A Monetary Policy Primer, Part 3: The Price Level

flexible prices, New Keynesians, price level, purchasing power, sticky prices
"McDonald's Menu c. 1960," photo by Stephen Bove https://www.flickr.com/photos/stephenbove/7132647401/

macdonalds with Text 2Few people would, I think, take exception to the claim that, in a well-functioning monetary system, the quantity of money supplied should seldom differ, and should never differ very much, from the quantity demanded.  What's controversial isn't that claim itself, but the suggestion that it supplies a reason for preferring some path of money supply adjustments over others, or some monetary arrangements over others.

Why the controversy?  As we saw in the last installment, the demand for money ultimately consists, not of a demand for any particular number of money units, but of a demand for a particular amount of monetary purchasing power.  Whatever amount of purchasing X units of money might accomplish, when the general level of prices given by P, ½X units might accomplish equally well, were the level of prices ½P.  It follows that changes in the general level of prices might, in theory at least, serve just as well as changes in the available quantity of money units as a means for keeping the quantity of money supplied in line with the quantity demanded.

But then it follows as well that, if our world is one in which prices are "perfectly flexible," meaning that they always adjust instantly to a level that eliminates any monetary shortage or surplus, any pattern of money supply changes will avoid money supply-demand discrepancies, or "monetary disequilibrium," as well as any other.  The goal of avoiding bouts of monetary disequilibrium would in that case supply no grounds for preferring one monetary system or policy over another, or for preferring a stable level of spending over an unstable level.  Any such preference would instead have to be justified on other grounds.

So, a decision: we can either adopt the view that prices are indeed perfectly flexible, and proceed to ponder why, despite that view, we might prefer some monetary arrangements to others; or we can subscribe to the view that prices are generally not perfectly flexible, and then proceed to assess alternative monetary arrangements according to their capacity to avoid a non-trivial risk of monetary disequilibrium.

Your guide does not hesitate for a moment to recommend the latter course.  For while some prices do indeed appear to be quite flexible, even adjusting almost continually, at least during business hours (prices of goods and financial assets traded on organized exchanges come immediately to mind), in order for the general level of prices to instantly accommodate changes to either the quantity of money supplied or the quantity demanded, it must be the case, not merely that some or many prices are quite flexible, but that all of them are.  If, for example, the nominal stock of money were to double arbitrarily and independently of any change in demand, prices would generally have to double in order for equilibrium to be restored.  (Recall: twice as many units of money will command the same purchasing power as the original amount only when each unit commands half as much purchasing power as before.)  It follows that, so long as any prices are slow to adjust, the price level must be slow to adjust as well.  Put another way, an economy's price level is only as flexible as its least flexible prices.

And only a purblind observer can fail to notice that some prices are far from fully flexible. The reason for this isn't hard to grasp: changing prices is sometimes costly; and when it is, sellers have reason to avoid doing it often.  Economists use the expression "menu costs" to refer generally to the costs of changing prices, conjuring up thereby the image of a restaurateur paying a printer for a batch of new menus, for the sake of accommodating the rising costs of beef, fish, vegetables, wait staff, cooks, and so forth, or the restaurants' growing popularity, or both.  In fact both the restaurants' operating costs and the demand for its output change constantly.  Nevertheless it usually wouldn't make sense to have new menus printed every day, let alone several times a day, to reflect all these fluctuations!  Electronic menus would help, of course, and now it is easy to conceive of them (though it wasn't not long ago).  But those are costly as well, which is why (or one reason why) most restaurants don't use them.

The cost of printing menus is, however, trivial compared to that of changing many other prices. The prices paid for workers, whether wage or salaried, are notoriously difficult to change, except perhaps according to a prearranged schedule, which can't itself accommodate unexpected change.  Renegotiating wages or salaries can be an extremely costly business, as well as a time-consuming one.

