June 16, 2011 Reading Time: 4 minutes

Price stability has become the main concern of central banks around the world. Both, inflation and deflation, are considered bad outcomes. But because deflation is considered to be worst than inflation, it became practice to prefer to err to the side of inflation to be sure we avoid deflation. If price stability (low inflation) is achieved, the argument follow that distortions will be avoided and the economy will go on smoothly. But there are a few important challenges that complicates the policy of price stability:

  1. Increases in productivity
  2. Trade with other countries

The first one, the problem of an increase in productivity, is taking more presence lately. For example, if new technologies allow to produce goods cheaper, then the prices of theses goods should be allowed to fall. Electronic products, like computers and mobile phones, are two examples of this. The prices of these goods have been fallen during the last decades. In terms of demand and supply, an increase in productivity will be a shift to the right of the supply curve, which results in a higher quantity of goods at a lower price. But because this is an increase in productivity, producers lower their prices to compete with each other until they reach the normal rate of return. Consumers gain, producers don’t loose. This is a good outcome, not a bad one; nothing is gained by inflating the price level to offset this effect.

Then, the problem is that an increase in productivity can conceal inflation. If the increase in productivity is a 5% and the central bank inflates a 12%, then the net effect on the level of prices is an increment of 7%. If we observe only the behavior of the price level, assuming other things constant, then we will conclude a 7% of inflation. But once we consider the increase in productivity it should be clear that the total inflation was a 12%, prices should have fallen a 5% due, for example, to the effect of applying new technologies in the market.

If we want to maintain loyalty to the use of the ceteris paribus in economics, and we define inflation as a change in the level of prices, then inflation should be the change in the price level net of changes in productivity. That means, for example, that in our previous example, after controlling for changes in productivity we should conclude a 12% inflation and not 5%. If we don’t control for other changes, then the central bank will be following a price level that changes for motives other than inflation as well. If inflation/deflation is the change in the price level for whatever reason, then is not true that any inflation/deflation is a problem.

Of course, theory and practice are far away from each other by more than just a step. Just to measure inflation in itself is a complex process. But if the effects of the monetary policy affect the market with long lags, how does the central bank foretell the future effects of changes in productivity in the market? When and in which industries will affect and to what extent? What if productivity increases in other countries that allows them to export at a cheaper price?

The second problem, having an open economy, also reflects in the behavior of the price level and so affects the monetary policy as well. As long as the economy is open to the world, and treadable goods are part of the CPI that is used to measure inflation, then this indicator looses reliability. Domestic producers of treadable goods cannot increase their price, if they do so they loose their customers against international producers. Similarly, there’s no incentives for them to lower the price because they can export their production at the international price. Then, if the central bank expands the money supply there’s no effect on the level of prices (or this effect is watered down). The extra money, of course, doesn’t disappear, it has to go somewhere. If the country has a fixed exchange rate then imports increase, if the country has a floating exchange rate, then the domestic currency depreciates. The price level becomes anchored to the international price level to the extent the economy is open and goods in the CPI are treadable.

Because inflation is based only on a subset of all the prices on the market, inflation does not capture all the potential effects of monetary mismanagement. The symptom of monetary expansion is not unique, it may well be an increase in the price level, an increase in imports (trade deficit) or exchange rate depreciation. As long as inflation is considered a problem and we overlook other economic indicators as potential signals for monetary policy, we may put forward a wrong diagnosis. Just as to not have fever does not mean we are healthy, if CPI does not show inflation does not mean the problem is not being manifested somewhere else. A healthy economy does not have inflation, but the absence of inflation does not mean we have a healthy economy.

Are these problems relevant? It may well be. The 20’s are usually mentioned as an example of the first problem. The Fed was expanding too much, but increases in productivity were cancelling out the inflationary effect and everything seemed to be right. The Great Depression showed that not everything was right. The second problem was probably present before the financial crisis. Despite the low interest rates of the Fed before the financial crisis there was no high rising inflation, but there was an important trade deficit. The Fed may have though that monetary policy was on track because the price level was stable, but the excess of monetary expansion was being manifested in the trade deficit.

To aim at the price level is not only a difficult process, it is not even a good estimator. Price level stability is desirable, or not problematic, once we are in equilibrium. But if the economy is not in equilibrium, as is actually the case, then price stability of consumer goods may be a policy that causes distortions. It is not, then, price level neutrality what the central banks should aim at, but interest rate neutrality, that is, to avoid distortions in the capital structure that the market has to support. As the studies of free banking show, is this neutrality what happens in a free market of money and banking.

But this begs the questions. If the central bank should do what the market does by itself, why do we need central banks in the first place?

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Image: jscreationzs / FreeDigitalPhotos.net

Nicolás Cachanosky

Dr. Cachanosky is Associate Professor of Economics and Director of the Center for Free Enterprise at The University of Texas at El Paso Woody L. Hunt College of Business. He is also Fellow of the UCEMA Friedman-Hayek Center for the Study of a Free Society. He served as President of the Association of Private Enterprise Education (APEE, 2021-2022) and in the Board of Directors at the Mont Pelerin Society (MPS, 2018-2022).

He earned a Licentiate in Economics from the Pontificia Universidad Católica Argentina, a M.A. in Economics and Political Sciences from the Escuela Superior de Economía y Administración de Empresas (ESEADE), and his Ph.D. in Economics from Suffolk University, Boston, MA.

Dr. Cachanosky is author of Reflexiones Sobre la Economía Argentina (Instituto Acton Argentina, 2017), Monetary Equilibrium and Nominal Income Targeting (Routledge, 2019), and co-author of Austrian Capital Theory: A Modern Survey of the Essentials (Cambridge University Press, 2019), Capital and Finance: Theory and History (Routledge, 2020), and Dolarización: Una Solución para la Argentina (Editorial Claridad, 2022).

Dr. Cachanosky’s research has been published in outlets such as Journal of Economic Behavior & Organization, Public Choice, Journal of Institutional Economics, Quarterly Review of Economics and Finance, and Journal of the History of Economic Thought among other outlets.

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