There is almost complete unanimity among economists that the most important role of the central bank is to attain price level stability. It is held that price stability promotes economic growth and people’s well-being by increasing the efficiency of the market mechanism. 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]

In other words, price level stability is the key to economic growth and prosperity. But does it make sense?

Expected versus unexpected inflation

According to the popular way of thinking a policy of price stability enhances the transparency of the relative changes in the prices of goods and services and this in turn contributes to the efficient allocation of resources. For instance, it was observed that the prices of tomatoes increased relatively to potatoes. This relative price increase gives impetus to businesses to lift the production of tomatoes versus potatoes by attracting more tomatoes growers. By being able to observe and respond to market signals as conveyed by changes in relative prices, businesses generate an efficient allocation of resources.

As long as inflation – which is defined as increases in the price level – is stable and predictable producers can identify changes in relative prices and thus maintain the efficient allocation of resources intact, or so it is held. However, when inflation is unexpected it makes it so 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 real wealth. It follows then that a central bank policy of stabilising the changes of the price level could be instrumental in promoting economic prosperity.

Price stability and deflation

The popular way of thinking maintains that the policy of price stability does not always imply that the central bank must fight inflation. It is also the role of the central bank to prevent large falls in the rate of inflation, or an outright decline in the general price level. Why is that so? Because it is held that a fall in the price level i.e. deflation, postpones consumer and business expenditure thereby paralysing economic activity.

Moreover, a fall in inflation raises real interest rates thereby further weakens the economy. Additionally, as expenditure weakens this further raises unutilised capacity and puts further downward pressure on the price level.

Most economists are of the view that it is much harder for the central bank to handle deflation than inflation.

When inflation rises, the central bank can always cool it off by tighter monetary policies, which weaken aggregate demand. There is no limit, so to speak, for the central bank as far as raising interest rates is concerned. This is, however, not so with regard to deflation. The lowest level that the central bank can go is the zero interest level.

For instance, let us assume that Fed policy makers have reached the conclusion that in order to revive the economy real interest rates must be lowered to negative figure.

This, however, may not be always possible to accomplish, so the argument goes, when nominal or market interest rates are at a zero level.

Thus when the pace of deflation is 1% i.e. the growth rate of the price level is minus 1%, real interest will be +1%. (Following the accepted view that nominal interest rate=real interest rate + % change in price level it follows that 0%=1% + (minus 1%)).

In order to lower real interest to minus 0.5% the central bank would need to lower nominal interest rates to minus 1.5% i.e. minus 1.5%= minus 0.5% + (minus 1%). Obviously, this cannot work for no one would lend in return for negative interest rates.

Likewise, when the rate of inflation is very low it can also create problems. Suppose that because of weak aggregate demand inflation has fallen from 2% to 1%. Within this set-up, the central bank can only target a real interest rate of minus 1% i.e. 0%= minus 1% + 1%.  It cannot aim at a lower real interest rate since this would imply setting nominal interest rate below zero.

Likewise, as the economy weakens further and inflation falls to 0.5% this will not allow the central bank to target real interest rates to below minus 0.5% i.e.

0%=minus 0.5% +0.5%

On this way of thinking deflation, or low inflation, reduces central bank’s flexibility in reviving the economy. Hence, the policy of price stability must aim at a certain level of inflation, which will give the central bank the flexibility to keep the economy moving along the growth path of economic prosperity and prevent it ever falling into a deflationary black hole.

So what should this level of inflation be? Some experts are of the view that 2% to 3% is the best range. Some other experts are of the view that the range should be between 1% and 2%.

The essence of all this is that a little bit of inflation is necessary in order to have economic prosperity and stability. The inflationary buffer must be big enough to enable the Fed to manoeuvre the economy away from the danger of deflation, or so it is held.

Is the assumption of money neutrality valid?

At the root of price stabilisation 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. 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 potatoe is half an apple. Now, if one apple exchanges for one dollar then it follows that the price of a potatoe is $0.5.

Note that the introduction of money does not alter the fact that the relative price of potatoes versus apples 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. Money therefore appears to be just a 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. All this however, will not alter the fact that one apple will be 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 halved, or the price level has doubled. This means that now one apple could be exchanged for $2 while one potatoe for $1. Note, that despite the doubling in prices a seller of an apple with the obtained $2 will still be able to purchase two potatoes.

There is a total separation between changes in the relative prices of goods and the changes in the price level. Therefore, it seems that the only problem with inflation is that it obscures the visibility in the movements of the relative prices of goods thereby causing a misallocation of resources. Other than that, inflation is harmless. So if one could somehow make changes in the price level stable and predictable one would be able to neutralise the negative effect of inflation, so it is held.

Now, when new money is injected there are always first recipients of the newly injected 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 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 set in motion new dynamics that give rise to changes in demands for goods 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 the demand for money. The effect of changes in the demand and the supply of money and the demand and the supply of goods on the 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 the 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.[2]

Since these influences cannot be separated obviously it is not possible to isolate and stabilise the purchasing power of money i.e. the price level. It follows then that since these influences are intertwined any attempt to stabilise the price level would imply tampering with relative prices and thereby disrupting the efficient allocation of resources.

The implementation of a policy of stabilising prices will lead to over-production of some goods and under-production of some other goods. This is, however, not what the stabilisers are telling us. For they believe that the greatest merit of stabilising 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 stabilise the price level is preposterous.

Price level cannot be established conceptually

Furthermore, the whole 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. 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 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.[3]

The popular notion that the central bank can implement a policy of price stability by stabilising changes in a price index like the consumer price index is therefore erroneous. The construction of price indices is an attempt at the impossible mission of establishing a non-existent price level. The policy of price stability is therefore a policy of stabilising an arbitrary price index, which supposedly represents the price level. Needless to say that this type of policy only destabilises businesses and weakens the generation of wealth. 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.[4]

Conclusion

It is not surprising that economists in 1920’s misread the economic scene. Rather than regarding inflation as increases in money and credit generated out of “thin air,” economists viewed inflation as rises in the mythical price level as depicted by increases in the consumer price index. 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.

[1] The importance of price stability. Remarks by William J. McDonough before the Economic Club of New York October 2, 1996.

[2] Murray N. Rothbard, Man, Economy, and State, Nash Publishing p 739.

[3] Ibid, p 743.

[4] Murray N. Rothbar America’s Great Depression, Sheed and Ward, Inc p 153.