One of the duties that a central bank is expected to fulfill is to keep the general level of prices in the economy stable. The whole idea of price stability originates from the view that volatile changes in the price level prevent individuals from clearly seeing market signals as conveyed by the changes in the relative prices of goods and services.
For instance, as a result of an increase in the demand for apples relative to potatoes the prices of apples increase relatively to the prices of potatoes. This relative price increase gives a push to businesses to lift the production of apples versus potatoes.
By being able to observe and respond to market signals as conveyed by changes in relative prices, businesses are said to be in tune with market wishes and therefore promote an efficient allocation of resources.
As long as the rate of increase in the general price level is stable and predictable, individuals can identify changes in relative prices and thus maintain the efficient allocation of resources, so it is held.
However, when the rate of increase in the price level is unexpected i.e. the rate of increase in the price level is of a sudden nature, it tends to obscure the visibility of the relative price changes of goods and services. This in turn makes it much harder for people to clearly observe market signals. Consequently, this leads to the misallocation of resources and to a loss of real wealth.
Note that in this way of thinking changes in the price level are not related to changes in relative prices. Unstable changes in the price level only obscure but do not affect the relative changes in the prices of goods and services. So if somehow one could prevent the price level from obscuring market signals obviously this will set the foundation for economic prosperity.
Popular thinking of neutrality of money
At the root of price stabilisation policies is a view that money is neutral. Changes in money only have an effect on the price level while having no effect whatsoever on the real economy.
For instance, if one apple exchanges for two potatoes then the price of an apple is two potatoes, or the price of one potato is half an apple. Now, if one apple exchanges for one dollar then it follows that the price of a potato is $0.5.
Note that the introduction of money does not alter the fact that the relative price of potatoes versus apples is 2:1 (two-to-one). Thus, a seller of an apple will get one dollar for it, which in turn will enable him to purchase two potatoes.
In this way of thinking, an increase in the quantity of money leads to a proportionate fall in its purchasing power i.e. a rise in the price level. While a fall in the quantity of money results in a proportionate increase in the purchasing power of money i.e. a fall in the price level. All that, according to this way of thinking, does not alter the fact that one apple is exchanged for two potatoes, all other things being equal.
Let us assume that the amount of money has doubled and as a result, the purchasing power of money has halved, or the price level has doubled. This means that now one apple can be exchanged for $2 while one potato for $1. Note that despite the doubling in prices a seller of an apple with the obtained $2 can still purchase two potatoes.
We have here a total separation between changes in the relative prices of goods (how many apples exchanged per potatoes) and the changes in the price level. Therefore, it would appear that the only problem with changes in the price level – also labeled as inflation – is that if it is unstable it can obscure the visibility in the movements of relative prices of goods thereby causing a misallocation of resources. Other than that, inflation is harmless. In reality though this way of thinking is problematic.
Why money is not neutral?
When new money is injected there are always first recipients of the newly injected money who benefit from this injection. The first recipients with more money at their disposal can now acquire a greater amount of goods while prices of these goods are still unchanged.
As money, starts to move around the prices of goods begin to rise. Consequently, the late receivers benefit to a lesser extent from monetary injections or may even find that most prices have risen so much that they can now afford fewer goods.
Increases in the money supply lead to a redistribution of real wealth from later recipients, or non-recipients of money to the earlier recipients. Obviously, this shift in real wealth alters individuals’ demands for goods and services and in turn alters the relative prices of goods and services.
Changes in money supply set in motion new dynamics that gives rise to changes in demands for goods and to changes in their relative prices. Hence, changes in money supply cannot be neutral as far as the relative prices of goods are concerned.
The purchasing power of money cannot be established conceptually
The whole idea of the general purchasing power of money and hence the price level cannot even be established conceptually.
When $1 is exchanged for 1 loaf of bread we can say that the purchasing power of $1 is 1 loaf of bread. If $1 is exchanged for 2 tomatoes then this also means that the purchasing power of $1 is 2 tomatoes. The information regarding the specific purchasing power of money does not however allow the establishment of the total purchasing power of money.
It is not possible to ascertain the total purchasing power of money because we cannot add up 2 tomatoes to 1 loaf of bread. We can only establish the purchasing power of money with respect to a particular good in a transaction at a given point in time and at a given place.
On this Rothbard wrote,
Since the general exchange-value, or PPM (purchasing power of money), of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we do not know what something is, we cannot very well act to keep it constant.
Now, the Fed’s monetary policy that aims at stabilising the price level, by implication affects the growth rate of money supply. Since changes in money supply are not neutral, this means that a central bank policy amounts to the tampering with relative prices, which leads to the disruption of the efficient allocation of resources.
As a result, a policy of stabilising prices leads to over-production of some goods and under-production of some other goods. This is, however, not what the stabilisers are telling us. For they believe that the greatest merit of stabilising changes in the price level is that it allows transparent fluctuations in the relative prices, which in turn leads to the efficient allocation of scarce resources.
 Murray N. Rothbard, Man, Economy, and State, Nash Publishing p 743