How Price Stability Policy Generates Greater Economic Instability – Analysis – Eurasia Review


By Frank Shostak*

Many mainstream economists believe that economic stability refers to an absence of excessive fluctuations in the overall economy. An economy with steady output growth and low and stable price inflation is likely to be considered stable, while an economy with frequent boom and bust cycles and variable price inflation would be considered stable. unstable.

According to popular thought, a stable economic environment with stable price inflation and stable output growth acts as a buffer against shocks, making business planning easier. Thus, price level stability is the key to so-called economic stability.

Suppose people increase the demand for potatoes over tomatoes. This relative strengthening is illustrated by the relative increase in potato prices. Successful businesses must pay attention to consumer instructions demonstrated by changes in the relative prices of goods and services, while disregarding consumer wishes will lead to the wrong combination of goods and services production and result in losses. . Therefore, in our example, when firms pay attention to relative price changes, they will make the right decisions.

If the price level is not stable, the visibility of relative price changes becomes blurry and hence firms cannot determine relative changes in demand for goods and services and make correct production decisions. according to the mainstream economy. This supposedly leads to a misallocation of resources and weakening economic fundamentals. Therefore, unstable changes in the price level mask changes in the relative prices of goods and services. Therefore, firms would find it difficult to recognize changes in relative prices when the price level is unstable.

This way of thinking justifies the mandate of the central bank to pursue policies that will bring price stability, i.e. a stable price level, with price level stability measured by popular price indices such than the consumer price index (CPI). Using various quantitative methods, Fed economists have established the current policy of maintaining price inflation at 2%. Any significant deviation from this figure constitutes a deviation from the price stability growth path.

Observe that Fed policymakers tell us that they must stabilize the price level in order for the market economy to function effectively. This is obviously a contradiction in terms, since any attempt to manipulate the so-called price level involves interference with the markets and therefore leads to false signals conveyed by the evolution of relative prices.

Price stability policy leads to more instability

Suppose the rate of the so-called price level visibly declines, in order to prevent this decline, the Fed aggressively pumps money into the banking system. Thanks to this policy, the price level stabilizes over time.

Should this be considered a successful monetary policy action? The answer is emphatically no. Since monetary pumping triggers the diversion of wealth from wealth-generating activities to non-wealth-generating activities, this policy weakens the process of wealth generation and leads to economic impoverishment.

Note that economic impoverishment has taken place despite price level stability. Also note that to achieve price stability, the Fed designed an increase in the growth rate of the money supply.

Fluctuations in the growth rate of money supply are significant. This triggers the threat of the boom-bust cycle, regardless of price level stability.

While increases in the money supply are likely to be revealed in general price increases, this does not always have to be the case. Prices are determined by real and monetary factors. Therefore, if real factors push things in the opposite direction to monetary factors, no visible price change can occur.

While monetary growth is strong, prices could post moderate increases. Obviously, if we were to pay attention to the so-called price level and ignore increases in the money supply, we would come to misleading conclusions about the state of the economy.

The price level cannot be determined conceptually

The very idea of ​​the general purchasing power of money and therefore of the price level cannot even be established conceptually. When a dollar is exchanged for a loaf of bread, the purchasing power of a dollar can be said to be a loaf of bread. If one dollar is exchanged for two tomatoes, it also means that the purchasing power of one dollar is equal to two tomatoes.

The information concerning the specific purchasing power of the currency does not, however, make it possible to establish the total purchasing power of money. It is not possible to determine the total purchasing power of money because we cannot add two tomatoes and a loaf of bread.

We can only establish the purchasing power of money relative to a particular good in a transaction at a particular time and place. On that Murray N. Rothbard wrote:

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 very well to keep it constant.

However, the Fed’s monetary policy, which aims to stabilize the price level, implicitly affects the growth rate of the money supply. Since a central bank policy amounts to altering relative prices, which leads to the disruption of the efficient allocation of resources. Therefore, a price stabilization policy leads to overproduction of some goods and underproduction of other goods. However, this is not what the stabilizers tell us. Instead, they argue that the greatest merit of stabilizing price level changes is that it allows free and transparent fluctuations in relative prices, which in turn leads to efficient allocation of scarce resources.

Economic stability has nothing to do with stabilizing the economy

We argue that economic stability is not about keeping prices stable, but rather about avoiding price fluctuations. It is only in an environment free from government and central bank interference in the economy that free fluctuations in relative prices can take place.

This, in turn, enables businesses to comply with consumer instructions, resulting in efficient allocation of scarce resources. We suggest that price fluctuations will reflect changes in relative supply and demand conditions.

Summary and conclusion

Most economists believe that price stability is the key to sound economic fundamentals. A stable price level, it is argued, leads to efficient use of scarce resources in the economy and, therefore, results in better economic fundamentals. Not surprisingly, the mandate of the Federal Reserve is to pursue policies that will generate price stability.

By trying to stabilize the price level, the Fed undermines economic fundamentals. Ever-increasing government and central bank interference in the functioning of markets is driving the US economy toward persistent economic impoverishment resulting in lower living standards.

*About the Author: Frank ShostakApplied Austrian School Economics’ consulting firm provides in-depth assessments of financial markets and global economies. Contact email.

Source: This article was published by the MISES Institute


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