Sunday, October 12, 2014

Inflation Is Not Good; Deflation Is Not Bad

As the world economy continues its sluggish recovery, it’s fitting to look back on the monetary policy the Federal Reserve pursued in an attempt to pull the economy out of recession. The Fed drastically increased the money supply through multiple rounds of “quantitative easing” among other programs. The hope of such policies is to increase overall demand in the economy in order to encourage banks to lend money and consumers to spend. The extent of the monetary inflation can be seen in the graph below.
Increasing the money supply almost always leads to price inflation, which the Fed has been desperately trying to create since the economic downturn in 2008. The exact extent of inflation is disputed, with many claiming that real inflation rates are much higher than those reported by the government, but the real question is why the Fed is so afraid of deflation that it is willing to take such drastic measures to ensure inflation. An analysis of the economic consequences of monetary inflation and the price inflation it causes shows that there is not any general benefit to inflation. Instead, it benefits some people at the expense of others.

Even if the effect was desirable, inflation does not result in a long term increase in overall demand. When new money is introduced to the economy, it creates an excess supply of money so that people will act to decrease the amount of money they are holding by spending it on producer and consumer goods. This doesn’t happen in a vacuum, though. The increased demand for producer and consumer goods causes an increase in price, just as all rightward shifts in demand curves do. The result is a decrease in the purchasing power of money until prices rise high enough that people decide to hold money again instead of spending it. This effect is exacerbated by the fact that the excess supply of money incentivizes producers to restrict production causing a leftward shift in the supply curve, further increasing the prices of producer and consumer goods. In short, an increase in money stock does not change the fact that the money market tends toward equilibrium, so the influx in demand caused by monetary inflation will be diminished by a rise in prices. There is, therefore, no general benefit to inflationary policies.

It must be noted, however, that money is not neutral. That is, changes in the money supply do have effects on the real economy because prices all move independently and at different rates. As this happens, price signals are distorted by the uneven flow of the money through the economy.

While society as a whole is not helped by inflation, there are benefits isolated to certain well positioned individuals through Cantillon effects. When new money enters the economy, it must do so at a specific place and time, so some people get the new money before others. The equilibrating process of an increase in prices, described above, takes place as the money moves through the economy, not all at once. So those who get the newly created money early will get to spend it on goods whose prices have not yet risen so that they will possess goods which are relatively more valuable in the marketplace after prices rise. This results in redistribution of wealth as those closer to the point of injection (often those in the financial sector) get wealthier at the expense of others.

The advantage given to those who acquire the new money first comes at a cost, as some people are harmed by the nonuniform introduction of new monetary units. Those who are on a fixed income, for example, are faced with reduced purchasing power to pay higher prices for the goods they need. Creditors are harmed as the money they are paid by debtors is worth less than it was when the loan was agreed upon, making them less likely to lend money. As usual, distorting the price system provides benefits for some at the expense of others. Inflationary monetary policy gives increased purchasing power to the well-connected and those in the financial industry while decreasing the purchasing power of creditors and those on fixed incomes.

As we have seen, monetary inflation is not an economically beneficial policy. The Fed continues to engage in inflationary behavior, however, because it fears deflation most of all. To many people, deflation is synonymous with economic downturn and depression. This fear, however, is contradicted by history. From 1880-1886 prices fell by an average of 1.75% while real income rose 5% in the same period. Large increases in productivity can cause prices to fall, but if they fall more than real income, then people are better off not worse.

The United States monetary policy should be to maintain a stable money supply rather than stable prices. By allowing freely fluctuating prices, economic signals can be effectively transmitted to producers and consumers. A stable money supply means an end to monetary inflation and the resulting Cantillon effects that benefit the few at the expense of others. The Fed should stop playing games with the money supply which have no societal benefit and which are potentially dangerous.

Another version of this article was published on Rightly Wired

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