The myth of the policy of price stability
For most economists the key to healthy economic fundamentals is price stability. However these so called stable policies set the menace of the boom-bust cycle.
There is almost complete unanimity among economists that the most important role of the central bank is to attain price stability. It is held that the policy of price stability promotes economic growth and individuals’ well-being.
According to the popular way of thinking, a policy of price stability increases the visibility of the relative changes in the prices of goods and services. This in turn enables businesses to identify the changes in the demand-supply conditions of goods and services.
By acting on these changes businesses are abiding by consumers’ wishes thereby contributing to the efficient allocation of resources. According to the former President of the Federal Reserve Bank of New York William J. McDonough,
Over the long run, price stability is the one sustainable contribution monetary policy can make to growth. This applies to all countries.1
For instance, it was observed that the price of tomatoes increased relatively to potatoes. This relative price increase generates incentive for businesses to increase the production of tomatoes versus potatoes. By being able to observe and respond to changes in relative prices, businesses are setting in motion an efficient allocation of resources i.e. allocation in line with consumers’ instructions.
On this way of thinking as long as inflation, which is defined by popular thinking as increases in the price level, is stable, producers can ascertain changes in relative prices and thus maintain the efficient allocation of resources.
However, when inflation is volatile this makes it much harder for businesses to distinguish between relative price changes and changes in prices that are associated with inflation i.e. changes in the price level. This in turn leads to a misallocation of resources and to the loss of wealth, or so it is held.
Is the assumption of money neutrality valid?
At the root of price stabilization policies is a view that money is neutral. Changes in money only have an effect on the price level while having no effect on the relative prices of goods and services.
For instance, if one-apple exchanges for two potatoes, then the price of an apple is two potatoes or the price of one potato is half an apple. Now, if one apple exchanges for one dollar, then it follows that the price of a potato is half a dollar.
Note that the introduction of money does not alter the relative price of potatoes versus apple, which is 2:1 (two-to-one). Thus, a seller of an apple will get for it one dollar, which in turn will enable him to purchase two potatoes.
On this way of thinking an increase in the quantity of money leads to a proportionate decline in it purchasing power i.e. a rise in the price level, while a fall in the quantity of money will result in a proportionate increase in the purchasing power of money i.e. a fall in the price level. All this however, will not alter the fact that one apple is exchanged for two potatoes, all other things being equal.
Let us say that as a result of an increase in the quantity of money the purchasing power of money has halved, or the price level has doubled. This means that now one apple is going to be exchanged for two dollars while one potato for one dollar. Note that, despite the doubling in prices a seller of an apple with the obtained two dollars will still be able to purchase two potatoes.
There is a total separation between changes in the relative prices of goods and changes in the price level. Again, on this way of thinking a stable price level is going to make changes in the relative prices visible to businesses. For instance, it is observed that the price of an apple is two dollars and the price of a potato is one dollar. Now, the average price level over the time span of several years, is observed to stand at 100. This information it is held enables businesses to ascertain that the relative price of potatoes vs apple is two to one. Let’s now say that the price of an apple rose to three dollars per apple whilst the price of a potato remains at one dollar. Given that the price level remains at 100 businesses could ascertain that the relative price of apples versus potatoes has increased to three to one. If, however, the price level is not stable businesses may find it hard to separate how much of the price changes is on account of the change in the price level and how much because of changes in demand supply conditions of various goods and services.
Now, when money is injected, there are always first recipients of the money who benefit from this injection. The early recipients with more money at their disposal can now acquire a greater amount of goods while the prices of these goods are still unchanged.
As money, starts to move around the prices of goods begin to rise. Consequently, the late receivers benefit to a lesser extent from monetary injections or may even find that most prices have risen and they can now afford fewer goods.
Increases in money supply cause a redistribution of wealth from later recipients, or non-recipients of money to the earlier recipients. We suggest that this shift in wealth alters individuals’ demands for goods and services and in turn alters the relative prices, all other things being equal.
Hence, changes in money supply set in motion new dynamics that give rise to changes in demands for goods and services and to changes in their relative prices.
The effect of changes in the purchasing power of money on goods prices cannot be isolated
Observe that the price of a good is determined by the supply and demand for this good and by the supply and demand for money.
The effect of changes in the demand and supply of money and the demand and supply of goods on the prices of goods is intertwined and there is no way that one can isolate these effects.
For instance, it was observed that over a time span of one year the price of tomatoes increased by ten percent while the price of potatoes went up by two percent. This information, however, cannot tell us how much of the increase in prices was on account of changes in the demand and the supply for goods and how much on account of changes in the demand and the supply for money.2
Given that it is not possible to isolate the monetary effect on individual prices of goods, obviously then the whole idea that one can measure and somehow stabilize the price level is questionable.
On this Rothbard wrote,
Since the general exchange-value, or PPM, 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 do not know what something is, we cannot very well act to keep it constant.3
Total purchasing power of money cannot be established conceptually
Furthermore, when one dollar is exchanged for one loaf of bread, we can say that the purchasing power of one dollar is one loaf of bread. If one dollar is exchanged for two tomatoes then this means that the purchasing power of one dollar is two tomatoes. However, the information regarding the specific purchasing power of money does not allow the establishment of the total purchasing power of money.
It is not possible to ascertain the total purchasing power of money since we cannot add up two tomatoes to the one loaf of bread. We can only establish the purchasing power of money with respect to a particular good in a transaction at a given point in time and at a given place.
Conclusion
For most economists the key to healthy economic fundamentals is price stability. A stable price level, it is held, leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals. Note that the so called stable monetary policy that generates stable increases in the price index is still increases in the money supply. This sets in motion the exchanges of nothing for something, which in turn sets the menace of the boom-bust cycle.
The importance of price stability. Remarks by William J. McDonough before the Economic Club of New York October 2, 1996.
Murray N. Rothbard, Man, Economy, and State, Nash Publishing p 739.
Ibid, p 743.