Tuesday , November 5 2024
Home / SNB & CHF / Is Price Stability Really a Good Thing?

Is Price Stability Really a Good Thing?

Frank Shostak November 25, 2021 SNB & CHF

Frank Shostak by
Frank Shostak
My articles My booksMy videos
Follow on:
Summary:
Contrary to popular thinking, there is no such thing as a price level that should be stabilized by the central bank in order to promote economic prosperity. Original Article: “Is Price Stability Really a Good Thing?” One of the mandates of the Federal Reserve System is to attain price stability. It is held that price stability is the key as far as economic stability is concerned. What is it all about? The idea of price stability originates from the view that volatile changes in the price level prevent individuals from seeing market signals as conveyed by changes in the relative prices of goods and services. For instance, because of an increase in the demand for apples, the prices of apples increase relatively to the prices of potatoes. This relative price

Topics:
Frank Shostak considers the following as important: , ,

This could be interesting, too:

Guillermo Alcala writes USD/CHF slides to test 0.8645 support with US inflation data on tap

Swissinfo writes Swiss central bank posts CHF62.5bn profit

Nachrichten Ticker - www.finanzen.ch writes Trump-Faktor und Marktbedingungen könnten für neuen Bitcoin-Rekord sorgen

Charles Hugh Smith writes Is Social Media Actually “Media,” Or Is It Something Else?

Is Price Stability Really a Good Thing?Contrary to popular thinking, there is no such thing as a price level that should be stabilized by the central bank in order to promote economic prosperity.

Original Article: “Is Price Stability Really a Good Thing?”

One of the mandates of the Federal Reserve System is to attain price stability. It is held that price stability is the key as far as economic stability is concerned. What is it all about?

The idea of price stability originates from the view that volatile changes in the price level prevent individuals from seeing market signals as conveyed by changes in the relative prices of goods and services.

For instance, because of an increase in the demand for apples, the prices of apples increase relatively to the prices of potatoes. This relative price increase gives an impetus to businesses to increase the production of apples relative to potatoes.

By being able to observe and respond to market signals as conveyed by changes in relative prices, businesses are said to be able to stay in tune with market wishes and therefore promote an efficient allocation of resources.

It is held that as long as the rate of increase in the price level is stable and predictable, individuals can identify changes in relative prices and thus maintain the efficient allocation of resources. However, when the rate of increase is unexpected, i.e., of a sudden nature, it tends to obscure the relative price changes of goods and services. This in turn makes it much harder for individuals to ascertain the true market signals. Consequently, this leads to the misallocation of resources and to a loss of real wealth.

Note that 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 will lay the foundation for economic prosperity. Consequently, a policy that can stabilize the price level will enable businesses to observe the relative price changes. This in turn will allow businesses to abide by consumers’ wishes.

The Root of Price Stabilization Policies: Money Neutrality

At the root of price stabilization policies is a view that money is neutral—that 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 and 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. Thus, a seller of an apple will get one dollar for it, which in turn will enable him to purchase two potatoes.

Under the framework of monetary neutrality 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. None of this will alter the fact that one apple will be exchanged for two potatoes, all other things being equal.

Now, following this logic, if the amount of money has doubled, the purchasing power of money is going to halve, i.e., the price level is going to double. This means that now one apple can be exchanged for two dollars and one potato for one dollar. Despite the doubling in prices, a seller of an apple can still purchase two potatoes with the two dollars obtained.

We have here a total separation between changes in the relative prices of goods (how many apples exchange per potato) and the changes in the price level. Why is this way of thinking problematic?

How New Money Enters the Economy: The Cantillon Effect

Following the Cantillon effect, when new money is injected there are always first recipients who benefit from the new money. With more money at their disposal, the first recipients can acquire a greater amount of goods while the prices of these goods remain unchanged.

As the money starts to move around, the prices of other goods begin to rise. Consequently, the late receivers benefit to a lesser extent from the monetary injections and may even find that most prices have risen so much that they can now afford fewer goods.

The increase in money supply leads to a redistribution of wealth from later recipients, or nonrecipients of money to the earlier recipients. Obviously, this shift in wealth alters individuals’ demands for goods and services and in turn alters the relative prices of goods and services.

