The Free Market Center
The Free Market Center
I created this model and its simulations to demonstrate the effect that changes in production have on prices in direct exchange and the effect that changes in production and the quantity of money, in combination, have on prices in indirect exchange (specifically using money).
The model demonstrates the direct exchange prices that result when traders exchange shoes and wheat directly. At the same time it shows the money prices of these two commodities when the goods for goods exchanges occur indirectly using dollars.
The table below summarizes the results of the simulations that you have walked through in the four different scenarios.
The left-most three columns define the four scenarios used in these simulations. The second two columns indicate the rates of increase for production and sales for the goods listed at the top of those columns.
The next six columns give the annualized rates of change (during months 11 through 50) for dollar prices for each of the products in the scenario in that row based on the annual money supply rate of increase—defined as Fixed, Inflation, and Deflation (actual rates shown below titles). For example: In the increasing production scenario shoe production and sales increase at a rate of 8.0%/Yr. When money supply inflates at a rate of 7.0%/Yr, dollar prices will decline at a rate of -1.0%/Yr.
| Production & Sales | Money Supply | |||||||
| Increase (Decrease) |
Fixed | Inflation | Deflation | |||||
| 0.00 | 0.07 | (0.07) | ||||||
| Shoes | Wheat | Shoes | Wheat | Shoes | Wheat | Shoes | Wheat | |
| Fixed | 0.0% | 0.0% | 0.0% | 0.0% | 7.0% | 7.0% | (7.0%) | (7.0%) |
| Increasing | 8.0% | 4.0% | (7.9%) | (4.0%) | (1.0%) | 3.0% | (14.9%) | (11.0%) |
| Decreasing | (8.0%) | (4.0%) | 8.1% | 4.0% | 15.1% | 11.0% | 1.0% | (3.0%) |
| Mixed | 8.0% | (4.0%) | (7.9%) | 4.0% | (1.0%) | 11.0% | (14.9%) | (3.0%) |
| Annual rate of price change during months 11 through 50. | ||||||||
You will notice, in this side by side comparison, that with a fixed supply of money the rate of dollar price change equals almost exactly the inverse of the rate of production and sales growth or decline. (Fractional rates do not exactly equal the fractional rate of production increase because of rounding and the effects of compounding.) When the money supply changes (inflation or deflation) the dollar prices no longer give a clear signal as to the relative changes in the supply of the goods.
On the next four tabs I have provided static diagrams of each of the production scenarios showing the resulting dollar prices from the three types of money growth. They depict graphic representation of the information in the table above.
The fixed production scenario gives the best indication of the inflation of changes in the quantity of money. When the quantity of money remains the same throughout, dollar prices remain flat. Dollar prices rise (or decline) at the same fractional rate as the fractional rate of increase (decrease) in the quantity of money.
In a generally growing economy (production and sales increasing) dollar prices decline at the inverse of approximately the same fractional rate at which their respective production rates increase, when the quantity of money remains fixed. Inflation tends to push dollar prices higher, while deflation tends to push them down.
When production declines dollar prices tend to rise when the quantity of dollars remain fixed. As with the other production scenarios changes in the quantity of money tend to push prices in the same direction as the direct of the change in the money supply. In some cases, as with wheat dollar prices during deflation, the dollar price can actually run counter to the direction the production and sales would indicate.
In a typical economic system the rates of production for some goods increase as the rates of production for other goods decline. Thus, our scenario of mixed production rates presents a more realistic picture of the effects of inflation/deflation.
In the next tab I will give some preliminary comments about inflation and deflation.
Much of the information about this pricing model parallels the presentation on Inflation and Deflation in the Money and Banking section of this site—as a matter of fact I have borrowed some of the explanations from that presentation. This presentation uses the same model implemented in different software, which operates online. Eventually I will redesign both of these presentations to make a clearer separation.
Before you can understand the effects of inflation/deflation, you must first understand pricing—that explanation would make up the first presentation. Once you understand pricing, you can more easily comprehend the effects of (money) inflation/deflation—the topic of the second presentation. But, for the time being, I have two presentations that overlap.
Within that structure I do feel obliged to add the following comments about inflation/deflation:
The "general" money price increase/decrease that many refer to as inflation/deflation amounts to a flawed logic. Without the influence of a change in the supply of money, price movements of individual goods tend to offset each other. Thus, no general money price increase/decrease would occur.
