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
Article from Mises Wire