The “price stability” myth undermines our economy and well-being – Analysis – Eurasia Review

By Frank Schostak

For most commentators, a “stable price level” is the key to economic stability. For example, let’s assume that consumer demand for potatoes increases relatively compared to tomatoes. This relative increase is represented, other things being equal, by the relative increase in the price of potatoes. To be successful, companies must pay attention to consumer demand. If this is not done, losses may occur. So if producers pay attention to relative price changes, they are likely to increase production of potatoes compared to tomatoes.

According to many economists, if the “price level” is not “stable”, the visibility of relative price changes is blurred and, as a result, companies cannot determine the relative changes in demand for goods and services and make correct production decisions. This leads to a misallocation of resources and a weakening of economic fundamentals. Thinking like this, unstable changes in the price level hinder an entrepreneur’s ability to detect changes in the relative prices of goods and services. Therefore, it is difficult for companies to detect a change in relative prices when the price level is unstable.

Given these premises, it is not surprising that the central bank’s mandate is to pursue policies that supposedly bring “price stability” (i.e. a stable price level). Using a variety of quantitative methods, Fed economists have determined that policy should aim to maintain the annual growth rate of prices for goods and services at two percent. Any significant deviation from this number supposedly represents a deviation from stable growth.

The assumption of monetary neutrality and “price stability”

Price stabilization policy is based on the view that money is neutral, that is, changes in the money supply only affect the price level but have no influence on relative prices. For example, if an apple is exchanged for two potatoes, then the price of one apple is two potatoes or the price of one potato is half an apple. Now, if an apple is exchanged for one dollar, the price of a potato is $0.50. Note that the introduction of money does not change the fact that the relative price of potatoes versus apples is 2:1 (two to one). So the seller of an apple receives one dollar for it, which in turn enables him to buy two potatoes.

Let’s assume that the money supply has doubled and that the purchasing power of money has halved or the price level has doubled. This means that an apple can now be exchanged for two dollars and a potato for one dollar. Despite the doubling of prices, an apple seller can still buy two potatoes with the two dollars earned. Assuming monetary neutrality, an increase in the money supply leads to a relatively Price increase. Conversely, a decrease in the money supply leads to a relatively Decrease in prices. Why is this way of thinking problematic?

Money is not neutral

When new money is injected, there are always the first recipients of the new money who benefit from this financial injection. The first recipients, now that they have more money at their disposal, can purchase a larger quantity of goods while the price of those goods still remains unchanged. As money begins to flow through the economy, the prices of goods begin to rise, uneven And disproportionate. As a result, late recipients of the excess money recognize the costs of the cash injections and may even find that most prices have risen so much that they can now afford fewer goods.

Artificial increases in the money supply result in a redistribution of wealth from subsequent recipients or non-recipients of money to earlier recipients. Obviously, this shift in wealth changes individuals’ demand for goods and services and, in turn, further changes the relative prices of goods and services. Inflationary increases in the money supply set in motion new dynamics that lead to changes in demand for goods and services as well as changes in their relative prices. Therefore, increases in the money supply cannot be neutral.

Here too, a change in relative demand is due to the diversion of wealth from the last recipients of money to the earlier recipients. This change in relative demand cannot be sustained without a continued increase in the money supply. Once the growth rate of the money supply slows or stops, various activities that have arisen as a result of this inflationary increase in the money supply come under pressure. It follows that an artificial increase in the money supply leads to changes in relative prices, which sets in motion an unsustainable production structure.

Therefore, the Fed’s monetary policy – aimed at stabilizing the price level – necessarily involves growth in the money supply. Since inflationary changes in the money supply are not neutral, this means that central bank policy amounts to manipulation of relative prices, leading to a disruption in the efficient allocation of resources.

While an increase in the money supply is likely to be reflected in general price increases, this is not always the case. Prices are determined by real and monetary factors. As a result, real factors may pull things in an opposite direction to monetary factors. In such a case, there may be no visible price change. While money supply growth is strong, prices could rise moderately. If we paid attention to changes in price levels and ignored increases in the money supply, we would reach misleading conclusions about the state of the economy. Rothbard wrote:

The fact that general prices were more or less stable in the 1920s told most economists that there was no threat of inflation and were therefore completely unaware of the events of the Great Depression.

There is no “price level”

The overall idea of ​​the general purchasing power of money and therefore the “price level” cannot even be justified conceptually. If a dollar is exchanged for a loaf of bread, we can say that the purchasing power of the one dollar is equal to the one loaf of bread. When one dollar is exchanged for two tomatoes, it also means that the purchasing power of the one dollar is equal to two tomatoes. However, such information about the specific purchasing power of money at this point in time does not allow determining the general overall purchasing power of money. It is not possible to determine the total purchasing power of money because we cannot meaningfully add two tomatoes to a loaf of bread. We can only determine the purchasing power of money in relation to a specific good in a transaction at a specific time and place. According to Rothbard,

Since the general exchange value or PPM (Purchasing Power of Money) of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we don’t know what something is, we can’t act well enough to keep it constant.

Diploma

For most commentators, “price stability” is the key to sound economic fundamentals. A “stable price level,” it is said, leads to efficient use of the economy’s scarce resources and thus to better economic fundamentals. Not surprisingly, the Federal Reserve’s mandate is to pursue policies that supposedly lead to price stability. Through monetary policy (inflation) aimed at stabilizing price levels, the Fed actually undermines economic fundamentals. Increasing central bank interference in the functioning of markets is putting the U.S. economy on a growth path of continued economic impoverishment and drastically declining living standards.

Rather, what is needed is not a policy of dubious “price stability,” but rather allowing free price fluctuations and maintaining a healthy currency. Only in an environment without central bank manipulation can free and voluntary fluctuations in relative prices take place. This, in turn, allows companies to follow consumer instructions.

• About the Author: Frank Shostak is an Associate Scholar at the Mises Institute. His consulting company Applied Austrian School Economics provides in-depth assessments and reports on financial markets and global economies. He received his bachelor’s degree from Hebrew University, his master’s degree from the Witwatersrand University, and his Ph.D. from Rands Afrikaanse University and taught at the University of Pretoria and the Witwatersrand University Graduate Business School.
• Source: This article was published by the Mises Institute