Random Thoughts on inflation and interest rates

Let's assume that you live in an area that has been flooded. Let's assume that there are thousands of you sitting in houses on a large "island" caused by the flood. Now let's assume that the flood takes years to subside and that you don't have any way of getting goods from the outside or exporting goods to the inside. Let's also assume that there is no legal tender and that rescue is impossible.To summarise:

• Forcible closed economy for many years.
  
• No way for imports/exports.
• No currency.
• Rescue is impossible.
  

So what would you do? Naturally the best option would be to ration out necessities, like food. Because food is so scarce, and because it is so important, hoarding it for future use is logical. Other economic activities, like dance classes, would become less important. As a result, the relative value of food goes up while the relative value of dance classes goes down. In this environment, people are more likely to stop teaching people to dance and more likely to plow up their back yards to grow food. By contrast, people who chose to teach dance instead of grow food are idiots.

Now let's add money into the equation. With the economy suddenly becoming closed and no longer having the ability to export/import goods and services, the result would be a huge jump in inflation in some sectors (such as the cost of food) and deflation in other sectors (such as the cost of dance classes). But let's assume that the net effect is inflationary. What to do?

There is a choice - you can increase interest rates to control prices, or you can keep rates low to stimulate production.

If you increase interest rates to control prices, the "economy" contracts considerably. Because money becomes more valuable, people are no longer using it to purchase food, which results in a drop off in the purchase of food.

In other words, the raising of interest rates to control the inflationary effect of a supply shortage leads to the common sense conditions of the currency-less flooded island economy I have outlined.

By contrast, letting money devalue via inflation will lead to people using it to purchase the wrong goods and services, which occurs because confusion over money's usage increases the more often it changes in value. If money keeps inflating out of value, a barter system will eventually result and the "common-sense conditions" will eventually arrive... except the currency system has been ditched.

So, when faced with inflationary pressures from supply shortages, we have a choice - we can either kill off inflation, which leads to common sense austerity in the face of poverty while still using a currency; or we can let inflation confuse everyone for a while before common sense austerity is finally reached after having ditched the currency.

And, of course, the removal of currency then leads to further poverty, or at least a severely impaired potential to regrow.

tl;dr Price stability is essential when using currency, no matter where the inflationary pressure comes from.