The idea of price stability originates from the view that volatile changes in the price level prevent individuals from clearly seeing market signals as conveyed by changes in the relative prices of goods and services. For instance, because of an increase in the demand for apples, the prices of apples increase relatively to the prices ...
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The idea of price stability originates from the view that volatile changes in the price level prevent individuals from clearly seeing market signals as conveyed by changes in the relative prices of goods and services.
For instance, because of an increase in the demand for apples, the prices of apples increase relatively to the prices of potatoes. This relative price increase gives an impetus to businesses to lift the production of apples versus potatoes.
By being able to observe and respond to market signals as conveyed by changes in relative prices, businesses are said to be able to be in tune with market wishes and therefore promote an efficient allocation of resources.
It is held that as long as the inflation rate as measured by the rate of increase in price level is stable and predictable, individuals can identify changes in relative prices and thus maintain the efficient allocation of resources.
However, when inflation is unexpected (i.e., the rate of increase in the price level is of a sudden nature) it tends to obscure the relative price changes of goods and services. This, in turn, makes it much harder for people to observe market signals. Consequently, this leads to the misallocation of resources and to a loss of real wealth.
Note that on this way of thinking changes in the price level are not related to changes in relative prices. Unstable changes in the price level only obscure but do not affect the relative changes in the prices of goods and services.
So if somehow one could prevent the price level from obscuring market signals obviously this will set the foundation for economic prosperity. On this way of thinking, policy that could stabilize the price level will enable the clear observation of changes in the relative prices.
The Root of Price Stabilization Policies
At the root of price stabilization policies is a view that money is neutral. On this way of thinking changes in money only have an effect on the price level while having no effect whatsoever on the real economy.
For instance, if one apple exchanges for two potatoes then the price of an apple is two potatoes or the price of one potato is half an apple. Now, if one apple exchanges for one dollar then it follows that the price of a potato is half a dollar. Note that the introduction of money does not alter the fact that the relative price of potatoes versus apples is 2:1 (two-to-one). Thus, a seller of an apple will get one dollar for it, which in turn will enable him to purchase two potatoes.
In this way of thinking an increase in the quantity of money leads to a proportionate fall in its purchasing power (i.e., a rise in the price level) while a fall in the quantity of money will result in a proportionate increase in the purchasing power of money (i.e., a fall in the price level). All this however, will not alter the fact that one apple will be exchanged for two potatoes, all other things being equal.
Let us assume that the amount of money has doubled and as a result, the purchasing power of money has halved, or the price level has doubled. This means that now one apple can be exchanged for two dollars while one potato for one dollar. Despite the doubling in prices a seller of an apple with the obtained two dollars can still purchase two potatoes.
We have here a total separation between changes in the relative prices of goods (how many apples exchanged per potatoes) and the changes in the price level. Why is this way of thinking problematic?
How New Money Enters the Economy
When new money is injected there are always first recipients of the newly injected money who benefit from this injection. With more money at their disposal, the first recipients can now acquire a greater amount of goods whilst the price of these goods remains unchanged.
As money starts to move around the prices of other goods begin to rise. Consequently, the late receivers benefit to a lesser extent from monetary injections or may even find that most prices have risen so much that they can now afford fewer goods.
The increase in money supply leads to a redistribution of real wealth from later recipients, or non-recipients of money to the earlier recipients. Obviously, this shift in real wealth alters individuals’ demands for goods and services and in turn alters the relative prices of goods and services.
The changes in money supply set in motion dynamics which give rise to changes in demands for goods and to changes in their relative prices. Hence, changes in money supply cannot be neutral as far as relative prices of goods are concerned. According to Mises,
I wish to emphasize that in a living and changing world, in a world of action, there is no room left for a neutral money. Money is non-neutral or it does not exist. (A lecture in Paris in 1938) .
The Price Level Cannot be Observed
When one dollar is exchanged for one loaf of bread, we can say that the purchasing power of one dollar is one loaf of bread. If one dollar is exchanged for two tomatoes then this also means that the purchasing power of one dollar is two tomatoes.
The information regarding the specific purchasing power of money does not however allow the establishment of the total purchasing power of money. It is not possible to establish the total purchasing power of money because we cannot add up two tomatoes to the one loaf of bread. We can only establish the purchasing power of money with respect to a particular good in a transaction at a given point in time and at a given place.