My model, because it focuses on only two products, did not reflect this fully, but in real markets, when the dollar price of one product rises (declines), the dollar prices of one or more other products declines (rises). The likelihood that all production will rise or fall simultaneously remains very small.
For a generalized increase or decrease in money prices to occur requires the influence of a change in the one common denominator: money.
Inflation or deflation consist only of changes in the quantity of money in circulation.
It's that simple. But those changes have significant impact in the economy.
What happens, then, when the quantity of money increases or decreases?
First, changing the quantity of money changes its value per unit (More money—dollars lose value. Less money—dollars gain value.) These changes in value inversely affect the dollar prices of other goods. (More money—prices rise. Less money—prices fall.) These changes in dollar prices caused by changes in the quantity of money distort the dollar price information referred to above.
The economy does not feel the effect of inflated dollars evenly. Those who receive these digital dollars first benefit; those who receive them later lose. So, in reality the distorting effect of monetary expansion on dollar prices also acts to distort the relative price relationships between different sectors of the economy.
Remember how rising prices should signal shortages and a need for investment. The uneven impact of inflation (increasing money) causes dollar prices in one sector to rise more than other sectors. This influences investors to put money into that sector hoping to reap rewards for curing what they interpret as a real shortage.
Thus, rational decisions, based on faulty information, lead to malinvestment—investments not justified by real production rates. These malinvestments lead to a boom that must eventually bust.
Boom then bust.
Do you see the relationship to the housing market?
We find a different story on the other side of the equation. Deflation (decreasing money) causes an artificial drop in dollar prices. Declining prices signal adequate (possibly excess) production, thus discouraging additional investment. As we have seen from this example a decline in money prices caused by deflation (decreasing money) may disguise real shortages. This may lead to retrenchment just when the market needs investment.
The generalized decline in dollar prices and the resulting retrenchment, all caused by deflation (decreasing quantity of money), lead people to make the flawed correlation between falling dollar prices and economic decline. That flawed correlation encourages re-inflation, and the cycle starts all over again.
Bust.
A dangerous idea persists in many economic circles. That idea says that all general price declines lead to economic decline. Yet, all "deflation" does not have the same cause. Therefore, all general price declines do not have the same effect.
General price declines have three basic causes—monetary contraction, market correction, and economic growth:
Price declines caused by monetary contraction represent the only cause for concern. Other types of price declines indicate positive changes in the market. Implementing monetary expansion to fight "deflation" only lead back to the beginning of another boom-bust cycle.
The message to the interventionists: Keep your hands off the money supply!!
In what some have referred to as "the information age," you should have no difficulty understanding that systems distill an incredible amount of information into single units. The words and colors you see on your screen have been packed into small groups of ones and zeros, then unpacked again for you to see.
Free markets pack immense amounts of information into money prices. If we don't interfere with money prices, they can tell us a lot about what people in the market want and what businesses offer.
In this very simple demonstration I have focused on information about production. Although real markets do not operate as cleanly as this imaginary one, they still convey the same basic information:
In the case of #1, potential demand tends to exceed supply. Entrepreneurs take that as a signal for profit opportunities and work to increase supply.
In the case of #2, potential supply tends to exceed demand. Entrepreneurs take that as a signal for reduced profit opportunities and look to invest their resources elsewhere.
These simple price signals lead to highly efficient resource allocation.
Money only has value as a medium of indirect exchange. Increasing its quantity adds nothing to economic welfare. So, even moderate inflation, advocated by some, has no economic benefit. And, decreasing the quantity of money subtracts nothing from the economy. The quantity of money, however, does influence dollar prices, which have a vital role conveying economic information.
Dollar prices provide vital signals for effective, efficient, and adaptable decisions by market actors. Any disruption of those signals by artificial changes in the quantity of money (inflation or deflation) causes rational decisions to produce flawed results.
I have included the actual formulas included in the model used for this presentation:
© 2010—2020 The Free Market Center & James B. Berger. All rights reserved.
To contact Jim Berger, e-mail:
© 2010—2020 The Free Market Center & James B. Berger. All rights reserved.
To contact Jim Berger, e-mail:
