Monetary Policy and Inflation (8) Cooling It

The current fallacy is that inflation is caused by an economy growing too fast. The governor of the central bank is worried that the New Zealand economy is overheating. He has announced that he may have to increase interest rates to cool the economy, so inflation does not get out of control.

This idea that someone has to slowdown the economy is absurd. For a start, economic growth does not cause inflation. More importantly, an economy cannot grow too fast.

There are natural limits on how fast an economy can grow. It is constrained by the size of its labour force. The availability of raw materials and capital equipment also act as a constraint on economic growth. If the economy is growing fast, the price of the types of raw material and capital equipment that are scarce might increase. However, these price increases are good, because they weed out the inefficient producers. The entrepreneur who bids up prices to obtain scarce resources must be able to use them more efficiently than those that miss out. Bidding productive resources will make the economy stronger; it does not cause inflation.

The wage rates for the skills that are scarce might also increase, as new businesses vie the skills they need. Those who are able to attract skilled staff by paying higher wages will need to use their skills more efficiently, so rising wages are also good for the economy. The rising wages shift some of the benefits of the economic growth to employees. Growing incomes provides buyers for the extra goods and services.

An economy cannot grow faster than the engine that propels it. As economic growth comes up against the constraint of scarce skills and resources, less efficient producers will be forced out of business because they cannot compete and the weaker parts of the economy will contract. This process will make the economy stronger as inefficient producers are replaced by those that are more efficient. Once all resources are in the hands of the most efficient businesses, a new business will have to extremely efficient just to get started, so the rate of growth will slow to match the growth in productive resources.

The economy can look after itself. It does not need a government appointed monetary policy expert to slow it down.