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

Chapter Twelve: Money Mischief 291 their current jobs you’ll have to pay higher wages. You increase the size of the mine’s machinery and make capital investments of your own. That capital investment would not have been profitable under the old demand (before the expansionary Fed policy), but now it is. You have to burn more fuel in your operations as well. Since you are not alone, and this is happening economy-wide, energy costs start to rise. With higher material and labor costs rising, you pass those costs along to the purchasers of your steel.The users of the steel will face the same problems and pass their costs on through price hikes, and only finally will those costs be passed on to consumers for the first order (consumer) goods. As prices start to rise, inflationary expectations rise in concert, and savers demand higher nominal interest rates to compensate for the lost purchasing power. When interest rates start to rise, the very long-term projects that were profitable after the Fed’s initial expansion no longer are. Only additional expansion by the central bank can keep the interest rates low, but this only delays and accentuates the problem, as consumer goods prices will continue to rise. But as we’ve mentioned, there will be political pressures to keep interest rates low, at least while there is little visible consumer inflation. Since asset inflation is alive and well in the prices of stocks that produce higher order goods, the public may well be comfortable with a “little” inflation. Meanwhile, the capital stock for higher order goods is increased, while consumption of consumer goods has not abated. Even worse, the public may see their wealth increase due to the asset inflation and may decide to save less. This will allow them to increase consumption of present goods, and it will also cause the supply of loanable funds to shift to the left, driving up interest rates. To keep the interest rates fixed at the lower levels, the Fed must then provide even more monetary liquidity. This only provides additional purchasing power in the economy, with no corresponding increase in goods and services, creating further inflationary pressures. This “inflationary spiral” ultimately comes to an end when the central bank fears consumer price inflation is getting out of control and raises interest rates. With rising interest rates, the investment in longer-term capital equipment will no longer be profitable and will have to be abandoned. Stock and bond markets will quickly price in the reality of the misallocated capital and many firms will suffer both lower stock prices and increased borrowing costs (above and beyond the higher interest rate from the loanable funds framework, they will pay an additional risk premium). The Fisher Equation would have to be modified to include this risk premium: Some firms will go bankrupt, and resources that were falsely directed to those firms will have to be reallocated, potentially at great cost. Misallocated resources include both workers and physical capital. Workers that were hired by “bubble” industries may need to be retrained before they are able to compete i = r + π e + RP