The changes in money supply set in motion dynamics which give rise to changes in the demand for goods and in their relative prices. Hence, changes in money supply cannot be neutral as far as relative prices of goods are concerned. As Ludwig von Mises emphasized, “

n a living and changing world, in a world of action, there is no room left for a neutral money. Money is non-neutral or it does not exist.”1

The Price Level Cannot Be Ascertained

When one dollar is exchanged for one loaf of bread, we can say that the purchasing power of one dollar is one loaf of bread. If one dollar is exchanged for two tomatoes, this means that the purchasing power of one dollar is also 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 establish the total purchasing power of money because we cannot add up the two tomatoes and the 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 in a given place.

The employment of a fixed weight price index seems to offer a solution that bypasses the problem of the direct calculation of an average price. By means of this index, it is held, we could establish changes in the overall purchasing power of money. The following example illustrates the essence of a fixed weight price index.

In period one, Tom bought a hundred hamburgers for $2 each. He also bought five shirts at $20 each. His total outlay in the period one is $300 ($2*100 + $20*5 = $300). Observe that hamburgers carry a weight of 0.67 of total outlays while shirts carry a weight of 0.33.

In period two, hamburgers exchange for $3, an increase of 50 percent, while shirts sell for for $25—an increase of 25 percent. By applying unchanged weights, i.e., assuming an unchanged pattern of consumption, we will find that the purchasing power of Tom’s money fell by 41.7 percent (50%*0.67 + 25%*0.33 = 41.7%).

If we were to assume that Tom’s pattern of consumption is representative of that of an average consumer, then we could say that the overall purchasing power of money fell by 41.7 percent.

Periodically government statisticians conduct extensive surveys to establish the pattern of spending of a “typical” or “average” consumer. The weights obtained through this process in turn serve to establish changes in the average price and hence in the purchasing power of money.

The assumption that weights remain constant over a prolonged period is, however, not applicable in the real world. This assumption implies an individual with frozen preferences, i.e., a robot. According to Mises, in the world of frozen preferences the idea that money’s purchasing power could change is contradictory.2

Moreover, according to Murray N. Rothbard,

There are only individual buyers, and each buyer has bought a different proportion and type of goods. If one person purchases a TV set, and another goes to the movies, each activity is the result of different value scales, and each has different effects on the various commodities. There is no “average person” who goes partly to the movies and buys part of a TV set. There is therefore no “average housewife” buying some given proportion of a totality of goods. Goods are not bought in their totality against money, but only by individuals in individual transactions, and therefore there can be no scientific method of combining them.3

The view that a variable weight price index could bring more realism and permit the estimation of the purchasing power of money also misses the point.

Changes in prices are driven by monetary and nonmonetary factors. The influence of these factors on prices are, however, intertwined and cannot be separated. Consequently, it is not possible to isolate changes in the purchasing power of money from changes in this price index. On this Rothbard wrote,

This contention rests on the myth that some sort of general purchasing power of money or some sort of price level exists on a plane apart from specific prices in specific transactions. As we have seen, this is purely fallacious. There is no “price level,” and there is no way that the exchange-value of money is manifested except in specific purchases of goods, i.e., specific prices. There is no way of separating the two concepts; any array of prices establishes at one and the same time an exchange relation or objective exchange-value between one good and another and between money and a good, and there is no way of separating these elements quantitatively.

It is thus clear that the exchange-value of money cannot be quantitatively separated from the exchange-value of goods. Since the general exchange-value, or [purchasing power of money] 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.4

Also, according to Mises, “In the field of praxeology and economics no sense can be given to the notion of measurement. In the hypothetical state of rigid conditions there are no changes to be measured. In the actual world of change there are no fixed points, dimensions, or relations which could serve as a standard.”5

We can thus conclude that the various price deflators that government statisticians compute are arbitrary numbers.

Why Price Stabilizations Policies Lead to More Instability

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 this policy amounts to tampering with relative prices. The Fed’s tampering with the so-called price level undermines businesses’ ability to calculate, thereby resulting in the misallocation of resources. As a result, a policy of stabilizing the so-called price level leads to overproduction of some goods and underproduction of others.

