In this section we saw how the decline in the money supply had a negative influence on the direction of dollar prices. Dollar prices declined in all of these scenarios, even when one would expect prices to rise (with falling production).

Deflation sends false signals to the market.

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Why should we worry about deflation (decreasing money supply)?

First, relative dollar price declines should signal rising production. Declining dollar prices cause entrepreneurs to invest elsewhere, maybe reducing production. Dollar price declines caused by increasing production, therefore, help to allocate resources where needed more.

Second, when dollar prices decline because of growing money, the market gets a false signal. The market thinks declining prices signal rising production and reduced entrepreneurial opportunity. This effect may happen in cases of falling production. Thus, entrepreneurial investment steers clear of situations that need investment.

Third, you can see from the various scenarios of inflation and deflation that only changes in the quantity of money can cause generalized changes in dollar prices. Remember, with a fixed money supply dollar prices move interdependently.

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Now, we'll look at the effect of changing the growth of money in surges.