Doing the math: what the FEDs 2% inflation goal and CPI fudging means for purchasing power

[ababba]

Just try and answer a hypothetical once in your life. It won't kill you, you might learn something. I don't even understand your criticism of the apples and oranges point. Its just a question, just answer it. We can argue all day about whether it applies at all to the real world, but just leave your baggage behind for a minute and think about it as a pure intellectual question.

Anyway, if you don't answer the question, I'm done responding. Its clear you don't want to engage on an intellectual level. Is the person worse off, better off or as well off or you can't tell?

If you don't want to respond to a simple question, which may or may not have any relevance to economics or the real world, just so we can start to find some common ground, then have a nice day sir, enjoy your life.

[Steven Douglas]

Just try and answer a hypothetical once in your life. It won't kill you, you might learn something. I don't even understand your criticism of the apples and oranges point. Its just a question, just answer it. We can argue all day about whether it applies at all to the real world, but just leave your baggage behind for a minute and think about it as a pure intellectual question.

Anyway, if you don't answer the question, I'm done responding. Its clear you don't want to engage on an intellectual level. Is the person worse off, better off or as well off or you can't tell?

If you don't want to respond to a simple question, which may or may not have any relevance to economics or the real world, just so we can start to find some common ground, then have a nice day sir, enjoy your life.

Your reading comprehension leaves MUCH to be desired. I did answer it (WORSE OFF, go back and read) -- in the context of monetary inflation.

But now let's answer your completely irrelevant apples to oranges question--as best as it can be answered.

I have an income of 10 dollars in year one. I buy five apples and five oranges in year 1, each of which cost one dollar. In year 2, the price of apples increases to 2 dollars and I decide to buy 10 oranges with my 10 dollars. What is the rate of decrease in my standard of living?

ANSWER: The "rate" (of decrease or increase) cannot be answered without a definition of "rate" (of what, precisely?) AND "standard of living". Apples and oranges are both in the fruit category, but are nonetheless unlike things. Since I assume that I am consuming the fruit and not buying it for direct resale, or as a factor of production to some finished good for resale, I can only gauge the "standard of living" based on its utility, or what you receive from each, and what you lost or gained through the substitution.

Oranges have slightly more Vitamin C on average, so your Vitamin C "standard of living" increased slightly.
Oranges have Folate, where apples contain none, so your Folate "standard of living" increased substantially.
Oranges have almost twice as much Potassium on average than apples, so your Potassium "standard of living" increased substantially.
Apples have about twice as much fiber as oranges, so your Fiber "standard of living" decreased substantially.
Apples have slightly more calories on average, but it's negligible, so your Caloric Intake "standard of living" remains roughly the same.
Because apples are not oranges, your Fruit Variety "standard of living" went DOWN substantially.

Now we get to your preference, which is wholly subjective, but you it brought up. When both apples and oranges were priced equally, you bought equal amounts of each. What I do not know, and it would be ridiculous for me to assume, is why you made those choices on that day, or whether you would demonstrate this same preference again, all other things being equal. Furthermore, I don't know how much of your decision is made on the basis of economics vs. health vs. taste preferences (or "other"?). It is quite possible that you would have bought all apples if they were priced the same as oranges. If so, then you're even a bigger loser, and WORSE OFF than if you would have made the same choice as before had the prices been the same.

See that? I can talk about the differences between apples and oranges, but since these are YOUR BUYING PREFERENCES, I am not in a position to tell YOU whether or not you are better off, worse off, or as well off. I am also not in a position to tell YOU what has happened to your "standard of living", because you have not phrased it as an economics question.

And that's just the tip of the iceberg, after both humoring you and cutting through your horse shit of a question. Did I miss something? Or is this one of those cases where you stomp your feet in a huff and say, "Bah! Such a simple question, but he just doesn't get it."

And, btw, answer your own question, and tell me why, specifically, you answered that way. I am really curious to see how you process your own information.


EDIT: BTW, if you try to invoke the strawman argument that I am implying that ALL price differences and changes between unlike things are all because of the Fed, you will be officially out to lunch--because such a universal and absolute pronouncement is not, nor has it ever been, my claim.

