For most economists, the key to healthy economic fundamentals is price stability. Price stability is an economic condition where the general price level of goods remains relatively constant over time. It is held that a stable price level leads to the efficient use of the economy’s scarce 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.
Now, changes in the consumer demand for goods are mirrored by changes in the relative prices of goods. Thus, an increase in the demand for potatoes versus tomatoes is likely to increase the price of potatoes relative to tomatoes. Businesses, if they want to be successful (i.e., to be profitable) are likely to increase the supply of potatoes versus the supply of tomatoes.
As long as inflation—which is often misdefined by popular economics as increases in the price level—is stable and predictable, businesses can identify changes in relative prices and thus maintain the efficient allocation of resources. Businesses will respond to signals issued by consumers through changes in relative prices.
For instance, let us say that the average price level stands at 100. It is observed that the price of potatoes has increased by two percent while the price of tomatoes remains unchanged. Given an unchanged price level, businesses could establish that there is a high likelihood of an increase in demand for potatoes versus tomatoes. Consequently, businesses will increase the supply of potatoes.
If, however, the price level is not stable, businesses may find it difficult to ascertain how much of the price changes of goods are because of the change in general price level and how much on account of changes in the demand supply conditions of goods. Based on this way of thinking it is not surprising that the mandate of the central bank is to pursue policies that will allegedly result in price level stability.
The Fed’s economists have established that policymakers should target inflation at two percent. Any significant deviation from this figure, it is held, constitutes a deviation from the growth path of price stability.
Price Level and Relative Prices
At the root of the idea that a stable price level is the key for a healthy economy is the view that changes in the money supply only have an effect on the price level while having no effect on the relative prices of goods. In this way of thinking, an increase in the supply of money leads to a proportionate decline in the money’s purchasing power (i.e., an increase in the price level). A decline in the supply of money results in a proportionate increase in the purchasing power of money (i.e., a fall in the price level). All this, it is held, will not alter the relative prices of goods.
Now, an increase in the money supply sets an exchange of nothing for something, causing a diversion of wealth from individuals that did not receive the newly-injected money and credit to individuals that did receive the money. Hence, increases in the money supply cause a redistribution of wealth from individuals that did not receive the money, or received it later, to individuals that did receive the money or received it earlier. This redistribution alters individuals’ demands for goods and, in turn, alters the relative prices, all other things being equal.
Furthermore, the policy of stabilizing the price level, which amounts to the setting of interest rate targets and affecting the money supply growth rate, is interfering with the markets. This falsifies the markets’ signals as conveyed by changes in relative prices. This undermines the wealth-generation process.
Price Stability Policy Leads to Instability
Let us say that the yearly growth rate of the price level is starting to exhibit a decline well below the two percent mark set by the Fed’s economists. To prevent this decline, the Fed embarks on aggressive monetary inflation.
As a result, after a time lag, the yearly growth rate of the price level becomes stable. Should we regard this as a successful monetary policy action?
Given that the monetary inflation and credit expansion sets in motion the diversion of wealth to individuals that have received the newly-pumped money from the individuals that did not receive the money, this leads to the weakening of the wealth-generation process and to economic impoverishment.
It is the fluctuations in the yearly growth rate of the money supply that matters here. It is this that sets in motion the menace of the boom-bust cycle regardless of whether the price level is stable or not.
A Stable Price Level Cannot Undo the Damage of Monetary Inflation
While increases in the money supply are likely to be revealed by general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in the opposite direction to the monetary factors, no visible change in the price level might take place. While the money supply growth rate is buoyant the price level might display moderate increases. Thus, according to Rothbard, the stability of wholesale prices in the 1920’s was the result of monetary inflation, which was offset by increased productivity.
Clearly, if we were to pay attention to the price level and disregard increases in the money supply, we would reach misleading conclusions regarding the state of the economy. On this, Rothbard wrote,
The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.
According to Rothbard, the stability of the price level in 1920’s was demonstrated by wholesale prices, which stood at 93.4 (100=1926) in June 1921, rose to 104.5 by November 1925, and then fell back to 95.2 by June 1929.
Furthermore, during July 1921 to July 1929 (the great boom) the money supply increased by $28 billion—a 61.8 percent increase over the eight-year period. This is an average annual increase of 7.7 percent—a very sizable degree of monetary inflation.
Total Purchasing Power of Money (PPM) Cannot Be Established Conceptually
When one dollar is exchanged for the one loaf of bread, it means that the purchasing power of one dollar is the 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 arithmetically we cannot add up two tomatoes to the one loaf of bread in a coherent way. We can only establish the purchasing power of money with respect to a specific good, which is exchanged at a given point in time and at a given place. On this Rothbard suggested,
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.
Moreover, the price of a good is determined by the supply and demand for this good and by the supply and demand for money. However, the effects of changes in the demand and supply of money and the demand and supply of goods on the prices of goods are intertwined and there is no way that one could isolate these effects.
In the framework of the free market and in the framework of the gold standard and in the absence of the central bank, no one would have to be concerned with price stability. Businesses would be able to observe clearly the signals issued by consumers in terms of relative prices and act accordingly.
Conclusion
By popular thinking, the key to healthy economic fundamentals is price stability. Note, however, that the monetary policy that is employed at establishing the stable level of prices is about the tampering with the money supply and the interest rates. This sets distortions to the structure of production and sets in motion the menace of the boom-bust cycle. Hence, the policy of attaining price stability leads to economic instability.
