[THOMAS.BEHNKE]

…proportionate to price cuts? In other words, say a bagel store sells bagels for $1 and has 3 people on the payroll who make $5/hour. If the store owner is forced to cut the price of bagels down to 0.50, will the workers now make $2.50/hour? Or will the wage cuts be greater than that? If they’re greater, can you please explain why? If they’re not greater, then how exactly are people who are NOT laid off hurt by the “bust” period (other than by maybe receiving less hours)? Because if everyone is receiving proportionate pay cuts, but at the same time the price of virtually everything is decreasing, then isn’t it like nothing’s happening? There’s less money in the economy, so people are simply getting paid less and spending less to get stuff?
—I understand that the higher stages of production are affected by inflation a lot more than the lower stages. So in a way, I can see how wage cuts hurt consumers because it costs them more to buy things like groceries (since the prices of these things remains relatively stable). But aren’t all of the stages (from manufacturers to grocery stores) currently feeling the effects of inflation right now (just on different levelsof severity)?

Also, does the dollar regain its purchasing power after the “bust” is completed? Is the answer to this question, “Yes, it will, but only if the Fed allows us to have a FULL bust – a complete liquidation – like it did in 1920-1921?” Or does the bust never fully restore the dollar’s purchasing power?

Thanks for your time.

[jmherbener]

In analyzing any situation of profit and loss in production, one must look at all costs of production and not just wages. If output prices are falling, then costs of production overall must fall close to proportionately to the fall in output prices to maintain profitability. Costs fall close to proportionately and not exactly proportionately because the interest rate, which is the rate of return or price spread between output prices and input prices, changes over the phases of the cycle. But setting that issue aside, falling output prices will affect the movement of prices of inputs according to the specificity of the inputs. Since labor is generally less specific than capital goods, wages will fall less relative to the fall in output prices and prices of capital goods will fall more relative to the fall in output prices. The symmetric movement occurs during the boom. Prices of capital goods rise relative to wages as prices of output are pushed up by monetary inflation and credit expansion.

Real wages fall over the cycle because capital goods have been malinvested and labor misallocated. Production is less efficient than it would have been had capital and labor not been squandered. Even if nominal wages rise relative to output prices, real wages will be lower because fewer goods have been produced than would have been without the malinvested capital.

It would be very unusual for money to have the same purchasing power at the end of a cycle as it had at the beginning. During the boom there is inflation of the money stock and typically, but not necessarily, a reduction in the demand to hold money and during the bust there can be either deflation or inflation of the money stock and typically, but not necessarily, an increase in the demand to hold money. It’s rare for these various forces to render the same purchasing power of money over time.

[THOMAS.BEHNKE]

Thank you so much for that very thorough explanation. Two quick follow-ups to it:

1.) So if costs of production (including real wages) fall relatively proportionately to prices, then how exactly are the Average Joes (who manage to remain on the payroll without their hours being cut) hurt by the bust? If they’re making less due to the bust, but at the same time, everything costs less, are they really that worse off than before? On the other side of the coin, how are the business owners (those that did not face insolvency) hurt? Though they were forced to lower their prices, won’t they also be purchasing lower priced items for both production and consumption? So doesn’t this balance it out?

2.) Can you please explain why the increased demand to hold money during the bust causes purchasing power to decline? I don’t understand why people would be so willing to hold on to their money when the bust causes prices to fall!, I also don’t get how holding money reduces purchasing power…does the lack of market activity not permit prices to adjust back to normal?

[jmherbener]

If people hold onto money, then they are not spending it on consumer goods or saving it in which case the money gets spent on producer goods. The reduced demand for goods lowers their prices. Lower prices for goods means a larger purchasing power of money. The larger purchasing power of money (i.e., the higher price of money) is what satisfies people’s desire to hold more purchasing power in the form of money even though the stock of money has not changed.

If we were to diagram the analysis, the increase demand for money shifts the demand for money curve upward to the right, which results in a higher price for money (in the link below ignore the Keynesian assumption that the price of money is the interest rate). The higher price for money eliminates the excess stock of money which the increase demand for money (the difference between a and b) would bring about in the absence of a higher price for money.

https://fixingtheeconomists.files.wordpress.com/2013/09/money-supply-demand-curve.jpg?w=500

On average people are worse off over the cycle because there are fewer goods produced in the economy than if there had been no cycle. Of course, some workers might be better off and others worse off depending on the relative movement of demand for their labor and some entrepreneurs may be better off and others worse off depending on the relative movement of demand for their goods. But overall, society is worse off.

As you say, people are not worse off or better off because prices and wages both have fallen.

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