The burden is on you to show how an apples to oranges substitution relates to PRICE INFLATION. And if you call it something else, the burden is on you, once again, to make the logical connection between PRICE INFLATION and whatever relativistic, equivocating term you have inserted as a substitution.

[ababba]

I am just trying to get at a very basic Micro Economics fact. If you change relative prices of goods but give someone enough to be able to afford their old consumption bundle at the new prices, then they must be better off.

Why? Because they can afford their original bundle but relative prices have changed. They can do no worse and now there is an entire set of new possibilities that they couldn't afford before but they can afford now.

Its the reason why if you give someone just enough to be able to buy what they bought last year but relative prices have changed, they will actually be better off.

Thus, if social security is based off of a shadowstats index, an attempt to make seniors no worse off by indexing will actually make them better off than the previous year, because of substitution.

[Steven Douglas]

I am just trying to get at a very basic Micro Economics fact. If you change relative prices of goods but give someone enough to be able to afford their old consumption bundle at the new prices, then they must be better off.

Why? Because they can afford their original bundle but relative prices have changed. They can do no worse and now there is an entire set of new possibilities that they couldn't afford before but they can afford now.

That isn't "a very basic Micro Economics fact". In fact, it's gibberish. What the hell does that mean: "If you change relative prices...but you give someone enough..." - Who is doing all of this? Who is 'changing' relative prices, and by what mechanism, and who is 'giving someone enough'? You think you're talking Micro Econ, but you're doing it with gibberish, and from a decidedly statist, monetarist Macro Econ social engineering perspective. Which then begs more questions...which you evade while pretending to talk Micro Econ only...which you are not.

You throw out terms like "...able to afford their old consumption bundle...", in the context of substitutions that are NOT the old consumption bundle at all!
Your standard for "better off" is also flawed for a number of reasons. For one, you take EXTREME liberties with "better off" attribution for things NOT ATTRIBUTABLE TO MONETARY INFLATION; things like efficiency and technological improvements, which, it can be argued, might otherwise have been greatly INCREASED in the absence of wasteful resource misallocation and malinvestment. Ergo, we could be much WORSE OFF, because you have completely ignored the potential LOSS OF AN OTHERWISE GAIN.

Once again, you are fixated on the notion that so long as someone's "standard of living" (as YOU loosely, presumptuously and subjectively define it) remains the same, nobody is harmed in the process. That is an absolute absurdity, which brings back full circle to the point I made--which you ignored. So here it is again, to give you another opportunity to address it. You don't have to answer. You can attack the phrasing or relevance of my question--but not out of ignorance or hand-waving dismissal. At least be logical about it.

You think that if you can demonstrate a zero-sum-game, (i.e., so long as people can make substitutions, or can afford exactly the same shit), that you can then argue that they are "as well off", if not "better off" (in the context of CURRENCY DEBASEMENT and resulting PRICE INFLATION).

ONCE AGAIN: You hold stock. That stock periodically pays you dividends. I steal those dividends, intercepting them, forging your signature, and cashing those checks EVERY TIME YOU RECEIVE THEM. And let's say that you're none the wiser. You didn't even know you had a dividend coming. Furthermore, I don't touch your stock. That's yours to keep. Can I now declare with a straight face that you are "no worse off" than before, or "as well off" as before, and is there anything whatsoever even meaningful about that?

Oh, and to sweeten the pot, as we roll up our sleeves and decide things for others: What if I see you can't quite afford next year what you could last year, and "give you enough to be able to afford" yada yada yada. Would that make you "better off", if I, as a thief, did that for you?

It's a simple question. If you think it doesn't apply, or has no relevance, EXPLAIN WHY.

Its the reason why if you give someone just enough to be able to buy what they bought last year but relative prices have changed, they will actually be better off.

WTF is with your "if you give someone just enough"? You make it sound as though allowances are being doled out from some parent figure who is looking over your shoulder and approving a personal budget. What the fuck kind of Orwellian bullshit planet are you living on?

Furthermore, what you said MADE NO SENSE! How can having just enough to be able to buy next year as last year make anyone BETTER off? Explain. Is your Inflation Normalcy Bias so freakishly ingrained in you that merely keeping pace with an artificial treadmill counts AS A GAIN?! The fucking gain would be if there was no treadmill, and you actually ADVANCED.

