Home > Bubbles, crisis > The difference a price level makes

The difference a price level makes

The European Central Bank targets the consumer price level, among other reasons because neoclassical macro-economic models often picture a world where this is the only level which matters. Indeed, as there is only one product in quite some models, the only level which even can exist. In reality, money is not only used to purchase vegetables and cars (household consumption) but also to pay for street lights (government consumption)and new houses and machinery (fixed investment). Theoretically, a broader inflation metric like ‘domestic demand inflation’ (household consumption + government consumption + investments) is therefore superior to a consumption price metric as far as targets go.

Domdem

In a practical sense, this wold not matter too much if all metrics showed the same medium term developments. But they don’t. One of the causes of the Euro crisis are differences in the rate of, especially, asset price inflation, including the price of land which shows up in the price of investments in new houses and buildings. This holds too when we compare domestic demand prices with core prices, i.e. consumption prices without energy. And these investment prices show up in the price level of total domestic demand. When we look at differences in changes in the domestic demand price level it shows that these are much larger than changes in the consumer price level. Notice that in Germany the domestic demand price level increased less than consumption prices while the opposite was the case in Spain.

Looking at the price level of domestic demand instead of the consumer price level, in combination with a theory of the relation between asset price rises, finance and bubbles (Minskyian or Austrian, doesn’t matter) would have shown a much faster increase of imbalances than just looking at consumer prices. Let me be clear on this: for years in a stretch higher inflation in Spain attrackted money, instead of leading to lower expenditure – which is not really what the neoclassical models state.

As an alternative to consumption price inflation the GDP deflator is often used, which is even broader based than domestic demand inflation. This metric is however influenced by the terms of trade of a country, i.e. by the exchange rate, which makes it less fit (to say the least) as a policy target.

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