The use of a fixed weight price index seems to offer a solution that bypasses the problem of direct calculation of an average price. By means of this index, it is held, we could establish changes in the overall purchasing power of money. The following example illustrates the essence of a fixed weight price index.
In period one, Tom bought 100 hamburgers for 2 dollars each. He also bought five shirts at 20 dollars each. His total outlay in the period one is $2*100 + $20*5 = $300. Observe that hamburgers carry a weight of0.67 of total outlays while shirts carry a weight of 0.33.
In period two, hamburgers are exchanged for 3 dollars, an increase of 50% whilst shirts are exchanged for 25 dollars - an increase of 25%. By applying unchanged weights, i.e. an unchanged pattern of consumption, we will find that the purchasing power of Tom's money fell by 41.7%. (50%*0.67 + 25%*0.33 = 41.7%)
If we were to assume that Tom's pattern of consumption represents an average consumer then we could say that the overall purchasing power of money fell by 41.7%.
Every five years government statisticians conduct extensive surveys to establish a pattern of spending of a "typical" or an "average" consumer. The obtained weights in turn serve to establish changes in the average price and hence in the purchasing power of money.
The assumption that weights remain constant over a prolonged period is, however, not applicable in the real world. This assumption implies an individual with frozen preferences i.e. a robot. According to Mises, in the world of frozen preferences the idea that money's purchasing power could change is contradictory. (Human Action, p. 222).
Moreover, according to Rothbard,
There are only individual buyers, and each buyer has bought a different proportion and type of goods. If one person purchases a TV set, and another goes to the movies, each activity is the result of different value scales, and each has different effects on the various commodities. There is no 'average person' who goes partly to the movies and buys part of a TV set. There is therefore no 'average housewife' buying some given proportion of a totality of goods. Goods are not bought in their totality against money, but only by individuals in individual transactions, and therefore there can be no scientific method of combining them .
The view that a variable weight price index could bring more realism and permit the estimation of the purchasing power of money also misses the point.
Now changes in prices are driven by monetary and non-monetary factors. The influence of these factors on prices are however, intertwined and cannot be separated. Consequently, it is not possible to isolate changes in the purchasing power of money from changes in this price index. On this Rothbard wrote,
This contention rests on the myth that some sort of general purchasing power of money or some sort of price level exists on a plane apart from specific prices in specific transactions. As we have seen, this is purely fallacious. There is no “price level,” and there is no way that the exchange-value of money is manifested except in specific purchases of goods, i.e., specific prices. There is no way of separating the two concepts; any array of prices establishes at one and the same time an exchange relation or objective exchange-value between one good and another and between money and a good, and there is no way of separating these elements quantitatively. It is thus clear that the exchange-value of money cannot be quantitatively separated from the exchange-value of goods. Since the general exchange-value, or PPM, of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we do not know what something is, we cannot very well act to keep it constant. 
Also according to Mises, "In the field of praxeology and economics no sense can be given to the notion of measurement. In the hypothetical state of rigid conditions there are no changes to be measured. In the actual world of change there are no fixed points, dimensions, or relations which could serve as a standard." (Human Action, p. 222)
We can thus conclude that the various price deflators that government statisticians compute are arbitrary numbers.
Why a Policy of Stabilizing the Price Level Leads to More Instability
Now, the Fed’s monetary policy that aims at stabilizing the price level by implication affects the growth rate of money supply. Since changes in money supply are not neutral, this means that a central bank policy amounts to tampering with relative prices.
The Fed’s tampering with the so-called price level destroys businesses ability to calculate thereby resulting in the misallocation of resources.As a result, a policy of stabilizing the so-called price level leads to over-production of some goods and under-production of some other goods. On this, Joseph Salerno quotes Mises,
“What economic calculation requires is a monetary system whose functioning is not sabotaged by government. The endeavors to expand the quantity of money in circulation either in order to increase the government’s capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation . . “
This is, however, not what the stabilizers are telling us. For they believe that the greatest merit of stabilizing changes in the price level is that it allows for free and transparent fluctuations in the relative prices, which in turn leads to the efficient allocation of scarce resources.
Contrary to popular thinking, there is no such thing as price level that should be stabilized by the central bank in order to promote economic prosperity. Conceptually, the price level cannot be ascertained notwithstanding the most sophisticated mathematics. Obviously if we do not know what something is it stands to reason that we cannot keep it stable. Policies that are aiming at stabilizing an unknown price level only stifle the efficient use of scarce resources and lead to an economic impoverishment.