The Real Definition of Inflation — and Why Technology Should Make Life Cheaper

In Part 1, we made one claim: a price spike in one area — oil, food, tariffed goods — just reshuffles household spending. It doesn't raise the overall price level. It's not inflation.

That raises an obvious question. If supply shocks don't cause broad inflation, what does?

The answer is surprisingly simple. It involves one equation. Don't worry — it's the only equation in this article, and it's not as intimidating as it looks. In fact, once you see it, you won't be able to unsee it.

Two definitions of the same word

Most people use “inflation” to mean “prices are going up.” That's the popular definition, and it's not wrong — prices are going up — but it confuses the symptom with the disease.

The economist Milton Friedman put it differently:

“Inflation is always and everywhere a monetary phenomenon.”

What he meant: inflation isn't the rising prices. Inflation is the growth of the money supply that causes prices to rise. The prices going up are the effect. The extra money is the cause. They're related, but they're not the same thing.

Why does this distinction matter? Because if you define inflation as “prices going up,” you can blame anything — oil companies, grocery chains, unions, supply chains, tariffs, wars. The list is endless. But if you define inflation as “the money supply growing faster than real output,” the cause narrows to one institution: the central bank.

The popular definition lets that institution off the hook. The precise definition does not.

How it actually works

Forget equations for a moment. Think about a tiny economy.

There's a village with $100 in circulation and 100 loaves of bread for sale. Each loaf costs $1. Simple enough.

Now the village's central bank prints another $100 and hands it out. There's $200 in circulation, but still only 100 loaves. People have more money, so they bid prices up. Each loaf now costs $2. Nobody made less bread. Nobody was greedy. There's just twice as much money chasing the same amount of stuff, so prices doubled.

That's inflation. Not “bread got expensive.” Not “the baker raised prices.” The money supply grew while the amount of bread didn't, so each dollar became worth less.

Scale that up to an entire economy and the same logic holds. If the total money supply grows by 7% per year and the real economy — the actual production of goods and services — grows by 2% per year, there's roughly 5% more money chasing each unit of output. Prices rise by about 5% per year. That's not a theory. It's arithmetic.

Economists have a shorthand for this: MV = PY, where M is the money supply, V is how fast money changes hands, P is the price level, and Y is real output. You don't need to memorize it. The only thing that matters is the takeaway: if money grows faster than stuff, prices go up. Everything else is a footnote.

The relationship isn't instant — there are lags, sometimes long ones, between money creation and price effects. But over years and decades, the connection between money supply growth and inflation is one of the most robust patterns in economics. More money, same stuff, higher prices. Every time.

The unsettling question

So far, this might feel like a textbook lesson. Here's where it stops being one.

Technology makes things cheaper to produce. That's not a theory — it's the most documented economic trend of the past 200 years. Computing power falls in cost by roughly half every two years. Solar panel costs dropped over 90% between 2010 and 2024. The first human genome cost roughly $2.7 billion to sequence; today it costs under $1,000. Manufacturing, agriculture, transportation — nearly every sector has seen productivity gains that should, in principle, make output cheaper.

Go back to the village. If the bakers figure out how to make 200 loaves instead of 100 — but the money supply stays at $100 — each loaf now costs 50 cents. Prices fell. The same dollar buys more bread. That's what productivity does.

This isn't a hypothetical. We can see it happening right now in the few sectors where productivity gains are large enough to outrun monetary expansion. Televisions. Computers. Consumer electronics. Solar panels. These are real examples of prices falling year after year despite overall inflation — because the productivity gains in those sectors are so enormous that even the expanding money supply can't fully offset them.

Now ask the unsettling question: if technology makes things cheaper to produce every year, why do most prices go up every year?

Because the money supply is being expanded fast enough to offset the productivity gains and push prices upward anyway. The 2% inflation target — the number nearly every central bank in the world aims for — mechanically means: expand the money supply enough to convert productivity-driven price declines into a 2% price increase.

Sit with that for a moment. In a world where technology genuinely makes things cheaper every year, a “stable” price level would actually mean slowly falling prices. The 2% inflation target isn't neutral. It's actively fighting productivity. And the purchasing power you lose each year is the gap between what technology would have given you and what monetary policy takes away.

“But healthcare and college keep getting more expensive”

If you're thinking critically, you've spotted an objection. Not everything has gotten cheaper. Healthcare, college tuition, childcare, haircuts — services that depend on human attention rather than equipment — have gotten dramatically more expensive, faster than the overall price level.

How does that fit with the argument that technology should make life cheaper?

The answer has a name: Baumol's cost disease, identified by economist William Baumol in 1966. His observation was simple. A Beethoven string quartet still takes four musicians and the same amount of time to perform as it did in 1800. The productivity of performing a string quartet is essentially fixed. But the musicians still have to be paid wages competitive with the rest of the economy — an economy where other jobs have gotten more productive. So the cost of a string quartet rises, even though nothing about the performance has changed.

The same pattern applies to teaching a class, examining a patient, cutting hair, caring for a child. These services can't be easily automated or sped up by technology. Their wages have to keep up with the broader labor market. So their prices rise faster than average — not because of inflation, but because of the structure of the work.

Here's the crucial point: Baumol's cost disease actually strengthens the inflation argument. It explains why services rise faster than the average, but it doesn't explain why the average itself keeps going up. If the only thing happening were Baumol's effect, manufactured goods would get cheaper (productivity gains) while services got more expensive (wage competition). The overall price level would be roughly flat — a reshuffling, not a broad increase.

The fact that both goods and services are getting more expensive, on average, year after year — that's the monetary part. That's the money supply growing faster than real output. Baumol explains the composition. Money explains the level.

The takeaway

Inflation is monetary. Not supply-side, not oil, not tariffs — monetary. The money supply grows faster than the real economy, and prices rise as a result.

Technology should make life cheaper. In a stable monetary environment, the relentless march of productivity gains would show up as gradually falling prices — more stuff for less money, every year. That's what technology does.

The reason prices go up instead of down is a deliberate policy choice: expand the money supply fast enough to produce 2% annual inflation, overriding the natural deflationary effect of productivity. The purchasing power you lose each year is the difference between what technology earned you and what monetary policy took.

That leads to the final question in this series — the uncomfortable one. If the 2% inflation target is a choice, not a law of nature, why was it chosen? Who benefits from a system that deliberately erodes the value of money? And is there an alternative?

That's Part 3.