Effects of Price Controls and Central Banks on Stock Investments - dummies

Effects of Price Controls and Central Banks on Stock Investments

By Paul Mladjenovic

Before and after election time, stock investors must keep a watchful eye on the proceedings. Election Day brings a new slate of politicians into office, and they in turn joust and debate on new rules and programs in the legislative halls of power.

Price controls

Stock investors should be very wary of price controls, which are a great example of regulation. A price control is a fixed price on a particular product, commodity, or service mandated by the government.

Price controls have been tried continuously throughout history, and they’ve continuously been removed because they ultimately do more harm than good. It’s easy to see why. Imagine that a law is passed that states, “From this point onward, chairs can only be sold for $10.” If all costs stay constant at $9 or less, the regulation wouldn’t be harmful at that point. However, price controls put two dynamics in motion:

  • First, the artificially lower price encourages consumption — more people buy chairs.

  • Second, production is discouraged. What company wants to make chairs if it can’t sell them for a decent profit (or at the very least cover its costs)?

What happens to the company with a fixed sales price coupled with rising costs? Profits shrink, and depending on how long the price controls are in effect, the company eventually experiences losses. The chair producer is eventually driven out of business. The chair-building industry shrinks, and the result is a chair shortage. Profits (and jobs) soon vanish.

Central banks

Central banks are the governmental entities that are charged with the responsibility of managing the supply of currency that’s used in the economy. The problem with this is the tendency of central banks to overproduce the supply of currency. This overproduction leads to the condition of having too much currency, which leads to the problematic condition of inflation.

If too many units of currency (such as dollars or yen, for example) are chasing a limited supply of goods and services, consumers end up paying more money for goods and services (ugh!), but this is the reality that occurs when central banks (in the case of the U.S., the Federal Reserve) create too much of the currency.