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For most economists the key factor that sets the foundation for healthy economic fundamentals is a stable price level as depicted by the consumer price index.

According to this way of thinking, a stable price level doesn’t obscure the visibility of the relative changes in the prices of goods and services, and enables businesses to see clearly market signals that are conveyed by the relative changes in the prices of goods and services. Consequently, it is held, this leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals.

The Rationale for Price-Stabilization Policies

For instance, let us say that demand increases for potatoes versus tomatoes. This relative strengthening, it is held, is going to be depicted by a greater increase in the price of potatoes than for tomatoes.

Now in an unhampered market, businesses pay attention to consumer wishes as manifested by changes in the relative prices of goods and services. Failing to abide by consumer wishes will lead to the wrong production mix of goods and services and will lead to losses.

Hence in our example, by paying attention to relative changes in prices, businesses are likely to increase the production of potatoes versus tomatoes.

According to this way of thinking, if the price level is not stable, then the visibility of the relative price changes becomes blurred and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.

Thus, it is feared that unstable prices will lead to a misallocation of resources and to the weakening of economic fundamentals. Unstable changes in the price level obscure 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, policymakers must aim at keeping price inflation at 2 percent. Any significant deviation from this figure constitutes deviation from the growth path of price stability.

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 set the foundation for economic prosperity.

At the root of price stabilization policies is a view that money is neutral. Changes in money only have an effect on the price level while having no effect whatsoever on the real economy. In this way of thinking changes in the relative prices of goods and services are established without the aid of money.

There's a Problem: Newly Created Money Is Not Neutral

When new money is injected there are always first recipients of the newly injected money who benefit from this injection. The first recipients with more money at their disposal can now acquire a greater amount of goods while the prices of these goods are still unchanged.

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

Increases in money supply lead to a redistribution of real wealth from later recipients, or non-recipients of money to the earlier recipients. Obviously this shift in real wealth alters individuals demands for goods and services and in turn alters the relative prices of goods and services.

Changes in money supply sets in motion new dynamics that give rise to changes in demands for goods and to changes in their relative prices. Hence, changes in money supply cannot be neutral as far as relative prices of goods are concerned.

Now, the Fed’s monetary policy that aims at stabilizing the price level by implication affects the rate of growth of money supply.

Since changes in money supply are not neutral, this means that a central bank policy amounts to the tampering with relative prices, which leads to the disruption of the efficient allocation of resources.

Furthermore, while increases in the money supply are likely to be revealed in general price increases, this need not always be the case. Prices are determined by both real and monetary factors.

Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant, prices might display low increases.

Clearly, if we were to pay attention to the so-called price level, and disregard increases in the money supply, we would reach misleading conclusions regarding the state of the economy.

On this, Rothbard wrote,

The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.

From 1926 to 1929, the alleged stability of the price level caused most economic experts, including the famous American economist Irving Fisher, to conclude that US economic fundamentals were doing fine and that there was no threat of an economic bust.