"Menu costs" can account for prices being sticky even when the nature of underlying changes in supply or demand conditions is well understood.  Suppose, for example, that a restaurant's popularity is growing at a steady and known rate.  That fact still wouldn't justify having new menus printed every day, or every hour, or perhaps even every week.  But add the possibility that a perceived increase in demand may not last, and the restaurateur has that much more reason to delay ordering new menus: after all, if demand subsides again, the new menus may cost more than turning a few customers away would have.  (The menus might also annoy customers who would dislike not being able to anticipate what their meal will cost.)  Now imagine an employer asking his workers to take a wage rate cut because business was slack last quarter.  Get the idea?  If not, there's a vast body of writings you can refer to for more examples and evidence.

These days it is common for economists who insist on the "stickiness" of the price level to be referred to, or to refer to themselves, as "New Keynesians."  But the label is misleading.  Although John Maynard Keynes had plenty of innovative ideas, the idea that prices aren't perfectly flexible wasn't one of them.  Instead, by 1936, when Keynes published his General Theory, the idea that prices aren't fully flexible was old-hat: no economists worth his or her salt thought otherwise.[1]  The assumption that prices are fully flexible, or "continuously market clearing," is in contrast a relatively recent innovation, having first become prominent in the 1980s with the rise of the "New Classical" school of economists, who subscribe to it, not on empirical grounds, but because they confuse the economists' construct of an all-knowing central auctioneer, who adjusts prices costlessly and continually to their market-clearing levels, with the means by which prices are determined and changed in real economies.

Let New Classical economists ruminate on the challenge of justifying any particular monetary regime in a world of perfectly flexible prices.  The rest of us needn't bother.  Instead, we can accept the reality of "sticky" prices, and let that reality inform our conclusions concerning which sorts of monetary regimes are more likely, and which ones less likely, to avoid temporary surpluses and shortages of money and their harmful consequences.

What consequences are those?  The question is best answered by first recognizing the crucial economic insight that a shortage of money must have as its counterpart a surplus of goods and services and vice versa.  When money, the means of exchange, is in short supply, exchange itself, meaning spending of all sorts, suffers, leaving sellers disappointed.  In contrast, when money is superabundant, spending grows excessively, depleting inventories and creating shortages.

Yet these are only the most obvious consequences of monetary disequilibrium.  Other consequences follow from the fact that, owing to different prices' varying degrees of stickiness, the process of moving from a defunct level of equilibrium prices to a new one necessarily involves some temporary distortion of relative price signals, and associated economic waste.  A price system has work enough to do in coming to grips with ongoing changes in consumer tastes and technology, among many other non-monetary factors that influence supply and demand for particular goods and services, without also having to reckon with monetary disturbances that call for scaling all prices up or down.  The more it must cope with the need to re-scale prices, the less capable it becomes of fine-tuning them to reflect changing conditions within particular markets.

Hyperinflations offer an extreme case in point: during them sellers often resort to "indexing" local-currency prices to the local currency's exchange rate with respect to some relatively stable foreign currency, or to simply posting prices in foreign currency while accepting local currency in payment at the going rate of exchange.  In so doing, they largely cease referring to specific conditions in the markets for their particular goods, settling instead for keeping their prices roughly consistent with overall monetary conditions.  In light of this tendency it's hardly surprising that hyperinflations lead to all sorts of waste, if not to the utter collapse of the economies they afflict.  If relative prices can become so distorted during hyperinflations as to cease entirely to be meaningful indicators of goods' and services' relative scarcity, it's also true that the usefulness of price signals in promoting the efficient use of scarce resources declines to a more modest extent during less severe bouts of  monetary disequilibrium.

What sort of monetary policy or regime best avoids the costs of having too much or too little money?  In an earlier post I suggested that keeping the supply of money in line with the demand for it, without depending on help in the shape of adjustments to the price level,  is mainly a matter of achieving a steady and predictable overall flow of spending.  But why spending?  Why not maintain a stable price level, or a stable and predictable rate of inflation?  If, as I've claimed, changes in the general level of prices are an economy's way of coping, however imperfectly, with monetary shortages and surpluses, then surely an economy in which the price level remains constant, or roughly so, must be one in which such surpluses and shortages aren't occurring.  Right?

