Deflation Doesn't Undo The Problems Caused By Past Inflation

By a popular way of thinking, it is the role of the central bank to make sure that economy follows a path of stable economic growth and prices. The economy is perceived to be like a spaceship that occasionally slips from this trajectory.

Following this way of thinking when economic activity slows down and strays from the path of stable economic growth and stable prices, it is the duty of the central bank to give it a push, which will put it back on track. The push is given by means of a loose monetary policy, i.e., lowering interest rates and raising the growth rate of money supply.

deflation

Conversely, when economic activity is perceived to be “too strong,” then in order to prevent an “overheating” it is the duty of the central bank to “cool off” the economy by introducing a tighter monetary stance. This amounts to raising interest rates and slowing down on monetary injections. It is believed that a tighter stance is going to place the economy on a trajectory of stable economic growth and stable prices.

Hence, following this way of thinking it makes a lot of sense for the central bank to watch the economy all the time and to make the necessary adjustments in order to keep it on a stable growth path. It also appears as if a tighter monetary stance could offset the effects of the previous loose monetary stance.

Why Tight Monetary Stance Cannot Erase the Effects of an Easy Stance

A tight monetary stance cannot undo the negatives of the previous loose stance. A tighter stance cannot reverse the misallocation of resources that occurs during a loose one.

According to Percy L. Greaves Jr. in The Causes of the Economic Crisis, and Other Essays before the Great Depression,

Mises also refers to the fact that deflation can never repair the damage of a priori inflation. In his seminar, he often likened such a process to an auto driver who had run over a person and then tried to remedy the situation by backing over the victim in reverse. Inflation so scrambles the changes in wealth and income that it becomes impossible to undo the effects. Then too, deflationary manipulations of the quantity of money are just as destructive of market processes, guided by unhampered market prices, wage rates and interest rates, as are such inflationary manipulations of the quantity of money.

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