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That evening, over dinner, Farah explained it all, what she had always
wanted to tell them.
"You see, my teacher says that when the King expands money-supply
without there being an increase in savings or money flowing into the Kingdom
from elsewhere, each and every person receives more money. They feel richer
and respond by spending more. Seeing that demand has risen, retailers are
encouraged. They either do not know of the money supply expansion or
of its consequences, so they think that the rise in demand is a genuine (i.e.
permanent) one. Supply is expanded to absorb the higher demand. When
manufacturers find that retailers are ordering more from them, they too
think that there has been a genuine expansion and consequently increase their
capacity by increasing investment."
Sarah looked intently at her sister as she thought long and hard.
Finally, she spoke, "So what you're saying is that people think they have become
richer because initially they find themselves with more money, whereas prices
remained the same."
"That is correct. And they don't realise what's about to happen."
"So what does happen?" queried Mrs. Palmer eagerly.
"Well, the key to understanding what happens next is to note that there
are no new resources. With demand increasing all round, everybody - producers
of finished goods, semi-finished goods and raw materials alike, still
oblivious to the situation - attempts to expand their production. The retailer
who expands his capacity finds that he can only expand by offering higher
wages to new workers. As a result, he succeeds merely in pinching staff away
from other companies, rather than dipping into a pool of new workers. Of
course, now other people, themselves short of staff, would want to pinch his
staff away from him and find that they can do so only by offering even higher
wages. In this manner, non-productivity related wage inflation occurs.
Of course, this is not only true of workers, but for all other inputs
as well. For instance, since everyone is keen upon expanding production and
would thus require additional capital, a manufacturer may find himself having to
agree to pay the bank a rate of interest marginally higher than the base rate in
order to secure the amount of capital he desires. Or he may have to bid up
the price of raw materials lest he is able to obtain the quantity he needs.
All this results in accelerating inflation. Slowly, then, people will
begin to realise that they have been mistaken. They are not after all better
off. The retailer and manufacturer may find that whilst his revenues have
increased, but so have his costs. Since his profits have remained the same, his
new investment is in some sense 'unjustified'. He therefore finds himself
with a falling rate of return, an excess of capacity and may even be unable to
sell his products."
"Just like me this morning!" quipped Mr. Palmer.
"Indeed. Seeing this, the retailer may cancel previous orders from the
manufacturer and may layoff some shop assistants. The manufacturer
too, upon seeing this, responds by laying off some of his workers and cease
ordering any more raw material. My teacher says that in this manner, deflationary
forces spread across the economy and that, as a result, the Kingdom goes into
Of course, producers aren't the only ones to make mistakes. Workers do
so as well. Seeing that wages are rising, they may be willing to work longer
hours. Some may postpone their decision to retire; others, to join the
workforce early instead of pursuing higher academic qualifications. And of
course, with rising wages, people are also more confident of taking on personal
loans to buy new cottages or a new horse. When inflation finally bites, they
find that their decision to supply more labour or to take on new personal loans
Sarah once again looked intently at her sister as she thought long and
hard. "So, you mean to say that people think they can afford to consume more
because they have higher wages but then find that they cannot do so because
prices have also increased."
"Exactly! So, consumption doesn't increase in the long-run."
"So that's why no one bought any new clothes!" said Mr. Palmer. "What
a fool I was to have thought it proper to expand production, thinking that
consumption has increased."
"Oh, come on, Daddy." Farah replied. "Don't be so hard on yourself.
Consumption does increase in the short-run because people
either don't know or don't realise what's about to happen."
"What made you keep money with Tessa, then?" asked Mrs Palmer.
"Well," Farah began, "when money-supply expands, short-term interest
rates fall. But the long-term interest rate remains the same. When this
happens, my teacher says that we say the spread between the two has increased. An
increase in the interest rate spread portends increases in future short-term
interest rates. Knowing that this would happen, I decided to keep money with
Tessa to take advantage of the increases."
When Farah finished, Mr. and Mrs. Palmer and Sarah realised how wrong
they had been. They knew now that money-supply expansions could not lead to
higher output in the long-run and that in the short-run, growth exists only
because people are fooled into thinking that higher profits and wages meant
that everybody was richer. But they do not realise that higher inflation
would mean that, after all, they are but of the same degree in wealth.
From that day onwards, whenever they went into town and heard Mr.
Reuters shout out news of money-supply expansions, they did not join in the
celebrations, but headed straight for the bank to increase their
"These people do but forget." Mr. Palmer would say philosophically as
he watched the crowd going about its merriment. "I suppose that's why the
King gets away with it every time. But not me, Farah..." - and he would put
his arm around her - "...for my wonderful daughter has explained to me why it
is in the long-run the monetary neutrality proposition holds."
Never again were they under money-illusions and as a result, they lived
happily ever after.
Farah would later go on to become one of the top economists in the
Kingdom and dedicated her life to educating the public of the monetary-neutrality
"Remember!" she would urge them. "So long as you bear in mind that
money-supply expansions, whether by more credit or more liquidity,
cannot ultimately lead to output growth, you will always be safe."
"What do we do when we hear that the King has done this evil?" people
would ask in reply.
"Maintain consumption as before and keep the extra money you receive
with Tessa [i.e. in the bank]."
Her message spread like wild fire so that, not long after, every single
soul in the Kingdom of Adaptive Expectations responded to money-supply
increases by keeping more money with Tessa. Because of this, the King could not any
longer fool the public into thinking that there was economic growth simply by
pumping in more liquidity or by encouraging credit. But that was also good for
him. It forced him to reform and become a better King. Since he could no
longer fool his subjects by expanding money-supply, he was forced to make sure
that he adopted only the best of economic policies. He realised that the
only way he could achieve higher output was by encouraging technological
innovation and productivity growth.
Thus did the Kingdom of Adaptive Expectations become one of the
greatest in the land; and indeed, that has ever been known. So stark was the
transformation of the Kingdom that the King renamed it the Kingdom of
Rational Expectations, to show that his subjects were now rationally-motivated
and could not be fooled by money illusions. Generation after generation
ruled in this spirit so that the Kingdom of Rational Expectations prospered
forever more; until, that is, people grew saturated in their contentment and
began to forget the monetary neutrality proposition. Eventually, the Kingdom
became an inflation-ridden economy with a gross misallocation of resources.
So long as one bears in mind that money-supply expansions, whether by
more credit or more liquidity, cannot ultimately lead to output growth, one
will always be safe. Well, as Mr. Palmer might have said it, "People do but
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