Abstract
We assess monetary equilibrium theory by focusing on its foundation—price stickiness—and answer several ancillary questions. Prices are sticky at times. Contra monetary equilibrium theorists, this is not a reason to advocate an issuance of fiduciary media to counteract the effects of a sluggish price adjustment process. Issuances of fiduciary media will breed negative effects, primarily via wealth redistributions, faulty interest rate signals and exacerbated business cycles. Allowing the price level to adjust to maintain monetary equilibrium provides for fewer detrimental effects than adjusting the supply of credit.
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Notes
Throughout this paper, we use the term “free banker” to group together those who view price stickiness (or a sluggish adjustment of prices to monetary shocks) as a rationale for the issuance of fiduciary media. We do not intend to include “free bankers” who support fractional reserve free banking on ethical, legal, or banking sector profitability grounds. Examples of the former group of free bankers can be found in Garrison (1989), Horwitz (1992, 1996, 2000, 2006), Selgin (1988, 1994), and especially Yeager (1997).
We will overlook for the moment the critical question concerning sticky prices posed by Shah (1997: 42): “Sticky compared to what?”
Stickiness does not imply that prices are set without heed to supply and demand conditions. Rather, stickiness arises as prices are set individually and require some passage of time to achieve new equilibria after a monetary disturbance (Greenfield and Yeager [1989] 1997: 408).
This only applies in cases where the bond is not resold and the yield to maturity allowed to change along with changes in prevailing market interest rates.
Alternatively stated, they deem stable output as preferable to stable prices. Although there are some plausible explanations as to why this may be true for the majority of individuals (see, for example, Solow 1979), we cannot impose this judgment on market participants.
Even with constant proportions of consumption and investment expenditures, the demand for money can increase. Actors may simply abstain from consumption and investment in the same proportions in order to increase their real cash balances. Alternatively, individuals may increase their cash balances by disinvesting—increasing the proportion of consumption to investment expenditure—as accompanies an increase in time preference. Consumer goods’ prices increase relative to capital goods’ prices leading to a shorter structure of production.
Indeed, the increased volatility in the demand for money under the issuance, or even potential issuance, of fiduciary media arises for many of the same reasons discussed in Barro (1982). While Barro focuses on unanchored inflation expectations under fiat central banking regimes as compared to the relatively rigid Bretton Woods era, much of the amplification of inflationary expectations of the current demand for money also exists under a free banking system issuing fiduciary media.
Bagus (2006) critiques the common error that price deflation necessarily hampers business conditions. On the compatibility of deflationary expectations and full employment, see Hutt ([1960] 1995: 398). Atkeson and Kehoe (2004) sample 17 countries and 100 years of data to find only one sample point with a link between deflation and recession—America’s Great Depression.
Much New Keynesian monetary policy rests on the same prescription. Mankiw (1985) points to the externalities of changing prices. A firm that lowers its prices first will be raising the real incomes of consumers. This increase in real income allows consumers to increase purchases, but these new purchases may not be from the same firm that first lowered its price. As a result, the first-moving firm is reckoned to not receive the full benefit of their price adjustment. What New Keynesians (like Mankiw) and monetary equilibrium theorists overlook is that the firm that lowers its price first will only do so if it thinks it is the best alternative. A firm that lowers its prices will only do so in the expectation of increasing profits (if the good’s demand is elastic) or to prevent greater losses. Moreover, it is true that lowering prices can have a positive externality on other companies. Yet, the existence of a positive externality does not rule out an action. In addition, being the first to lower prices provides an important first mover advantage: higher priced competitors will lose market share.
One astute referee notes a conflict between the argument we make here for why rational expectations causes entrepreneurs to adjust their costs downward due to monetary shocks but does not cause entrepreneurs to refrain from utilizing fresh credit for production decisions under a fractional-reserve banking system. In fact these two arguments are of the same coin. Carilli and Dempster (2001), Huerta de Soto (2009), and Howden (2010) show that an Austrian business cycle will result under credit expansion due to a prisoner’s dilemma. Whether or not it is profitable in the long run to utilize fresh credit, the threat of a loss of market share to those who do utilize it entices entrepreneurs to partake in the credit expansion. A similar dilemma comes forth when an increase in the demand to hold cash balances occurs. Although entrepreneurs that reduce their selling prices first may suffer a negative externality of sacrificed profit relative to those that do not reduce their prices (as in Mankiw 1985); in the long run, these same entrepreneurs that fail to lower their prices will be forced to exit the market. As their prices will be above those of their competitors, they will lose market share accordingly. Alternatively, if no firm currently in the market reduces its selling price, an influx of competition seeking the higher relative profits in that specific good’s market will occur, thus forcing downward price pressure on the existing competitors.
We assume that entrepreneurs tend to be successful in estimating consumer valuations. If they were not, then supply and demand would never tend to coordinate. Factor prices failing to adjust to consumer price changes in advance would result in net losses at the higher stages of production. Even in the case where entrepreneurs were unsuccessful in forecasting a decrease in final consumer goods’ prices and bid factor prices down accordingly, the ensuing losses would eventually force these input prices down.
Dubai World’s 2009 debt restructuring presents one recent example of both debtors and creditors agreeing to alter the established terms of a contract.
Political interventions can also influence this preference (Hülsmann 2003b, 75).
Although not directly related to the demand to hold money, preferred idleness is interest rate-sensitive. As interest rates increase, the foregone profit opportunity of holding unsold goods increases. Low interest rates correspondingly offer little opportunity cost to entice entrepreneurs to offer their goods for sale at prevailing prices.
Another question would be if workers could and should be deceived by increasing the money supply. It is questionable that they could be deceived continuously about their real wage. It is certainly paternalistic to try to deceive the worker to induce him to work through changes in his real wage rate in the same way that it is paternalistic to change his preferences in regard to gambling, drinking, holidays, etc. (Hutt 1977: 141).
One question that could be asked of free bankers at this point is by what measure the costs of increasing the money supply are to be balanced against the benefits of halting a decrease in production through maintained output prices.
As Selgin (1998: 4) cautions in the introduction to his The Theory of Free Banking: “Throughout the study emphasis is placed on the distinctive, macroeconomic implications of free banking. Its microeconomic consequences, though not unimportant, are less controversial.” While the consequences of an aggregate approach to monetary disequilibrium may be uncontroversial, it is clear that the results stemming from the approach advocated to counter such disequilibria are decidedly less so.
Ball and Mankiw (1994: 137) make a similar point regarding monetary policy shocks to real versus nominal variables.
Yeager ([1956] 1997) largely brushes aside the question of what price level to adjust. While his reliance on the fact that a clear change on the value of money would be evident by “any reasonable indicator”, there can be no doubt that an equilibrium or disequilibrium situation was persisting. While this may be true for high rates of price inflation, or extreme situations of monetary disequilibrium, the more mundane state of affairs has mild price inflation and relatively little monetary disequilibrium. In these cases the question as to what price level to adjust takes on increased significance.
An atmosphere of price stability would still harm savers. The absolute level of price inflation or deflation is inconsequential. What matters is the level that prevails compared to what would have happened in the absence of fiduciary media issuance. For a similar point, see von Mises (1943).
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The authors would like to thank two anonymous referees. The usual disclaimer applies.
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Bagus, P., Howden, D. Monetary equilibrium and price stickiness: Causes, consequences and remedies. Rev Austrian Econ 24, 383–402 (2011). https://doi.org/10.1007/s11138-011-0151-7
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DOI: https://doi.org/10.1007/s11138-011-0151-7