Destructive Fluctuations in Monetary Policy

Students of monetary economics are taught that in the long-run “money is neutral.” By this, economists mean that changes in the supply of fiat money should have no lasting impact on real economic quantities. If money is neutral an anticipated doubling of the money supply will cause a doubling of prices, and also a doubling of money wages. The real wage rate, which is the ratio of the money wage to the average price paid for a good or service, is unchanged by the doubling of the nominal quantities, and workers are neither better nor worse off. Likewise, if nominal wages fall it doesn’t matter much as long as the prices of goods and services simultaneously fall by a comparable percentage. Output and employment are unaffected, and nobody is harmed.

Alas, if only it were so in the real world. The problems arise when changes in the money supply are NOT fully anticipated, which is almost always. When the money supply falls unexpectedly, as it did during the Great Depression, the result is an unanticipated fall in the economy’s price level. If a drop in the price level is unexpected, it will not have been forecast and built into wage contracts. When there is such a surprise, nominal wages do not fall as rapidly as the prices, and there is an increase in the real wage rate.

There are many reasons that money wages might not fall as quickly as prices in a sharp economic downturn. One obvious reason would be the existence of a minimum wage law that prevents any decrease in the wage paid to workers. A more important explanation for Keynes’ “sticky wages” is the presence of wage contracts, which are negotiated for a specified future period of time where the future inflation rate is unknown. If a wage contract is made with the expectation of a 4 percent rate of inflation, and instead the economy suffers a 4 percent rate of deflation, then labor’s real wage will unexpectedly increase. When a company is forced to pay a 4 percent higher money wage to workers—while at the same time the price of its output is falling—it will cut back on hiring labor, and may be forced to lay off workers. On the other hand, a surprise increase in the economy’s rate of inflation works the other direction. If companies see the price of their products increasing, while at the same time the wage paid to workers is fixed by contract, then the real wage rate paid to labor will fall. Workers are worse off until wage contracts can be changed to reflect the higher price level.

Surprise changes in monetary policy, and thus in the rate of inflation, will also impact debtors and creditors. The real interest rate, which is the difference between the nominal interest rate and the rate of inflation, is unknown at the time a loan is extended. When taking a 30-year home mortgage, nobody knows what the inflation rate will actually be over the life of the loan. If a loan is extended anticipating a rate of inflation of 3 percent, but then inflation soars to 7 percent, the lender is hurt (but the borrower benefits).

In a perfect world the rate of inflation would be known in advance, and all contracts could be structured accordingly. In the real world this is impossible, and the best we can hope for is a minimum of unexpected “surprises” in inflation caused by fluctuations in monetary policy. Following a Friedman-type rule of growing the money supply at the same rate as the growth rate in real GDP would certainly be a step in the right direction. But, a better solution would be to get the governments and their central banks out of the money creation business all together. We need Capital as Money!

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