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For a New Liberty
CTIR Literature Series 1
Part 4
Chapter 9
Inflation and the Business Cycle
Boom and Bust
• Economy in either boom or bust.
▫ Boom = prices rising (inflation).
▫ Bust = recession/depression (high
unemployment).
• Keynesian.
▫ In boom, government increase taxes.
▫ In bust, government increase spending.
• But what to do if inflation AND high
unemployment?
Inflation
• Prices rising.
• NOT required.
• War against inflation?
▫ Greedy businessmen increase prices to increase
profits (greed).
 But why not increase prices even more?
Price
• Amount of money the buyer is willing to spend.
• The interaction between the buyer and seller
brings about the ruling price in the market.
• Supply and demand.
▫ If supply increased, price lowers.
▫ If demand increases, price rises.
Money Can Set Price
• If amount of money in the buyer’s possession
increased by 20%, prices will rise 20%.
• Thus, the stock or supply of money increases
prices.
▫ NOT greed.
How is Money Created?
• Arises on the market as individual begin to
choose commodities to act as money.
▫ The best:
 High demand, durable, long storage, mobile, easily
recognizable, readily divisible without losing value.
▫ Historically, gold and silver.
Gold Standard
• When a society or state adopts a certain
commodity as money and is used daily it adopts
a commodity standard.
• Natural course is gold or silver standard.
• Supply of gold determined by the market:
▫ Technological conditions of supply;
▫ The price of other commodities.
Why Would State Want Control
Over Money Supply?
• Alternative to taxation.
• So, it acquired the monopoly power to
counterfeit.
▫ Result = fiat paper standard.
 Dollar is piece of paper with names stamped on
them issued by the State.
▫ Result = inflation.
Political Problems with Inflation
• Too visible.
▫ Fear of the public finding out and taking power
away.
• So, created Federal Reserve and fractional
reserve banking system.
Federal Reserve
• Central bank for the US.
• Controls the entire commercial banking system.
• Permits commercial banks to pyramid deposits
on top of the Fed’s own reserves.
▫ 6:1 ratio (1973).
▫ NOW:
 Less than $12.4 million = none.
 $12.4-$79.5 million = 1/3:1 (3%).
 Over $79.5 million = 10:1.
Bank Deposits are Money?
• Constitutes a promise by a bank that it will
redeem its demand deposits in cash (Federal
Reserve Notes) anytime the depositholder (bank
customer) may desire.
How Do Banks Create New
Deposits?
• Banks receive $1 billion new reserves.
• Lend out $6 billion.
▫ By creating new deposits (i.e. loans).
• But it’s NOT existing money that was deposited.
Open Market Purchases
• How the Fed determines the total reserves of the
banks.
• Fed goes to open market and buys an asset.
▫ Could be anything (mostly US government bonds).
▫ Seller receives the note.
▫ Seller takes note to bank.
 Fed NOT open to private individuals, only banks and
federal government.
▫ Seller gets note price in checking account.
▫ Bank gets note price from Fed.
Federal Reserve System (cont.)
• Created in 1913.
• In 1933, US went off gold standard.
▫ Removed the shackles.
▫ Prior, the note was redeemable in gold.
 Fed can’t create gold.
• In 1971, US went off gold window.
▫ Prior, gold standard still applied to foreign
governments.
The Business Cycle
• Regularly recurring series of booms and bust.
• NOT required.
▫ If boom in computers, bust in computers.
▫ NOT overall economy.
• Why occur?
▫ Industry’s fault;
▫ Banking system’s fault.
Banking System’s Fault
• Fractional reserve banking = bank credit
expansion.
▫ Raises prices.
▫ Artificially lowers rate of interest.
 Sends misleading signals to businessmen, causing
them to make unsound investments
(malinvestment).
Natural Rate of Interest
• Determined by time preferences of all buyers
and sellers in economy.
• Loan.
▫ Present good (money used now);
▫ Exchanged for future good (payment later).
• People want money NOW.
▫ NOT worth risk to wait.
▫ Present goods contain premium over future goods.
▫ Premium = interest rate.
Result of Decrease of Interest Rate
• Businessmen will invest in:
▫ More capital goods; and
 Durable equipment, industrial raw material,
construction.
▫ Higher wages.
• Result, increased demand.
▫ Labor costs increase.
▫ Businesses think they can meet the costs.
Result of Decrease of Interest Rate
(cont.)
• Workers spend higher wages.
▫ On consumer goods NOT capital goods.
▫ NOT saving.
• Result, depression in capital goods.
▫ Businessmen shouldn’t have invested so much in
capital goods.
• Proportions between consumption (consumer
goods) and investment (capital goods)
reestablish.
Solution?
• Government should NOT be involved.
• Stop inflating money supply.
• Stop intervening.
Themes
• Federal Reserve intervention in the economy
through open market purchases AND fractional
reserve banking results in:
▫ Inflation; AND
▫ Artificially low interest rates.
Thank you!
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