Should price stability be a legitimate goal for the Federal Reserve (or any central bank)? To answer this, let’s take a step back. Should the government be in charge of creating price stability for automobiles? When the price of autos increase, should the government increase the supply of autos? When the price of autos falls, should the government buy up automobiles on the open market? After all, the government (i.e. taxpayers) owns a car company (GM) and could manipulate the equilibrium price of automobiles.
Why might the government like price stability in cars? You could argue that producers could better plan production if they knew in advance what their cars would sell for. Consumers might be able to better plan their car purchases as well. So what’s the problem? By masking real prices, the government covers up information from market actors. Prices aren’t arbitrary or meaningless. The price of every product is a little piece of information telling the market how to efficiently allocate resources.
Does the government know better than the market how to allocate resources in the car (or for that matter any other) industry? History tells us that centrally planned economies fail in part because planners lack information. Hayek’s “man on the street” is the guy with information, and he uses this information he sees from prices to make decisions to maximize his own self interest. An ill informed central planner sets prices only to cause surpluses and shortages of products they mis-price.
If there is no individual price the government can set better than markets, why do we believe that a central bank can set average prices better than the market? There is an aggregation problem here that monetary policy activists need to come to terms with. Setting one price is bad; setting two prices is bad; setting three prices is bad; setting all prices is good? You have to go back to the 1700’s to find economists believing that inflation/deflation doesn’t affect relative prices.
What could possibly go wrong when a central bank uses activist monetary policy to achieve price stability at the cost of ignoring market signals? Tune in to next week’s post.