By Dr Frank Shostak
By popular economics, the key for businesses success is that they must pay attention to consumers’ wishes as manifested by changes in the relative prices of goods. On this way of thinking if the price level is not stable then the visibility of the relative price changes becomes blurred. Consequently, businesses cannot ascertain the relative changes in the demand for goods and make correct production decisions. Hence, it is held the central bank should stabilize the price level in order that businesses could be able to clearly observe changes in relative prices.
At the root of this way of thinking is a view that money is neutral. Changes in money only have an effect on the price level while having no effect on the relative prices.
For instance, if one-apple exchanges for two tomatoes then the price of an apple is two tomatoes or the price of one tomato is half an apple. Now, if one apple exchanges for one dollar then it follows that the price of a tomato is $0.5.
Note that the introduction of money is not going to alter the fact that the relative price of tomatoes 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 tomatoes.
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 tomatoes, 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 tomato 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 tomatoes. Hence, the relative price of tomatoes versus apples will remain 2:1 (two-to-one).
There is a total separation between changes in the relative prices of goods and the changes in the price level. So, if one could somehow make changes in the price level stable and predictable one would be able to assist businesses in the efficient allocation of resources, so it is held.
Now, when new money is injected, there are always first recipients of the newly injected money who benefit from this increase. 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 benefit 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 sets in motion the redistribution of wealth from later recipients, or non-recipients of money to the earlier recipients. This shift in wealth alters individuals’ demands for goods and in turn alters the relative prices of goods. Changes in money supply set in motion new dynamics that gives 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 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 apples went up by 2%. This information, however, cannot tell us how much of the increase in prices was on account of changes in the demand and the supply for goods and how much on account of changes in the demand and the 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 (the 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 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.
The implementation of a policy of stabilizing prices will lead to over-production of some goods and under-production of some other goods. This is, however, not what the stabilizers are telling us. For they hold 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 questionable.
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.
The popular idea that the central bank can implement a policy of price stability by stabilizing changes in a price index like the consumer price index is therefore erroneous. Needless to say, that this type of policy only destabilizes businesses and weakens the wealth generation process.
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. According to Rothbard,
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.
Conclusion
It is held the central bank should stabilize the price level in order that businesses could be able to clearly observe changes in relative prices. At the root of price stabilization policies of the central bank is a view that money is neutral. Changes in money only have an effect on the price level while having no effect on the relative prices. We suggest that this is not so.
