II. The effects of poor monetary policy
What might cause such a widespread failure of prices to convey reasonably accurate information? The most likely culprit in reality is poor monetary policy. If the money supply is stable—that is, if the money supply is not expanding or shrinking arbitrarily—the pattern of prices is likely to be mostly correct. There’s no good reason to suppose that in an economy in which markets are reasonably competitive and well-working that, suddenly, prices generally will become so out of whack that significant amounts of labour and resources are drawn into industries where they don’t belong. But if the money supply itself is changed, the pattern of prices might well become grossly distorted.
If the monetary authority (in most countries, a central bank with the power and authority to raise of lower the supply of money) injects streams of new money into the economy, significant distortions can occur. The reason is that new money enters the economy in particular places—specifically, through commercial banks making loans. This new money then spreads out to the rest of the economy from those places of entry. The people who are the first to get the newly created money spend it on particular goods and services. To make the explanation smoother, let’s assume that the new money is spent first on purchases of new automobiles (by bank customers who use their borrowed money to finance such purchases).
The injection into the economy of streams of newly created money will thus cause the price of automobiles to rise relative to the prices of all other goods and services. These higher automobile prices tell an economic lie to people throughout the economy. Entrepreneurs and investors, seeing automobile prices rise relative to the prices of motorcycles, air travel, jeans, bread, and every other good and service, are misled into the false conclusion that there is a genuine increase in the demand for automobiles relative to the demands for other goods and services.
In fact, however, the higher prices of automobiles reflect only the fact that automobile buyers include lots of people who are lucky enough to be the first to spend the newly created money. This additional demand for automobiles isn’t “real.” This additional demand doesn’t reflect people producing more output in order to earn more income to spend on new cars. Nor does this additional demand for automobiles come from these people decreasing their purchases in other markets in order to increase their purchases of automobiles.
In short, this higher demand for automobiles reflects only the fact that new money was created and spent, as it entered the economy, first on automobiles.
Once the stream of new money entering the economy stops flowing and these people no longer have this newly created money to spend, they will resume spending as they did before they got the new money. Demand for automobiles will fall back to its previous level (that is, demand for automobiles will fall to its level before being artificially driven up by the spending of the new money). But if enough new money is created and continually injected into the economy for a long-enough period of time, the prices of automobiles will rise by enough—and stay artificially high for long enough—to cause entrepreneurs and investors to shift some resources out of other industries and into automobile production.
Automobile producers will be the next in line to spend the newly created money. If automobile producers spend all of the additional money they get on, say, clothing, the prices of clothing will be the next to rise. Clothing sellers will, in turn, spend the new money that they get in some particular ways—say, on children’s toys and kitchen appliances. The prices of children’s toys and kitchen appliances will then rise.
Eventually, the newly created money works its way throughout the whole economy. This new money is ultimately spread out evenly across all markets. The final result is that the overall price level —that is, the average of all prices—is higher, but all individual prices relative to each other are unchanged from what they were before the new money was injected into the economy. For example, if as a result of the injection of new money the price of automobiles rises from $20,000 to $30,000 and the price of motorcycles rises from $10,000 to $15,000, the attractiveness to producers of producing automobiles relative to the attractiveness of producing motorcycles is unchanged: cars still fetch twice the price of motorcycles.