In the industrial era, economists thought they had a pretty good handle on economic drivers. Low interest rates spur investment. Investment results in more hiring. More hiring drives wages upwards as companies compete for workers. Having more and better-paid workers creates competition for goods and services as they spend their wages, thereby pushing prices upwards and creating inflation. When inflation increases, its time to raise interest rates to cool the economy down.
Today, this conceptual model no longer looks right. We have had a decade or so of very low interest rates and unemployment is low but we are not seeing an uptick of inflation. We have also seen anemic wage growth. There are a number of reasons why we are seeing fairly stagnant wages and low inflation, and one of these is advances in technology. The power of technology to cause deflation is, in fact, stunning. Inflation is measured by looking at costs of a set of goods and services over time. Technology has substantially lowered the costs of a vast array of things, from computers to financial services.
Along with deflationary pressures, technology also increase inequality. A small number of people can create software that does a job that previously employed many people. The income that used to be spread among a large group of modestly-paid workers now flows to a small number of people who write the software.
One problem for the standard concept of the economic cycle is that technology results in slow wage growth and reduces the costs of many goods, but certain major costs are rising fast, notably healthcare, housing, and education. Technology coincides with increased disparity in wealth, and wealthier people drive up the prices of certain goods (notably housing and education). Technology makes education more valuable because educated people reap disproportionate benefits from advances. As a result, wealthier households are willing to pay whatever it takes to access high-quality higher education. Housing in desirable areas also tends to increase in price because (1) tech jobs are often concentrated and (2) more tech workers can choose to be based in nice places.
In summary, technology drives down aggregate inflation by reducing the costs of many goods and services. At the same time, baseline inflation numbers simply don’t seem terribly relevant anymore. Try telling a young worker that inflation is low when she moves to a city to take a job after college and discovers that she will need to live three roommates to cover the rent. She may also discover that between rent, health insurance, and even a modest student loan payment, she is effectively poorer than her parents were at the same age. Inflation, wage growth, and other standard economic statistics may ultimately be victims of the flaw of averages–the average simply does enough of the story to be helpful.
Geoff Considine on Finance and Economics 