13 November 2005

What Is Currency "Inflation"?

Inflation = change in the value of money

Obverse of A dollar that I had in my pocket in 1960 could have bought a lot more than that same dollar bill would buy today, if I had kept it in my pocket for 45 years. For example, in 1960 that dollar would have bought about ten comic books, about two-thirds of a haircut, about three gallons of gas, ten Cokes, or a movie ticket (in California). Reverse of Today that same piece of paper (or coin -- but I would get some funny looks trying to plunk down a big, silver Peace Dollar today) would buy about one comic book, one-fifteenth of a haircut, less than half a gallon of gas, one Coke, or an eighth of a movie ticket.

The "nominal value" of that dollar would have stayed the same -- $1.00. But the "purchasing power" of the dollar has changed significantly over time. That change in purchasing power of a unit of money is what we call "inflation".

Economic Definition of Inflation

In economics, inflation is an increase in the general level of prices. In particular, general inflation is a fall in the market value or purchasing power of money within the economy. (This is different from currency "devaluation", which is the fall of the purchasing power of a currency relative to the currencies of other economies.)

The key concept is that the purchasing power of a unit of currency can change.

Prices can also rise for reasons unrelated to the change in the purchasing power of a currency. For example, scarcity of supply may drive up the price of a commodity, such as oil or wheat, due to depletion of oil fields or bad weather in wheat-growing regions. This restricted supply will drive up the price (assuming demand remains about the same). This is not quite the same as general price inflation due to a decline in the value of the currency.

"Real" vs. "Nominal"

Changes in the value of money make it difficult to compare economic statistics, prices, and so on from one period with those from other times. To compare "apples to apples" the currency units from different years have to be converted into equivalent "real" or "inflation-adjusted" units.

For example, the current (nominal, November 2005) price of oil is about $60 per barrel. In 1980 the then-current, nominal price was about $40 per barrel. But in fact the real price of oil was much higher in 1980 than it is today! After adjusting for 25 years of inflation (change in value of the dollar), we see that the price of oil in 1980 was about $100when expressed in September 2005 dollars. Thus the "real" price of oil is nowhere near its historical peak, though the "nominal" price is at a "record high". (Good discussion here.)

What Causes Inflation?

Increase in the supply of money is thought to be one primary reason inflation occurs. If people have more money, the theory goes, they will bid up the price of goods (assuming the supply of those goods is not increasing as fast as the quantity of money in the economy).

There are several ways the supply of money can increase:
Spanish Galleon
  • Injection of new wealth into the economy

    Gold and silver pouring in from the New World caused inflation in Europe that helped to wreck the economy of Spain in the 16th and 17th centuries. (facts and figures here)

    Rapid increases in the value of assets (property or housing "bubbles" or stock market "bubbles" such as the dot-com bubble of the 1990s) give people the feeling that they have more money to spend, so they spend it, often on the same assets that are part of the bubble in the first place. Often they borrow against the increased value of the assets which are part of the bubble.

  • Borrowing

    Low interest rates or inflated asset prices encourage borrowing, which puts more spendable money in the hands of the borrowers. This cash can be used to bid up prices for things those borrowers want. Credit cards are a tempting source of additional spending power for many people. (Americans currently owe about $800 billion in unsecured credit card debt -- and this is only a fraction of the credit that credit card companies have extended to them.)

  • "Printing" of money by governments

    Governments are always sorely tempted to overcome budget constraints by spending money they do not have. They can either print additional currency (or in earlier ages debase the coinage by reducing the quantity of gold or silver in it), or they can borrow money which they have no intention of paying back.

    Deficit spending is usually a sign of future inflation, since governments rarely pay off their accumulated debts. If it is necessary to make the debt go away the government will either just repudiate it, refusing to pay its creditors, or devalue the currency it was borrowed in, by allowing inflation to decrease its worth, so that the old debt can be paid off with new currency that, while it nominally looks the same, is worth much less.

    In addition to actual debt (money borrowed), most governments engage in over-promising -- they make commitments to pay out in the future money that they do not have and probably will not be able to obtain. For example, the United States government currently has public debt of about eight trillion dollars. In addition it has committed to make about $45 trillion worth future social security and other payments to its citizens. Since government income (taxes) will never be able to cover these promised expenditures, there is an almost overwhelming need for the government either to repudiate these obligations or to inflate the currency to make them easier to pay. (News article discussing this)

  • Deliberate inflationary policies

    Populist political factions sometimes call for deliberate increases in the money supply in an effort to increase prices (for farm products) and reduce the burden of debts. An example is the Free Silver Movement in the U.S. in the last quarter of the 19th century.

  • Changes in people's attitudes toward the currency

    one million Argentine peso note, from http://tomchao.com/hb.htmlIf people come to believe that the money they possess will become less valuable in the future, due to inflation, they will try to spend it now rather than saving it. Anything that encourages present spending rather than saving increases the amount of money being spent on the (more or less fixed) amount of goods available, which will lead to bidding up of prices (inflation). This process can become cyclical as increasing inflation drives people to save even less and spend any available funds immediately. This may even result in "hyperinflation".

For Further Information

Good one-page discussion

Inflation calculator

Inflation Conversion Factors for Dollars 1665 to Estimated 2015

Good site on changes in value of money, with excellent links

List of theories on causes of inflation

inflationdata.com -- useful site

Wikipedia on "Inflation"
Wikipedia on "Real vs. Nominal"

Image of Spanish Galleon from this site.

David Wheat's Science In Action site has articles about science and math in the real world, weird science, science news, unexpected connections, and other cool science stuff. There is an index of the articles by topic here.

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1 comment:

JC Ernharth said...

Nice summary. You should follow up with a summary of the deliterious effects it has on the economy because these new dollars are not backed by actual production, throwing the new money into dislocations from reality that eventually must be reconciled -- albeit long after many folks have changed their behaviors chasing in that direction. Very messy, indeed...

Everyone loves inflationary cycles when they start. Nobody likes it when the cycle finishes.