Newsgroups: sci.econ
Date: Sat, 15 Aug 1992 00:57:46 -0400 
From: Thomas Omar Smith <ts2a+@andrew.cmu.edu>
Subject: Re: It's not a Depression because prices aren't falling?
Distribution: usa

david@mail.sas.upenn.edu (R. David Murray) says:
>My grasp of monetary theory is weak, to say the least, but I thought
>I understood that cutting interest rates as the Fed has been doing
>was an inflationary action.  I was puzzled, then, that the 'inflation
>rate' is so low.  Then it occured to me: in the Depression, we were on
>a hard money standard, and so prices fell.  Now, we are on a fiat
>standard.  So suppose real prices are actually falling so rapidly that
>the fairly significant inflation of the money supply being practiced
>by the Fed can just barely keep up?

Well, I'll agree your grasp is weak.  But it does appear to be a lack of
education and not a lack of logic.  Let me try and enlighten you a bit. 
Your mistake is that you assume that the fed changing interest rates
occurs as a reaction to inflation.  In fact, the fed is probably not
worrying a whole lot about inflation right now.  What the fed is
concerned about is the fact that spending is way down.  The theory is
that if interest rates are sufficiently low, people will be inclined to
borrow money and take advantage of the low rates.  This increases
spending and pulls us out of the recession.  It is of limited value in
reality, although it is a good theory.  
	When inflation is high, interest rates tend to rise since future risk
is higher.  However, inflation is inversely guided by velocity, which is
a function of spending.  Therefore, inflation usually occurs when
spending exceeds what the money supply can handle.  More and more
currency becomes necessary for transactions, and inflation results. 
Lowering rates then may help pull down inflation, or it may help inflate
the spending trends and make the situation worse.  The normal way to
deal with inflation is to get interest rates at a level rate, and then
decrease the money supply (usually by shutting down the mint).  That
makes the currency left more valuable, which decreases the inflation.
	Also, real prices are not falling a lot.  Demand has dropped, but so
has supply (i.e. unemployment is up).  Therefore, prices should remain
in equilibrium.  The cost of producing goods has not changed, but the
level of production has.  Therefore, price maintains itself.  The reason
that there was a real drop during the depression is that producers were
able to make significant cuts in the real price of labor, since people
were willing to work for much less than previously.  Therefore, real
prices could drop.  Also, it is important to note that despite its best
efforts, the fed has not been able to increase the money supply by much,
so that should tell you that your theory is incorrect.

	It is well worth your time to get a full grounding in classical
economics.  Otherwise, you tend to start with incorrect premises and
follow them through quite logically to an incorrect conclusion.  Of
course, after studying economics, you may start from completely correct
assumptions, follow them to their logical conclusions, and still be
completely wrong.

					Tom the non hacker
					Kemp in 96!
					"If patriotism is the last refuge
					of scoundrels,  Then environmentalism
					is the current refuge of totalitarians."
					Bob Jackson