No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 290 Fear the Boom and the Bust We’ve seen that the Federal Reserve uses open market operations to buy securities and increase bank reserves. With these reserves, the banking system makes loans to individuals and creates money through the multiple deposit expansion process. This new money provides the borrower with purchasing power of present goods, but there are no more goods and services available than there were prior to the loan. Borrowers will tend to bid up prices, with the prices of higher order goods (or whatever the borrowed money is used to purchase) rising first. Consumer prices are usually the last to rise. The increased prices for higher order goods tend to increase the value of the stocks of those firms, making higher order goods. This brings about the main problem with the inflationary policies of the central bank. Recall from chapter 10 the information properties of the price system—that relative prices indicate scarcity and guide entrepreneurs to either expand or contract production. When profits go up in higher order goods, entrepreneurs are in effect being told that the market values higher order goods relatively more than other goods. Astute entrepreneurs will be quick to employ more resources in the relatively more profitable area. Entrepreneurs incorrectly believe that consumers value future goods more than present goods. Why? Because when the Fed engages in expansionary monetary policy, as Figure 12.8 earlier shows, interest rates are driven down. Longer-term projects are now relatively more profitable, and higher order goods prices are bid up. Entrepreneurs will be quick to invest in these longer-term capital projects, and they will use the newly created money they borrow to bid resources away from lower order goods (consumer goods). If the lower interest rate was the result of increased savings rather than an increase in credit by the Fed, then the actions of the entrepreneurs would be correct. If people are saving more today, they’ll want to consume more in the future. Therefore, entrepreneurs need to steer capital away from producing for the shorter term, and towards longer-term production. But if the lower interest rate is by the Fed’s creation of credit, consumer preferences have not changed and the actions of entrepreneurs will distort the economy. How does this work? Imagine you own a steel mine (raw steel being a higher order good) and interest rates are lowered. Other businesses find their longer-term capital projects more remunerative and they increase their order for steel. Initially, you may have some production slack as well as inventory, but as the orders keep coming in, you need to expand production. You have to hire more workers, but to bid them away from