Thus, if social security is based off of a shadowstats index, an attempt to make seniors no worse off by indexing will actually make them better off than the previous year, because of substitution.

Holy crap, what a loaded, screamingly fallacious, compound question. "...and attempt to make seniors no worse off by indexing..." WTF DOES THAT MEAN? What does that mean, first of all, and who, exactly, is trying to do whatever-that-means?

I deliberately avoided reference to that monstrously tortured scam called Social Security, and its relation to CPI. We're talking about the CPI and its accuracy or inaccuracy with regard to price inflation only, without respect to anything else. Even so, wow. Total meltdown--"...better off than the previous year, because of substitution(?!)..." is absolute gibberish! How is that true, and what, exactly, does that have to do price inflation?

[ababba]

That isn't "a very basic Micro Economics fact". In fact, it's gibberish. What the hell does that mean: "If you change relative prices...but you give someone enough..." - Who is doing all of this? Who is 'changing' relative prices, and by what mechanism, and who is 'giving someone enough'? You think you're talking Micro Econ, but you're doing it with gibberish, and from a decidedly statist, monetarist Macro Econ social engineering perspective. Which then begs more questions...which you evade while pretending to talk Micro Econ only...which you are not.

You throw out terms like "...able to afford their old consumption bundle...", in the context of substitutions that are NOT the old consumption bundle at all!
Your standard for "better off" is also flawed for a number of reasons. For one, you take EXTREME liberties with "better off" attribution for things NOT ATTRIBUTABLE TO MONETARY INFLATION; things like efficiency and technological improvements, which, it can be argued, might otherwise have been greatly INCREASED in the absence of wasteful resource misallocation and malinvestment. Ergo, we could be much WORSE OFF, because you have completely ignored the potential LOSS OF AN OTHERWISE GAIN.

Once again, you are fixated on the notion that so long as someone's "standard of living" (as YOU loosely, presumptuously and subjectively define it) remains the same, nobody is harmed in the process. That is an absolute absurdity, which brings back full circle to the point I made--which you ignored. So here it is again, to give you another opportunity to address it. You don't have to answer. You can attack the phrasing or relevance of my question--but not out of ignorance or hand-waving dismissal. At least be logical about it.

You think that if you can demonstrate a zero-sum-game, (i.e., so long as people can make substitutions, or can afford exactly the same shit), that you can then argue that they are "as well off", if not "better off" (in the context of CURRENCY DEBASEMENT and resulting PRICE INFLATION).

ONCE AGAIN: You hold stock. That stock periodically pays you dividends. I steal those dividends, intercepting them, forging your signature, and cashing those checks EVERY TIME YOU RECEIVE THEM. And let's say that you're none the wiser. You didn't even know you had a dividend coming. Furthermore, I don't touch your stock. That's yours to keep. Can I now declare with a straight face that you are "no worse off" than before, or "as well off" as before, and is there anything whatsoever even meaningful about that?

Oh, and to sweeten the pot, as we roll up our sleeves and decide things for others: What if I see you can't quite afford next year what you could last year, and "give you enough to be able to afford" yada yada yada. Would that make you "better off", if I, as a thief, did that for you?

It's a simple question. If you think it doesn't apply, or has no relevance, EXPLAIN WHY.



WTF is with your "if you give someone just enough"? You make it sound as though allowances are being doled out from some parent figure who is looking over your shoulder and approving a personal budget. What the fuck kind of Orwellian bullshit planet are you living on?

Furthermore, what you said MADE NO SENSE! How can having just enough to be able to buy next year as last year make anyone BETTER off? Explain. Is your Inflation Normalcy Bias so freakishly ingrained in you that merely keeping pace with an artificial treadmill counts AS A GAIN?! The fucking gain would be if there was no treadmill, and you actually ADVANCED.



Holy crap, what a loaded, screamingly fallacious, compound question. "...and attempt to make seniors no worse off by indexing..." WTF DOES THAT MEAN? What does that mean, first of all, and who, exactly, is trying to do whatever-that-means?

