Montreal, August 3, 2002  /  No 107  
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Dr. Younkins is a Professor of Accountancy and Business Administration at Wheeling Jesuit University in West Virginia. He is the author of Capitalism and Commerce
by Edward W.Younkins
           Ludwig von Mises explains the process through which changes in the quantity of money generate relative price changes, modify the allocation of resources among market sectors, redistribute wealth, distort interest rates, and cause business cycles. He does this by tracing the sequence of events by which changes in the money supply transmit from individual to individual and from sector to sector.
          Through its ability to expand the money supply, the monetary authority is able to create credit for lending purposes. This is accomplished by giving loans to borrowers without a corresponding increase in commodity money deposits in their institutions. Circulation or created credit results in the borrower receiving an amount of money substitutes with no corresponding sacrifice being made by another person in the economic community. Credit creation by the banking system thus can exceed the constraints by which investments would be limited to actual savings. An increase in the supply of money necessarily dilutes its purchasing power. As banks expand the money supply and make new loans, they push the rate of interest below the natural rate of interest. Present-day governments follow easy money policies, unfortunately but unavoidably leading to recurring periods of boom and bust. 
How inflation works its way in the economy 
          Mises observes that an increase in the supply of money will have a tendency to lower its value but that the extent of the decline in value (or even if it declines at all) is contingent upon changes in the marginal utility of the monetary unit as perceived by individuals. He also explains that increases (or decreases) in the quantity of money are not accompanied by simultaneous and proportional changes in all prices. This is because the increase of money is introduced at one point in the economy with prices rising as the new money spreads throughout the economy. The demand for goods and services starts to rise because of the increase in the money supply but not all demands will increase in the beginning or at the same time.  
          Mises illustrates the manner in which a change in the supply of money will bring about changes in the relative income and wealth situations of individuals, alter the structure of relative prices, and modify the allocation of resources among various sectors of the economy. Only slowly will the changes in the purchasing power of money work its way throughout the whole economy. Inflation is thus essentially a process of taxation and redistribution of wealth. Mises explains that the primary appeal of inflation is that not everyone receives the new money at the same time and to the same extent. Those who receive the increase in the supply of money earlier are able to buy more goods and services before the total inflationary effect on the economy has taken place. People affected later will end up paying higher prices for many of their purchases. The incomes of the favored recipients of the new money go up before many prices have risen. The unfortunate parties who receive the new money toward the end of the sequence (or those on fixed incomes who receive none of it) lose because the prices of their purchases increase before they can benefit from the increased income, if they can benefit at all. 
          In the first stage of the inflation process the prices of only those goods and services for which the initial individuals have a large demand begin to increase. Those who sell those goods and services have more money and, in turn, increase their purchases of goods and services. This process will continue until, at its completion, prices in general will be higher but each price will have been influenced by the monetary increase in a specific sequence, at different times, and to varied extent. The end result is that the relative price structure in the economy will have been changed. This restructuring of relative prices affects the demand for, and allocation of, resources among the diverse sectors of the economy. Income and wealth are thus redistributed among groups and individuals who are in essence winners and losers in the sequential-temporal process that springs from changes in the supply of money. 
     « Inflation is essentially a process of taxation and redistribution of wealth. Those who receive the increase in the supply of money earlier are able to buy more goods and services before the total inflationary effect on the economy has taken place. People affected later will end up paying higher prices for many of their purchases. »
          Only the prices of those goods and services demanded by the first beneficiaries of the inflation go up at the outset. Later, the prices of other goods are raised as the increased supply of money works its way step-by-step through the whole economy. Since all commodities are never affected simultaneously, the prices of all the goods and services will not have gone up to the same degree. The groups that make and sell goods and services that increase in price initially profit from the inflation. They enjoy higher incomes in the infancy of the inflation and are able to purchase goods and services at lower prices which are still based on the previous stock of money. Individuals and groups whose incomes do not change during the inflation process are compelled to compete in their purchasing endeavors with those who are obtaining inflated incomes. 
The origin of the business cycle 
          Banks have the ability to set the money rate of interest below the natural rate of interest. In the absence of the gold standard, or similarly under a fractional gold standard, government and central banks allow or endorse an artificial lowering of interest rates. This artificial lowering is effected through monetary expansion. Combining the depository and lending functions, the banking industry is able to pyramid the supply of money substitutes in the guise of loans surpassing the previously existing supply of money substitutes that represented claims on demand by depositors of commodity money. The result is that some segment of the banks' outstanding money substitutes are not totally backed by existing resources if enough possessors of money substitutes were to demand payment within some limited time period. 
          Mises explains how the monetary changes introduced via the banking system not only distort interest rates but also generate business cycles. The artificially lowered interest rates stimulate the demand for bank loans over and above the amount of real savings available for lending, This demand is met with inflationary increases in the quantity of money and credit. 
          The initial recipients of the newly created funds begin or expand business ventures. When the interest rate is artificially lowered, business invests the money in long-term projects and capital investments. The investment borrowers thus bid resources away from the production of consumer goods and shorter-term investment projects to start or expand projects with longer time horizons. Resources are drawn from other uses that would have been preferred by consumers who are deprived of a greater value of immediate consumer goods. This aberration of entrepreneurs' production plans has many consequences. 
          When the borrower offers higher prices for the required factors of production he siphons them away from alternative uses. The effect of newly created credit then transfers to those factors of production in the form of higher money incomes. When workers and others receive the new money, they will spend it in their previous proportions because their time preferences will have remained the same. This increased money demand for goods and services will cause prices of consumer goods to increase. Of course, because of the previous reallocation of resources away from consumer goods production and into long-term investment projects, the amount of consumer goods available is less than it would have been. This, in turn, accentuates the price upswing. As a result, consumer goods manufacturers and providers increase their demand for factors of production to attract them back to the consumer goods industry and into investment projects with short-term completion periods. 
          The original receivers of the created credit will find it challenging, or even impossible, to finish their long-term endeavors because of the increasing costs that stem from others' efforts to attract factors of production back to the consumer goods areas. Their demand for additional loans causes the market rate of interest to increase and an even greater predicament occurs. The expansion phase of the business cycle is thus replaced by the depression stage. The failure of some unsustainable projects and businesses is unavoidable because people will have not been saving a sufficient amount to finance the higher-order investments. The crisis can only be solved by means of a readjustment of the production process through which the market liquidates the malinvestments and moves back to the consumption – investment ratio desired by consumers. Mises concludes that, in the long run, the only way progress and increases in the standard of living can be achieved is through capital formation which includes the processes of saving and investment. He also deduces that the causes of business cycles are government mismanagement and manipulation of money and credit. 
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