A policy of price stability generates various nasty side effects that emanate from the monetary expansion used to carry it out, such as boom-bust cycles and economic impoverishment.6 This is, however, not what the stabilizers are telling us, for they believe that the greatest merit of regularizing changes in the price level is that it allows for free and transparent fluctuations in the relative prices, which in turn leads to the efficient allocation of scarce resources.

Conclusions

Contrary to popular thinking, there is no such thing as a price level that should be stabilized by the central bank in order to promote economic prosperity. Conceptually, the price level cannot be ascertained, notwithstanding the sophisticated mathematics. Obviously if we do not know what something is, it stands to reason that we cannot keep it stable. Policies aimed at stabilizing an unknown price level only stifle the efficient use of scarce resources and lead to economic impoverishment.

This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.

You Might Also Like

Is Price Stability Really a Good Thing? Fabrice Testa on Super Entrepreneurship

2021-10-13

Entrepreneurship is a method, and it’s also a mindset. Fabrice Testa has written a book that brilliantly integrates the two: he calls the integration "Super Entrepreneurship," and his book title is therefore Super Entrepreneurship Decoded (Mises.org/E4B_139_Book).

Is Price Stability Really a Good Thing? Age-Adjusted Mortality Is at 2004 Levels. Yet They Tell Us Covid Is Worse Than the 1918 Flu.

2021-10-11

Last week, the media again tried to ratchet up the public’s fear over covid-19 by labeling it more deadly than the 1918 flu epidemic. “COVID-19 Is Now the Deadliest Disease in U.S. History,” reads one headline from an NBC TV affiliate. Considering the realities of cancer and heart disease, that headline is absurdly false.

Is Price Stability Really a Good Thing? Why Worrying about Everything Is Bad Foreign Policy

2021-10-10

The subtitle of John Mueller’s excellent new book suggests that something unusual is in store for the reader. If someone is called complacent, he is hardly being complimented; how then can there be a “case for complacency”? In brief, Mueller thinks that most of the threats and dangers that confront nations are really not that much to worry about, if they are not altogether imaginary.

Is Price Stability Really a Good Thing? How to Cheat with Cost-Benefit Analysis: Double Count the Benefits

2021-09-10

Because my economics courses focus on public policy, I often deal with benefit-cost analyses (BCA) in them. While little discussed, the central idea is simply to identify and include all the relevant benefits and costs of a decision, do our best to estimate their values, then choose the option that provides the greatest net benefits. Hardly a radical idea. It can be useful in disciplining our thinking to be more consistent. Benjamin Franklin employed a version of it.

Is Price Stability Really a Good Thing? The G7’s Reckless Commitment To Mounting Debt

2021-06-15

Historically, meetings of the largest economies in the world have been essential to reach essential agreements that would incentivize prosperity and growth. This was not the case this time. The G7 meeting agreements were light on detailed economic decisions, except on the most damaging of them all. A minimum global corporate tax

Is Price Stability Really a Good Thing? Decentralization: Why the EU May Be Better than the US

2021-05-30

Over the years, I’ve been pretty hard on the European Union. Both as an editor and a writer, I’ve published articles criticizing its central bank and its unelected, bureaucratic central government. Especially objectionable is the EU ruling class’s propensity for cynical politics built around threatening and intimidating voters and national governments who don’t conform to Brussels’ wishes.

Is Price Stability Really a Good Thing? More Evidence the American Economic “Recovery” Will Disappoint

2021-05-28

The University of Michigan consumer confidence index fell to 82.8 in May, from 88.3 in April. More importantly, the current conditions index slumped to 90.8, from 97.2 and the expectations index declined to 77.6, from 82.7. Hard data also questions the strength of the recovery.


Tags: ,

Is Price Stability Really a Good Thing?Don’t miss posts anymore!
Subscribe to our newsletter!

Permanent link to this article: https://snbchf.com/2021/11/shostak-price-stability-really-good-2/

Leave a Reply

Your email address will not be published.

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

This site uses Akismet to reduce spam. Learn how your comment data is processed.


Full story here
Are you the author?
0 0

Tags

About Frank Shostak
Frank Shostak
Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. He received his bachelor's degree from Hebrew University, master's degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University.
My articlesMy books
Follow on:

Leave a Reply

Your email address will not be published. Required fields are marked *

More on this subject