I deliberately avoided reference to that monstrously tortured scam called Social Security, and its relation to CPI. We're talking about the CPI and its accuracy or inaccuracy with regard to price inflation only, without respect to anything else. Even so, wow. Total meltdown--"...better off than the previous year, because of substitution(?!)..." is absolute gibberish! How is that true, and what, exactly, does that have to do price inflation?

Its clear, you don't understand Intro Micro Economics. Read a book about it sometime. This is simple textbook substitution. I explained it clearly and you refuse to get it. Maybe the graphs and details in a book might help you understand the most basic of economic concepts.

Stop criticizing substitution adjustments until you understand what substitution is.

[Steven Douglas]

Its clear, you don't understand Intro Micro Economics. Read a book about it sometime. This is simple textbook substitution. I explained it clearly and you refuse to get it. Maybe the graphs and details in a book might help you understand the most basic of economic concepts.

Stop criticizing substitution adjustments until you understand what substitution is.

You said...nothing. I have no problem with substitution effects as it relates to microeconomics -- only your misapprehension and misapplication of them. It's clear to me now that you are the one without the slightest understanding of various substitution effects, and their relevance to the CPI's ability to accurately reflect price inflation. You say, in essence, "Hey, you don't get it, so why don't go and read a textbook", sounds very Southpark Cartman bluffish to me. You didn't cite a textbook (as requested), you didn't quote from a textbook, and you couldn't even recommend a specific book (so that I could go and do your work for you). If you ever did take an ME course (intro or otherwise), I seriously doubt that you paid attention.

[Danan]

4% would be better for a variety of reasons. Sticky wages, debt deflation and monetary policy flexibility near the zero lower bound.

What do sticky wages have to do with the inflation target? They would only be important if you tried to change the current target, according to neo-classical / new-keynesian belief. As long as the inflation rate is as expected, the absolut rate doesn't matter. And if it did, why not 20%? Or 100%?

Also, how does a higher inflation rate cause debt deflation, but not savings deflation at the same time? Earlier you argued that the store of people's value is not affected by monetary inflation, because people could simply invest in the loanable funds market in one way or another. Obviously the return of those investments will be denominated in the currency and thus be lower than it would have been otherwise - exactly by the amount of inflation. That doesn't mean that you have lower purchasing power tomorrow than you have today, but that tomorrow's purchasing power is lower than it would have been, had there not been inflation. Or you could argue that expected inflation is already somehow included in your investment-return - in which case the same would hold true for debt, too. In any way, it shows a lack of economic understanding to argue that debt-inflation should be a goal we ought to achieve. If the value of the money the borrower has to pay back is lower, it's at the same time also lower for the saver. Why would that be considered to be beneficiary, especially considering that most savers are retirees whose main source of income are capital returns?

But the last point about monetary policy flexibility has to be the worst argument in favour of higher inflation, on a libertarian board, where people can see the problems of the Keynesian paradigm of aggregated anything. People who studied economics carefully know how devastating the manipulation of interest rates is to the capital structure of an economy. Currently the Fed is somehow limited, because it can't drop nominal interest rates below zero. With an inflation rate of 2% the lower boundary of the real interest rate would be -2%. Would the interest rate target be higher, the Fed could decrease real interest rates even further - and that's what you want to have?

You must be aware of the fact, that the price brings demand and supply in equilibrium. If the price for lending money (the interest rate) goes down due to newly created money supply by the Fed, private savings are going to go down, relative to consumption (which goes up). At the same time investment goes up, because it's cheaper to borrow money. While without interventions from the central bank a decreasing interest rate would actually be a good sign for entrepreneurs to invest (because higher savings indicate more demand for consumptions goods in the future), there are no savings in our economy, justifying the increase in investment. At the same time companies in the early stages of production bid for workers and commodities, retailers have the time of their lifes, because of the increased consumption (due to a lower saving rate). This causes the overall prices to rise - which can only be "fought" by the central bank by even more monetary inflation. This unsustainable cycle will continue until either a recession ends the scheme, when the investments finally result in consumption goods, but nobody has any money to actually purchase all the goods. This causes a liquidation of debt and reallocation of malinvestments. Or the central bank continues what it does and causes a hyperinflation.

http://www.youtube.com/watch?v=5rJceunyCwU
http://www.youtube.com/watch?v=pNX1rMiCUO0

For further research on the topic the excellent Roger Garrison.