No, actually.  Despite everything I've said here, monetary order, instead of going hand-in-hand with a stable level of prices or rate of inflation, is sometimes  best achieved by tolerating price level or inflation rate changes.  A paradox?  Not really.  But as this post is already too long, I must put off explaining why until next time.

Continue Reading A Monetary Policy Primer:

[1] For details see Leland Yeager's essay, "New Keynesians and Old Monetarists," reprinted in The Fluttering Veil.

  • Michael Byrnes

    Fantastic discussion of price flexibility!

    • George Selgin

      Thank you, Michael.

  • Leland Yeager

    Very good about price flexibility. For two further reasons, perfect flexibility is not only impossible but undesirable. (1) The capricious redistribution of wealth between debtors and creditors, along with Fisher's debt deflation aspect of depression. (2) sabotage of money's essential role of economizing on the mental effort of making real price comparisons. For usefulness in making decisions, prices must have a certain degree of dependability, i.e., stability. See Abba Lerner, QJE, May 1952, p. 191.

    • George Selgin

      Thanks for these remarks, Leland, and for drawing my and other readers' attention to Lerner's article. As it happens, my next post, like Lerner's piece, uses the example of hyperinflations to show how the price system fails do do its job well when it must provide for major changes to the general level of prices in addition to signalling other, non-monetary developments.

  • Common_Sense_Post

    Perhaps you will get to it later in your discussion, but my view is that there is a highly political facet of monetary policy which trumps the economic discussion in which you engage.

    We want more jobs so we set policy to devalue of the dollar and increase demand for our products by lowering the cost in a way most voters cannot comprehend.

    We want our rich donors to get even richer, so we set policy to lower rates and increase short term asset prices even if future inflation may take these gains back. Again, the voters cannot comprehend, let alone anticipate, anything other than the first order impact.

    The regulator of these levels of easing or tightening are not controlled by supply and demand, per se, other than the supply of outcry by people when the market goes down and the demand for action when others deflate their currencies and lure jobs overseas.

    Finally, you may have indicated that the Fed does not technically control the banks, but that would be like saying a parent does not control his kids. Yes, technically, banks can do whatever they want within the law, but the reality is that if the Fed ever insists on something the banks will do it. There is a general view among the large banks that it is impractical to run the business without keeping regulators happy. Perhaps you mean that the Fed is too timid to do what it needs to enforce the implicit control it has over banks in the US?

    • George Selgin

      Thanks for your remarks, Common_Sense_Post. Of course you are quite right that the actual conduct of monetary policy is often shaped by political influences, broadly understood, rather than according to the more strictly economic ones I've outlined. But the extent to which that happens depends in part on people's (including some policymakers) awareness of the latter, and their consequent inability to tell whether or not money is being managed responsibly, and not for the sake of catering to special interests. Of course I'd write a much different set of essays were my intent merely to describe how monetary policy making is actually conducted these days. (I have written elsewhere on that topic.)

      As for having suggested that "the Fed does not technically control the banks," that was not my intent. Of course the fed, and other regulators, exercise all sorts of control over banks, including much that has little to do with explicit regulations. What I did suggest in a previous post is that the Fed does not control interest rates, and real interest rates in particular, at least in the sense of having anything like complete control of their movements. That interest rates are presently so low, for example, is more an unintended consequence of Fed actions, among other factors, than an intended one.

  • Andrew_FL

    George-You did not disappoint, this was indeed a good post!

    "Menu costs" can account for prices being sticky even when the nature of underlying changes in supply or demand conditions is well understood."

    I want to press this point a bit because it's what I was trying to get at with my comment on part two.

