For most experts the key factor that sets the foundation for healthy economic fundamentals is a stable price level as depicted by the consumer price index.
In this way of thinking, a stable price level ensures the visibility of the relative changes in the prices of goods and services.
Consequently, it is held, this leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals.
A stable price level enables businesses to see clearly market signals that are conveyed by the relative changes in the prices of goods and services.
For instance, let us say that a relative strengthening in people’s demand for potatoes versus tomatoes took place. This relative strengthening, it is held, is going to be depicted by the relative increase in the prices of potatoes versus tomatoes.
In a free market, businesses pay attention to consumer wishes as manifested by changes in the relative prices of goods and services. Failing to abide by consumer wishes will lead to the wrong production mix of goods and services and will lead to losses.
Hence, in our case, businesses, by paying attention to relative changes in prices, are likely to increase the production of potatoes versus tomatoes.
In this way of thinking, if the price level is not stable, then the visibility of the relative price changes becomes blurred and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.
Also, the thinking goes, while changes in the price level are set by changes in money supply, however, changes in money supply have nothing to do with changes in relative prices. Changes in relative prices are set by real factors i.e. changes in demand and supply that have nothing to do with changes in money supply. Or so it is held.
Thus, it is not surprising that the mandate of the central bank is to pursue policies that will bring price stability.
By means of various quantitative methods, the Fed’s economists have established that at present policy makers must aim at keeping US price inflation at 2%. Any significant deviation from this figure constitutes deviation from the growth path of price stability.
Why the Policy of Price Stability Leads to More Instability
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 whatsoever on the real economy and hence on the relative changes of prices of goods and services.
In this way of thinking changes in the relative prices of goods and services are established without the aid of money.
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. The rate of exchange between apples and potatoes is established by real factors that drive the demand and the supply for apples and potatoes.
In this way of thinking if one apple exchanges for one dollar then it follows that the price of a potato is $0.5. Note that the introduction of money doesn’t alter the fact that the relative price of potatoes versus apples is 2:1 (two-to-one). A seller of an apple will get for it one dollar, which in turn will enable him to purchase two potatoes. Money therefore appears to be just a mere numeraire.
In this way of thinking an increase in the quantity of money leads to a proportionate fall in its 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.
For instance, the amount of money has doubled and as a result the purchasing power of money has halved, or the price level has doubled. This means that now one apple could be exchanged for $2 while one potato for $1.
Despite the doubling in prices a seller of an apple with the obtained $2 will still be able to purchase two potatoes. As one can see, the doubling in the price level because of an increase in money supply has no effect on the relative prices of apples versus potatoes on this way of thinking. We suggest that this way of thinking is problematic.
Why Money Is Not Neutral
The problem with this way of thinking that it holds that in a market economy the relative prices of goods and services established independently of money. But this is not the case. It is changes in supply and demand for money and supply and demand for goods that set in motion changes in the prices of goods and services.
Furthermore, when new money is injected there are always first recipients of the newly injected money who benefit from this injection. The first recipients with more money at their disposal can now acquire a greater amount of goods while prices of these goods are still unchanged.
As money starts to move around the prices of goods begin to rise. Consequently, the late receiver benefits to a lesser extent from monetary injections or may even find that most prices have risen so much that they can now afford less goods.
Increases in money supply lead to a redistribution of real wealth from later recipients, or non-recipients of money to the earlier recipients. Obviously, this shift in real wealth alters individuals’ demands for goods and services and in turn alters the relative prices of goods and services.
Changes in money supply sets in motion new dynamics that give rise to changes in demands for goods and to changes in their relative prices. Hence, changes in money supply cannot be neutral as far as relative prices of goods are concerned.
The effect of changes in demand and supply of money and demand and supply of goods on prices of goods is intertwined and there is no way that one can somehow isolate these effects.
For instance, it was observed that over a time span of one year the price of tomatoes increased by 10% while the price of potatoes went up by 2%. This information, however, cannot tell us how much of the increase in prices was on account of changes in demand and supply for goods and how much on account of changes in demand and supply for money. According to Rothbard,
Even if all the prices in the array had risen we would not know by how much the PPM (purchasing power of money) had fallen, and we would not know how much of the change was due to an increase in the demand for money and how much to changes in stocks.
Since these influences cannot be separated obviously it is not possible to isolate and stabilize the so called purchasing power of money i.e. the price level. It follows then that since these influences are intertwined any attempt to stabilize the price level would imply tampering with relative prices and thereby disrupting the efficient allocation of resources.
This is, however, not what the stabilizers are telling us. For they believe that the greatest merit of stabilizing changes in the price level is that it allows free and transparent fluctuations in the relative prices, which in turn leads to the efficient allocation of scarce resources.
Since 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 flawed.
Furthermore, the idea of the general purchasing power of money and hence the price level cannot be even established conceptually. Here is why.
When $1 is exchanged for 1 loaf of bread we can say that the purchasing power of $1 is 1 loaf of bread. If $1 is exchanged for 2 tomatoes then this also means that the purchasing power of $1 is 2 tomatoes. The information regarding the specific purchasing power of money doesn’t 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 2 tomatoes to 1 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. 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.
The popular notion that the central bank can implement a policy of price stability by stabilizing changes in a price index such as the consumer price index is therefore erroneous. The construction of price indices is an attempt at an impossible task of establishing a non-existent price level.
The policy of price stability is therefore a policy of stabilizing an arbitrary price index, which supposedly represents the price level. Needless to say that this type of policy only destabilizes businesses and weakens the process of wealth generation.
In his book America's Great Depression, Murray Rothbard argued that one of the reason's that most economists of the 1920's did not recognize the existence of an inflationary problem was the widespread adoption of a stable price level as the goal and criterion for monetary policy.
Rothbard wrote,
Far less controversial is the fact that more and more economists came to consider a stable price level as the major goal of monetary policy. The fact that general prices were more or less stable during the 1920's told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.
Given the fact that present day economists are following exactly the same line of thinking it is quite likely that the Fed's policy of price stability may catch economists again unaware of the damage inflicted by this policy.