[ababba]

You said...nothing. I have no problem with substitution effects as it relates to microeconomics -- only your misapprehension and misapplication of them. It's clear to me now that you are the one without the slightest understanding of various substitution effects, and their relevance to the CPI's ability to accurately reflect price inflation. You say, in essence, "Hey, you don't get it, so why don't go and read a textbook", sounds very Southpark Cartman bluffish to me. You didn't cite a textbook (as requested), you didn't quote from a textbook, and you couldn't even recommend a specific book (so that I could go and do your work for you). If you ever did take an ME course (intro or otherwise), I seriously doubt that you paid attention.

LOL, I taught Micro for three years and have a graduate degree kid. Varian is the standard book. I'm using basic English.

Like wow, you balk at the phrase "relative prices", like its some kind of voodoo. Just use the dictionary for the word relative, it will help.

[ababba]

What do sticky wages have to do with the inflation target? They would only be important if you tried to change the current target, according to neo-classical / new-keynesian belief. As long as the inflation rate is as expected, the absolut rate doesn't matter. And if it did, why not 20%? Or 100%?

Also, how does a higher inflation rate cause debt deflation, but not savings deflation at the same time? Earlier you argued that the store of people's value is not affected by monetary inflation, because people could simply invest in the loanable funds market in one way or another. Obviously the return of those investments will be denominated in the currency and thus be lower than it would have been otherwise - exactly by the amount of inflation. That doesn't mean that you have lower purchasing power tomorrow than you have today, but that tomorrow's purchasing power is lower than it would have been, had there not been inflation. Or you could argue that expected inflation is already somehow included in your investment-return - in which case the same would hold true for debt, too. In any way, it shows a lack of economic understanding to argue that debt-inflation should be a goal we ought to achieve. If the value of the money the borrower has to pay back is lower, it's at the same time also lower for the saver. Why would that be considered to be beneficiary, especially considering that most savers are retirees whose main source of income are capital returns?

But the last point about monetary policy flexibility has to be the worst argument in favour of higher inflation, on a libertarian board, where people can see the problems of the Keynesian paradigm of aggregated anything. People who studied economics carefully know how devastating the manipulation of interest rates is to the capital structure of an economy. Currently the Fed is somehow limited, because it can't drop nominal interest rates below zero. With an inflation rate of 2% the lower boundary of the real interest rate would be -2%. Would the interest rate target be higher, the Fed could decrease real interest rates even further - and that's what you want to have?

You must be aware of the fact, that the price brings demand and supply in equilibrium. If the price for lending money (the interest rate) goes down due to newly created money supply by the Fed, private savings are going to go down, relative to consumption (which goes up). At the same time investment goes up, because it's cheaper to borrow money. While without interventions from the central bank a decreasing interest rate would actually be a good sign for entrepreneurs to invest (because higher savings indicate more demand for consumptions goods in the future), there are no savings in our economy, justifying the increase in investment. At the same time companies in the early stages of production bid for workers and commodities, retailers have the time of their lifes, because of the increased consumption (due to a lower saving rate). This causes the overall prices to rise - which can only be "fought" by the central bank by even more monetary inflation. This unsustainable cycle will continue until either a recession ends the scheme, when the investments finally result in consumption goods, but nobody has any money to actually purchase all the goods. This causes a liquidation of debt and reallocation of malinvestments. Or the central bank continues what it does and causes a hyperinflation.

http://www.youtube.com/watch?v=5rJceunyCwU
http://www.youtube.com/watch?v=pNX1rMiCUO0

For further research on the topic the excellent Roger Garrison.

Good questions.

