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Writer's pictureDaniel Rudis

Unraveling the AI Effect: How Technology Shapes Inflation


In June, Spain experienced a decrease in its annual inflation rate, with a year-on-year change in CPI falling to 1.9%. This made Spain the first EU member state to fall below the European Central Bank's target of 2% inflation. Unlike other countries, Spain's economy benefited from the absence of imported food and energy inflation, contributing to its favorable performance.


Another positive development took place in the United States, where the annual inflation rate (measured by CPI) slowed down from 4% in May to 3% in June. This marked the slowest inflation rate since March 2021 and slightly surpassed analysts' predictions for June. However, it's important to approach this good news cautiously. Regulators were quick to emphasize that the battle against inflation is far from over.


Instead of engaging in debates regarding base effects, calculation approaches, and measurement periods, let's take a long-term perspective and explore the potential impact of artificial intelligence (AI) on inflation. In principle, technology can have both inflationary and deflationary effects.


There are two obvious ways in which technology can contribute to inflation:

  1. Cost of technology implementation: Investment and ongoing costs associated with adopting new technologies can be passed on to consumers as higher prices.

  2. Increased demand: Technological advancements create new products and services, potentially driving up consumer demand.

Conversely, technological advancements can result in deflation through the following means:

  1. Increased productivity: Technological innovations often improve efficiency and productivity in various sectors. This can lead to cost savings for businesses, reducing their production costs which in turn reduces the prices consumers pay.

  2. Market competition: Technology can lower entry barriers and foster increased competition in markets. This competition can lead to greater price transparency and pressure businesses to offer better products at lower prices.

  3. Automation and labor market effects: Technology makes processes more cost-efficient and less labor intense. Supply and demand dynamics drive labor market costs down. As a result, businesses pass lower expenses on to consumers.

Considering AI as one of the dominant innovative forces, let's examine its case for both inflation and deflation:


Regarding inflationary mechanisms, the costs of implementing AI are primarily borne by providers such as OpenAI, Microsoft, Alphabet, or Meta. It remains to be seen whether AI will create new products and thus create new needs, or merely improve existing products without boosting consumer spending.


On the other hand, AI has clear deflationary potential. Firstly, it can significantly increase productivity. Secondly, the abundance of new downstream applications suggests that AI will lower barriers to entry, as exemplified by large language models. Lastly, the prospect of making human labor more scalable will impact labor markets. The combination of these factors creates a powerful mix with a potential deflationary effect.


The extent of AI's prevalence, the speed of its adaptation, and its substitution effect are still uncertain. However, the factors discussed above suggest a trend toward deflation.


To illustrate this argument: Recall the days when people spent significant sums of money to buy audio CDs. They often bought whole albums because they liked one or two songs that were playing in the charts. A few years later, it became possible to buy individual songs on the Internet at a more reasonable price without even having to make the (costly) trip to the store. From then on, things moved fast. Nowadays, people can listen to their favorite songs for a ridiculously low monthly price. Those who consume music on YouTube, for example, end up paying with the ‘attention’ monetized as advertising revenue, but in this case at zero cost to the listener. Other examples of how consumers save money with technology are easy to find.


Policymakers are rightly concerned about containing inflation at this stage. However, it may well be that policymakers will fight a battle from the other side once the technology comes into full play.

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