Saturday, February 07, 2009

Inflation and Growth Are Not Synonymous

People often cite the monetary contraction that occurred around the beginning of the Great Depression as a reason to adopt Keynesian ideas that state spending and creating inflation by increasing the money supply are appropriate ways of increasing aggregate demand and spurring growth. In the five-year period from 1929 to 1933, the money supply dropped by one third. The effect is that each remaining dollar is more valuable in proportion to the amount that the money supply has declined. This causes the dollar to rise in value relative to other currencies, and is preferable when the country is an importer of foreign goods because, for fewer dollars, it is able to obtain more goods and services from overseas.

One would expect that imports in this time period would have risen dramatically; however, this was not the case. Instead, due to the high tariffs that were imposed at the same time -- most notably, the Smoot-Hawley tariff of 1930 which raised import taxes to unprecedented levels -- imports declined by 66% from 1929 to 1933, despite the contraction of the money supply which would have otherwise had the opposite effect on imports. In retaliation for the strict protectionist policies of the 1930s, other foreign trade partners imposed restrictions and raised tariffs on U.S. products, further crippling industries in the U.S.

The fact that a monetary contraction coupled with the most protectionist policies of the time were contributors to a depression should not lend credence to the idea that printing more money to spend is an effective method for increasing productivity. Assuming the same protectionist tariffs were in existence today and that the U.S. were an importer of many foreign goods, inflationary policies would magnify the decline in imports by decreasing the value of the dollar on the world markets and would spark more retaliatory policies from our trading partners and further economic declines.

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