The sticky wages story is about psychology. People have difficulty dealing with cuts in their nominal wages. That means if there inflation of 4 percent and the optimal real wage change is -3% in real terms, the employer can just say "Your pay raise this year is 1%" and most employees will be happy because they don't think in real terms. However, if the inflation rate is 2%, the employer can't make the full adjustment necessary. They can say that the wage change is 0%, and decrease real wages by 2%, but not the full three. As inflation goes to zero, they have even less flexibility. Why is it bad that the employer can't decrease someone's real wages? Well if wages are higher than they should be, it means more people are going to be unemployed and unable to find work. This story has some empirical backing because wage changes all "pile up" around 0%, meaning almost nobody gets nominal wage cuts.

The debt deflation point is really a one time fix that a higher inflation target would yield for the current situation we are in. There are a lot of people out there with nominal mortgage and other debt. Higher inflation would make it easier on them and prevent a lot of defaults. This probably isn't true, but one could imagine situations where the banks even gain as well as homeowners because the higher inflation reduces defaults of underwater borrowers. My perspective on it, is that it would be good to reduce the deadweight losses of foreclosure and default.

On the third point, I disagree with the consensus on the board and have been arguing against it. I think the Fed moving interest rates can be good and more flexibility during recessions would be better.

On the last point, your explanation is a little off I think. The interest rates the Fed sets are equilibrium interest rates, they clear all markets and there is no excess supply or demand of savings or borrowing (As there would be in a classic price floor or ceiling). This is precisely because they move interest rates by changing the money supply and demand for money depends partially on interest rates. In your supply/demand example, they move the price by shifting the supply curve, not by creating a ceiling or floor.

Thanks for the videos.

[Danan]

The sticky wages story is about psychology. People have difficulty dealing with cuts in their nominal wages. That means if there inflation of 4 percent and the optimal real wage change is -3% in real terms, the employer can just say "Your pay raise this year is 1%" and most employees will be happy because they don't think in real terms. However, if the inflation rate is 2%, the employer can't make the full adjustment necessary. They can say that the wage change is 0%, and decrease real wages by 2%, but not the full three. As inflation goes to zero, they have even less flexibility. Why is it bad that the employer can't decrease someone's real wages? Well if wages are higher than they should be, it means more people are going to be unemployed and unable to find work. This story has some empirical backing because wage changes all "pile up" around 0%, meaning almost nobody gets nominal wage cuts.

I know about sticky wage theory and it's supposed effect, but I don't buy it entirely. First of all, the major reason why they exist to some extend in the first place, is because of governmental intervention in the labor market, special privileges for unions, etc. In a free market, inefficient behaviour of wage earners will put them out of business and people will learn that a 2% nominal wage cut is better than a 100% real wage cut if the firm goes out of business. Besides, why aren't wages sticky in both directions? You could also argue that with high inflation, businesses are going to increase wages at a lower rate than inflation, because workers will be satisfied with a 2-3% increase, even if inflation is at 10%, because they are to stupid to realize what real wages are. Thus creating the same inefficiency the other way around.

The debt deflation point is really a one time fix that a higher inflation target would yield for the current situation we are in. There are a lot of people out there with nominal mortgage and other debt. Higher inflation would make it easier on them and prevent a lot of defaults. This probably isn't true, but one could imagine situations where the banks even gain as well as homeowners because the higher inflation reduces defaults of underwater borrowers. My perspective on it, is that it would be good to reduce the deadweight losses of foreclosure and default.

First of all, the foreclosure and default argument is a mood point. If it is indeed better for banks to lower the debt of it's debtors, then they don't need price inflation for it. They could simply offer a "haircut".

Don't say that savers are not going to be hurt under higher price inflation if you make the point that the return will be devalued, thus helping debters. You can't have it both ways. It's a zero-sum game.

On the third point, I disagree with the consensus on the board and have been arguing against it. I think the Fed moving interest rates can be good and more flexibility during recessions would be better.

Of course you could delay recessions by increasing the money supply. Nobody says that this won't increase total output. In fact, that's a core assumption of the Austrian Business Cycle Theory. But you don't see recessions as what they are. A necessary evil to reallocate badly allocated ressources (most times because of bad monetary policy in the past). You're not doing society a big favour if you artificially stimulate the economy to continue in an inefficient way. In fact the same problem will come back later, only larger this time. History shows that those recessions that got the most political response have been the most severe and long lasting ones, while those where the economy was "left alone" restructured very quickly, even though the initial shock was just as hard. And that's not that hard to understand, once you realize what a recession really is. Of course if you blame everything on "animal spirits" rather than on systemic reasons, you won't be able to draw many conclusions out of it.

