In the last 2 weeks we’ve seen that to have an economy with increasing productivity we need investment (which we’ve defined in economic terms) and that to have investment we need to have credit. And we’ve considered that credit is actually a fundamental element of the economy. But before we can go any further, I need to show you what happens to prices as a result of increasing productivity.
Increasing productivity means firms can produce goods more efficiently, which means they can make more goods for the same cost. But our model of Dynamicland is based on the Orderlyland model, in which the money supply is fixed (the government had printed enough money to cover one months expenditure, which then just keeps circulating month after month). In Dynamicland, there are now more goods to be bought with the same supply of money, so the only way it can all be sold is if prices fall.
Now you might think stuff getting cheaper sounds pretty cool. But if all prices are continually falling, people will start to hold off buying goods (especially expensive, long-lasting ones) until the last minute, to benefit from the any reduction in price. They all become savers (like Bob in Orderlyland). The flow of money around the economy will slow down, and we’ll see the same knock on effects caused by Bob’s saving – the economy itself will slow down.
This is one reason why deflation is considered a very bad thing, and why we typically want inflation of 2-3% in an economy to encourage people to keep spending so money keeps flowing.
So it’s fairly clear to see that if productivity increases (which is a very normal, real-world thing), then we need the money supply to increase to prevent deflation, and in fact to cause a little bit of inflation.
In economics textbooks you’ll generally see this taught the other way around – they focus on increases in the money supply causing inflation, rather than the need for an increase in the money supply to prevent deflation when productivity is improving. In fact, they focus entirely on a relationship between money supply and prices, and almost leave productivity out of the equation altogether. I’m coming at it from a different angle so that we don’t end up making the same mistake that textbooks do – I’m trying to show you that productivity, investment, prices and the money supply are all connected.
I’m not saying the textbooks don’t talk about productivity at all (they do), but they don’t talk about it in the context of a discussion of prices, the money supply and inflation (and then linking this to investment and credit). Using our analogy of the economy being like an engine, I’m saying that you cannot consider any of these components in isolation, you have to understand the interconnections between them. An increase in the money supply can cause inflation, or it can enable demand to keep up with increasing productivity (preventing deflation), or it can stimulate falling demand and prevent a recession. Failing to see all these connections is a significant blind-spot if we want to understand how economies actually work.
What we’ve established so far is that in Dynamicland the Government needs to increase the money supply to keep pace with increases in productivity to avoid deflation. So next week we will complete our model of Dynamicland by assuming the most simple and coherent way for this increase in the money supply to take place, and then look at how all these components work together. Then in future weeks we’ll look at new models adding in additional components like banks and financial assets and seeing how these change the way the engine can work.