Why "Price Stability" Policies Fail
One of the duties that a central bank is expected to fulfill is to keep the general level of prices in the economy stable. The whole idea of price stability originates from the view that volatile changes in the price level prevent individuals from clearly seeing market signals as conveyed by the changes in the relative prices of goods and services.
For instance, as a result of an increase in the demand for apples relative to potatoes, the prices of apples increases relative to the prices of potatoes. This relative price increase pushes businesses to lift the production of apples versus potatoes.
In being able to observe and respond to market signals as conveyed by changes in relative prices, businesses are said to be in tune with market wishes and therefore to be promoting an efficient allocation of resources.
As long as the rate of increase in the general price level is stable and predictable, individuals can identify changes in relative prices and thus maintain the efficient allocation of resources, so it is held.
However, when the rate of increase in the price level is unexpected, it tends to obscure the visibility of the relative price changes of goods and services. This makes it much harder for people to clearly observe market signals, leading to the misallocation of resources and a loss of real wealth.
In this way of thinking changes in the price level are not related to changes in relative prices. Unstable changes in the price level only obscure but do not affect the relative changes in the prices of goods and services. So if somehow one could prevent the price level from obscuring market signals obviously this would lay the foundation for economic prosperity.
Popular Ideas about the Neutrality of Money
At the root of price stabilization policies is the 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.
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 fifty cents. (The introduction of money does not alter the fact that the relative price of potatoes versus apples is two to one. The seller of an apple will get one dollar for it, which in turn will enable him to purchase two potatoes.)
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 results in a proportionate increase in the purchasing power of money, i.e., a fall in the price level. None of that, according to this way of thinking, alters the fact that one apple is exchanged for two potatoes, all other things being equal.
Let us assume that the amount of money has doubled and as a result the purchasing power of money has been halved, or the price level has doubled. This means that now one apple can be exchanged for two dollars and one potato for one dollar. Note that despite the doubling in prices, a seller of an apple can still purchase two potatoes with two dollars obtained.
We have here a total separation between changes in the relative prices of goods (how many apples exchanged for a potato) and the changes in the price level. Therefore, it would appear that the only problem with changes in the price level—also labeled as inflation—is that it can obscure the movements of relative prices of goods if it is unstable, thereby causing a misallocation of resources. Other than that, inflation is harmless. In reality, though, this way of thinking is problematic.
Why Money Is Not Neutral
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 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 so much that they can now afford fewer goods.
Increases in the money supply lead to a redistribution of real wealth from later recipients or nonrecipients of money to the earlier recipients. Obviously, this shift in real wealth alters individuals’ demand for goods and services and in turn alters the relative prices of goods and services.
Changes in money supply set in motion new dynamics that give rise to changes in demand for goods and to changes in their relative prices. Hence, changes in money supply cannot be neutral as far as the relative prices of goods are concerned.
The Purchasing Power of Money Can't Be Established Conceptually
Moreover, the whole idea of the general purchasing power of money and hence the price level cannot even be established conceptually.
When one dollar is exchanged for one loaf of bread we can say that the purchasing power of $1 is one loaf of bread. If one dollar is exchanged for two tomatoes then this also means that the purchasing power of one dollar is two tomatoes. The information regarding the specific purchasing power of money does not, however, allow for the establishment of the total purchasing power of money.
It is not possible to ascertain the total purchasing power of money, because we cannot add up two tomatoes and 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.
On this Rothbard wrote in Man, Economy, and State,
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 do not know what something is, we cannot very well act to keep it constant. (p. 743)
Now, the Fed’s monetary policy that aims at stabilizing the price level by implication affects the growth rate of money supply. Since changes in money supply are not neutral, this means that a central bank policy amounts to the tampering with relative prices, which leads to the disruption of the efficient allocation of resources.
As a result, a policy of stabilizing prices leads to overproduction of some goods and underproduction of other goods. 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 transparent fluctuations in the relative prices, which in turn lead to the efficient allocation of scarce resources.