    Namely, that supply and demand changes being understood is a more fundamental problem! Yes, if the entrepreneur knows the market clearing price he will still rationally hesitate due to menu costs. But it seems to me knowing what his new price tags would say when weighing the costs and benefits of printing up new tags and menus, is the larger issue!

    Seems to me one could write up a sort if Kirznerian explanation for "sticky" prices. I've only seen a couple of writers talk about it that way, though.

    • George Selgin

      Of course entrepreneurs must rely mainly on the state of costs and demand for their products to determine how and when to adjust their prices. The problem (or one of them) consists of having to distinguish changes in demand that reflect genuine changes in the relative popularity of particular goods and services from changes that are mere components of fluctuations in aggregate demand. This is similar to the problem that Robert Lucas formalized with his famous "island" parable. However Lucas, being a New Classical, assumed that the prices themselves were always set correctly, the only problem being that of interpreting their movements correctly. A more realistic view allows that similar information deficiencies keep prices from being correctly set to begin with.

  • http://www.talkmarkets.com/content/global-markets/larry-summers-100-dollar-bill-ban-and-westfalia-lost?post=86090&uid=4798 Gary Anderson

    So, GDP was tanking in 2007 while inflation was constant until mid 2008. Of course that is the market monetarist argument that maintaining constant inflation doesn't always work so well.

    • George Selgin

      Correct, although the "tanking" mostly happened in 2008. And what's now regarded as a Market Monetarist argument was one that's been around for a long time. See http://hope.dukejournals.org/content/27/4/705.citation (gated, alas)

      • http://www.talkmarkets.com/content/global-markets/larry-summers-100-dollar-bill-ban-and-westfalia-lost?post=86090&uid=4798 Gary Anderson

        I don't think that the GDP decline was all happening in 2008, George. This chart does not imply that: https://research.stlouisfed.org/fred2/series/A191RL1Q225SBEA Q2 of 2007 was 3.1 growth. Q4 of 2007 was 1.4 growth. That was a massive decline and Q1 of 2008 was minus 2.7. There was a one quarter bounce back in 2008, but that was all. This is what drives the market monetarist crazy, for good reason. The Fed was asleep at the switch looking at inflation that stayed steady well into 2008 instead of GDP falling off a cliff in mid 2007 through Q1 2008!

  • gchakko

    There is only one argument to justify printing excess money. Population increase!

    Kindly let me ask a fundamental question. How do you know that GDP is the only parameter to gauge the total economic well- being of human beings which is what all economies should strive for instead of being a self-satisfactory luxurious tool of academics' engagement?. GDP is only an indicator. The psychological dimension has been totally and arrogantly “benigned”; applies equally to the poor man who is happy with little and the rich man with his multi-billions in total psycho disaster. Don’t you think it is obscene that in America over 14.6 per cent live under poverty and the U.S. spends over a trillion dollar per annum on defence (Senate approval figures), more than the rest of the world put together, not to talk of the rest of the world spending overtly on defence, esp. when the Cold War is long over and nobody in his proper senses disbelieves, venturing a nuclear war with first strike is self-annihilation. Is your defence budget to feed your defence industries to inflate prices, without asking the larger American “Christian” public?. Where is your ultima ratio in this GDP analysis sans a holistic vision? The U.S. seems the predominant country in the Western world averse to social spending unlike Ludwig Erhard’s social market economy of Germany.

    Price fixing. Who fixes the price in whose interest, the fractional billionaires against the majority of humanity? This is not socialism but fair justice demanded. Number attenuation econometrics will not solve the problem. The U.S. not only got out of the Bretton Woods since Nixon, because of America’s greed for world dominance to surrogate umpteen trillions of paper dollars' print with no equivalent gold value; the U.S. treasury, apparently has not carried out for decades an annual inventory of its gold stocks of the currently claimed 8,110 tons (approx.) under international control. The wider world will not take it anymore. 3 nuclear powers China, India and Russia have literally stopped U.S. power hegemony and are now by-passing the U.S. through BRICS, SCO and Eurasia Union. America wake up!.

