If money supply remains unchanged, demand to hold money remains unchanged, and quantity of goods decreases, then prices MUST rise. No change in demand to hold money, or the money supply needs to change for prices to rise.
How preferences regarding holding money change in response to the tax is a different issue. There is no praxelogical deductive truth that we can use to determine how other preferences will change. But the point is that regarding the questions of price inflation, you don’t need to complicate yourself with other factors to conclude that a decrease in production causes an increase in prices, all other things being equal. It’s quite intuitive actually.
Oh I see, so the price of a good is determined by three* factors: supply and demand for it, and the quantity of goods around to demand it with. Decreased supply of goods and decreased demand for money are two separate things.
OK, here are my thoughts now.
Will there be a “jump up” in general prices when VAT is brought in? (This is what I am trying to refute)
No, because the obvious “jump up” in the price of affected products will be cancelled out by a “jump down” in the price of products not affected. In my example, cigarettes “jump up”, milk “jumps down”, and guns will “jump up” when the government spends the money (assume: immediately), such that there is no overall “sudden” change in “general prices” aka “the price of money”. But then because less milk is being produced (and the same number of cigarettes), there are less goods chasing the same amount of money, so the price of money will fall, meaning general prices will rise.
So the tax will cause “general prices” to rise (what the mainstream calls inflation), but it won’t be in the simplistic “jump up” way envisioned by laymen. It will be longer-term, as the structure of production shifts from producing something desired by consumers to producing something desired by government: guns instead of milk.
If there is a “jump up” in the CPI when VAT is increased, it will only be because the index is biased in favor of the VAT-affected products. (Or some other cause entirely, of course, since the ceteris paribus condition does not hold in the real world).
Does that all sound right?
EDIT: Actually, it would be four wouldn’t it - reservation demand for other goods would also be a factor.
Perhaps. Basically the tax is a transfer of wealth. Assume the VAT applies to the entire economy. The government takes the revenue and spends it on steel. Now the steel industry will experience a boom at the expense of everybody else. The increase in revenue will more then compensate for the VAT imposed on the steel industry. Profits and eventually wages will rise in the steel industry while profits and wages will sink for everybody else. This will induce resources to shift to the steel industry. The shift of resources will cause the other industries to regain their profits at the expense of lower productivity and higher prices. The added resources in the steel industry will bring back their profits and wages back to “normal”.
So in the short run, the affect on prices will be that of a shift in preferences among the different goods and services. Some will win and some will lose. In the long run, the production is less efficient due to its resources diverted to satisfy government consumption. Less efficient means higher prices. Whether the various price indexes and statistics reveal this price increase is an entire different manner.