(Have you ever heard of the Great Depression of 1920? http://www.youtube.com/watch?v=czcUmnsprQI)

On the last point, your explanation is a little off I think. The interest rates the Fed sets are equilibrium interest rates, they clear all markets and there is no excess supply or demand of savings or borrowing (As there would be in a classic price floor or ceiling). This is precisely because they move interest rates by changing the money supply and demand for money depends partially on interest rates. In your supply/demand example, they move the price by shifting the supply curve, not by creating a ceiling or floor.

That's exactly what I've said. I did point out that the Feds actions represent a shift in the money supply curve. Maybe what confused you was my point about the liquidity trap situation you mentioned earlier?

Again, in a free market people save (and let's for the sake of the argument assume that savings=lendings=investments) and people borrow. When people suddenly decide to save more (higher savings rate represents a shift in the money supply to the right on the loanable funds market) more money at a lower price is being lent out, if the money demand curve remains unchanged (ceteris paribus).

What happens in the economy? Well, borrowers are taking that additional money in order to built capital goods so that they can increase their production in the future. The savers on the other hand are going to spend less today. Why? Because they save more. They can't use money twice. Y=C+I

Now Keynes would have (wrongly) argued that this situation would result in a recession. His reasoning was that if consumption goes down now, nobody is going to invest in the future (paradox of swift). That argument is really bad on a number of grounds. First of all, yes, retailers had to lay of workers if consumption goes down, no question about that. But the problem of Keynesian/neo-classical economics is that in those schools of thought Y equals Y equals Y... and K equals K equals K.

Just because some people lose their jobs and the economy restructers a little bit, doesn't necessarily mean that it's a bad thing. Also, the firms who want to borrow the higher amount of capital at lower interest rates, are certainly not retailers. They are companies in mining, housing, R&D, etc. with long term strategies at the earliest stages of production. These entrepreneurs are perfectly able to understand that low costs of borrowing money are great for them and that the demand for their product is not going to be affected by the current lower demand for consumption goods, because their goods are going to enter the shelves in 10, 20 or 30 years. And they also know that there has to be demand in the future, since they borrowed money from others who are going to want to consume eventually. Nobody invests for the sake of investing. In the end, for every salesman laid of, a miner or researcher is going to be employed.

So we see that in an unhampered market, the path to sustainable growth in the future is to save today. And that's perfectly sustainable because the payback of borrowed money with interest represents excess demand later, exactly at the time the exess supply of goods is occuring.

Now what happens if the central bank increases the money supply, not private savers? Again, the supply curve of loanable funds shifts to the right, but the amount of money that is actually being saved by market actors is still where it was before. The excess money does not represent savings.

How could that be? Because what the newly created money does is syphoning purchasing power from all currency holders. In a perfectly adjusting economy prices would rise instantaneously across the board, if the money supply where to be increased evenly. Since that new money mostly goes to the government via bonds it would in effect be equal to a lump sum tax.

But the economy is not perfectly adjusting and we do not have perfect information. Lenders are suddenly confronted with a lower interest rate, thus fewer people are going to save today and thus current consumption is going to go up (as opposed to the situation where lower consumption resulted in lower interest rates, because of higher savings). At the same time borrowers are confronted with lower interest rates too, which will result in a higher amount of investment. So I and C are both trying to increase at the same time. But since resources are scarce, this will result in prices being bid up - but not instantaneously, it will take time (Friedman's famous "time lag" he couldn't really figure out). For a short amount of time we will see zero unemployment (or rates below the natural rate, because of excess work force wanting to work in the boom economy) and higher total output. Everything seems to be great until inflation finaly kicks in and increases the prices of goods. To combat this the central bank increases the money supply again year after year, only delaying the inevitable. Eventually those investments will result in even more goods being produced. But (as opposed to the free market growth situation) there is no excess demand (desire and ability to purchase at prices X).

In no situation can a central bank know better what an economy needs than the actions of millions of individuals responding to other individuals' actions displayed by prices, profits and losses.