices. It is trivial, then, that increases in supply cannot cause a lower relative price level. Some prices fall relative to other prices. Those other relative prices must be rising.

Understanding the price level--whether it is stable or there is deflation or inflation--is about money prices. What happens to money prices depends on monetary institutions. The advocates of mild deflation understand this, of course.

But free market "amateurs" beware. A simple minded application of supply and demand analysis won't do. It is essential to develop a sound understanding of monetary economics. How does the growth process impact the demand for money? And, how do various monetary institutions allow the real quantity of money adjust to that demand?