    It is the U.S. greed for power that induced it delusion-wise to print worthless dollars that is the root of U.S. inflation, if you are candid to admit. This is not to say the U.S. cannot re-fix its position to a normal rational level. The thick-headed U.S. mega-billionaires has stranded the U.S. economic ship. One might want heed one golden statement (from Mahatma Gandhi cited from memory) – “Our needs are vulnerable indeed. Why multiply our needs with wants?”

    George Chakko, Vienna, 11/05/2016 17:44 hrs CET

    • George Selgin

      "How do you know that GDP is the only parameter to gauge the total
      economic well- being of human beings which is what all economies should
      strive for." I make no such claim in my post. I merely argue for keeping the money value of GDP (spending) stable, because fluctuations in spending cause resources to be wasted. Whatever the merits of (real) GDP as a measure of well-being, I should think we can all agree that the wasting of resources is something to be avoided.

      • gchakko

        Well, resources are also wasted due to ill-conceived and ill-defined targeted planning among other reasons (mostly political). Agree, you have not made such a claim. But I go with you hundred percent with your last sentence. “..the wasting of resources is something to be avoided.” Raw material-arm Europe began earnestly the recycling business after Club of Rome rang the alarm bell in the seventies. I do not know how far the U.S. has progressed on this front. Here in Vienna a good part of junk that is burnable is burnt to produce electricity. But that adds to atmospheric pollution that has its economic costs too (loaded on human health expenditure) like all non-alternative energy technologies. To round it off, my general contention is that we should take a more holistic view of things in our economic analyses, because there is a strong tendency among analysts, esp. those here in Vienna working for the United Nations Industrial Development Organisation (UNIDO), to hanker on GDP-based benchmark alone in working out solutions for developmental needs.

        G. Chakko, Vienna, Austria 11/05/2016 21:35 hrs CET

        • George Selgin

          Yes, perhaps. But this is rather far removed from matters of monetary policy, which is my only concern–and quite enough for me. I leave the rest of the world's troubles to others!

  • Ivo A. Sarjanovic


    Does "some temporary distortion" in the following statement implies that you assume neutrality in the long term, ie no real effect after the price level adjust?

    Other consequences follow from the fact that, owing to different prices' varying degrees of stickiness, the process of moving from a defunct level of equilibrium prices to a new one necessarily involves some temporary distortion of relative price signals, and associated economic waste.


    • George Selgin

      I had better hedge a bit, here, Ivo, by merely claiming that the distortions _tend_ to work themselves out over time, allowing of course that new disturbances will mean new distortions. Owing to hysteresis, long-run neutrality is only an approximation of reality.

  • Not a Banker

    Thanks for this installment, George!

    I've had a pretty good grasp on everything said so far, but this one cleared up just a little bit that I didn't quite grasp yet.

    I had understood that the supply of money should meet demand, and some of the reasons why, but now I understand how exactly "sticky prices" fit in.

  • Jannifu

    This article discussed about price changes and its relationship with money demand and money supply. I found it has many macroeconomic knowledge related with my class that I studied, such as "menu cost" and business fluctuations. The author gave us a good example about how a restaurant change its prices on its menu can influence customers' behavior, employee's salary and its business. I found that monetary policy, the quantity supplied of money and the quantity demanded of money play a very important role in the economy. In addition, prices always move to the equilibrium point, which help me better understand the concept taught in my macroeconomics class. This article also discussion the issue of price and inflation, and the author discussed about the importance to keep a relatively stable price level can help to grow a good economy.

  • http://miltonchurchill.com/ Milton Churchill

    What sort of monetary policy or regime best avoids the costs of having too much or too little money? The best government policy is to have no policy and end the monopolization of base money and the needless and highly disruptive regulatory and compliance requirements related to government oversight of banking institutions and their money-creating powers.