Money Isn’t Neutral: Why Economic Stabilization Schemes Are Counterproductive
For most commentators economic stability refers to an absence of excessive fluctuations in key economic data such as real gross domestic product (GDP) and the consumer price index (CPI).
An economy with constant output growth and low and stable price inflation is likely to be regarded as stable. An economy with frequent boom-bust cycles and variable price inflation would be considered as unstable.
According to popular thinking stable economic environment in terms of stable price inflation and a stable output growth acts as a buffer against various shocks. This makes it much easier for businesses to plan. In this way of thinking in particular, price level stability is the key for economic stability.
For instance, let us say that a relative strengthening in consumer’s demand for potatoes versus tomatoes took place. This relative strengthening is depicted by the relative increase in the prices of potatoes versus tomatoes.
To be successful businesses must pay attention to consumers’ demands—failing to do so is likely to lead to losses. Hence, in our case businesses, by paying attention to relative changes in prices, are likely to increase the production of potatoes versus tomatoes.
In this way of thinking, if the price level is not stable, then the visibility of the relative price changes becomes distorted and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.
This leads to a misallocation of resources and to the weakening of economic fundamentals. In this way of thinking, unstable changes in the price level obscure businessperson’s ability to ascertain changes in the relative prices of goods and services. Consequently, businesses will find it difficult to recognize a change in relative prices when the price level is unstable.
Based on this way of thinking, it is not surprising that the mandate of the central bank is to pursue policies that will bring price stability, i.e., a stable price level.
By means of various quantitative methods, the Fed’s economists have established that at present policy makers must aim at keeping price inflation at 2 percent. Any significant deviation from this figure constitutes deviation from the growth path of price stability.
The Assumption of Monetary Neutrality Is at the Root of Price Stabilization Policies
At the root of price
Article from Mises Wire