The Free Market Center
The Free Market Center
This presentation by itself proves nothing. It does, however, demonstrate the behavior of market actions based on very sound theory.
In what some have referred to as "the information age," you should have no difficulty understanding that systems can 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: 1) when the money prices of one product rise in relation to other products, it means that the relative rates of production for that product have declined, 2) when the money prices of one product fall in relation to other products, it means that the relative rates of production for that product have increased.
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 else where.
The "general" money price increase/decrease that many refer to as inflation/deflation amounts to a myth. Without the influence of a change in the supply of money, price movements of individual goods tend to offset each other. My model 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.
What happens, then, when the quantity of money increases of decreases?
First, changing the quantity of money changes its value per unit (More money - dollar loses value. Less money - dollar gains 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 that 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 relationship 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.
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.
Boom then bust.
Money only has value as a medium of indirect exchange. Increasing its quantity adds nothing to economic welfare. So, even the 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.
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