Hello all, i’m just starting my economics education and i’m sure this question is easy to answer but i’m having a bit of trouble with it so i thought i could find some help.
A friend of mine argues that lowering taxes is a bad idea because more money in the hands of the people means they will spend more and prices will rise faster (more inflation). It seems like something’s wrong with this assertion but i can’t pinpoint what it is. Any help? Thanks!
Sure, simple enough.
The entire point of taxation and the multiplier effect, as per Keynesianomics, is that the government has a marginal propernsity to consume higher than that of consumers. In other words, while consumers may save, governments immediately spend their money. In fact, governments almost always run permanent deficits. In other words, if we were to assume that consumption leads to inflation, then government spending their tax money would be even more inflationary.
However, the more fundamental issue at hand is that consumption does not lead to inflation in a free-market. This is because any rise in conumption is met by a rise in supply. Draw a supply/demand diagram. Then draw expanding demand. Then realise that at higher price levels, businesses will find it more profitable to produce, and will expand supply by as much, to reach a new equilibrium with the same price as before, but higher quantity supplied, in other words economic growth. What’s more, is entrepeneurs are in the business of anticipating demand, so it seems quite natural that they may see it in advance.
Thirdly, an increase in the demand for one good can only come about as compensating for a decrease in the demand for another good, in other words, there is no net change, and while one good’s price may be temorarily increased, the other’s will fall, and no inflation will occur. Of course, the other option is that consumption will increase at the expense of savings, in other words, the time preference will have risen, but at that point in time the savings will fall, causing interest rates to rise, and so the savings will once again rebound to their previous level, and time preferences will be restored, if nothing else changes.
Of course, this only applies to an unhampered market. The current bout of interventionism usually leads to this mechanism not functioning, for example interest rates are not determined by the time preference, but rather by a central bank’s “monetary policy”, which can never properly gauge time preferences.
I hope I didn’t overcomplicate the third point, but you should understand the first two points without trouble.
Ah wow that’s simple, thanks for the quick and easy to understand response.
By the way, it might help to understand that long-term inflation as we see it is actually a monetary phenomenon. When the supply of money increases, without an increase in demand, then the value of the money falls (once again, draw a supply and demand diagram with the supply curve shifting outwards, the price represents the value of money). Hence, inflation is quite literally when the money supply is inflated. If you’re interested, look into the Austrian Business Cycle Theory (ABCT) which explains how such monetary inflation then causes the entire boom-bust cycle.
I’ve only been studying economics for 1.5 years at school, but the only learning I did was through research into Austrian economics over the last few months, lately through this website. There are quite a few good books offered here for free, and the forums are a great help. Be very wary of your textbooks, since they conveniently disregard anything but a statist view in regards to the economy (no surprise considering the government chooses the curriculum, at least where I live).
Oh and your welcome [:)]
Isn’t this where they say that business can’t keep up with the increase in demand - “bottlenecks in production”; demand is rising faster than the supply, causing cost/price inflation?
Where there’s money to be made, entrepreneurs are usually all over it. The real ‘bottlenecks in production’ are the regulatory ones that keep businesses from responding to the demand. Price-gouging laws, for example.