What is Inflation?

How does inflation affect the economy and real world prices?
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The True Definition and Why it Should Matter

There is some debate on the basic definition of inflation. To keep things simple, the answer would depend on whether you go for the newer definition or the older one:

  • New definition: increase in prices of everyday things
  • Old definition: an expansion in the money supply (i.e. all the currency made up of cash and deposits) causing increased price levels

The definitions explain inflation very differently. They both agree that increased prices are seen but the old definition explains that rising prices are the cause of inflation and not inflation itself. You will be able to find the old definition on older dictionaries.

Both definitions agree that inflation results in a loss of purchasing power of a currency, which means your currency will buy you less items as time goes by. The process of lowering the value of a currency is called debasement.

How to Understand Inflation Rates

A good way to visualise this is by looking at charts. Here are a couple of charts one showing the value of the US Dollar since 1640 and the purchasing power of the Euro since 2000.

Purchasing power of one US dollar (USD) in every year from 1635 to 2020*

what-is-inflation-us-dollar-purchasing-power-1635-to-2020

Chart taken from Statista. *”…it is important to remember that the prices of individual goods and services inflate at different rates than currency, therefore this graph must only be used as a guide.”

Purchasing power of one Euro from 2000 to 2020

what-is-inflation-euro-purchasing-power-2000-to-2020

Chart taken from Statista

Please note parts of these charts are inaccurate as will be covered later on in this article.

Let’s get back to the charts – if we take the US Dollar chart we can see that since 1693 the value of the dollar has been going up and down but overall has been trending downwards. If we see how much a today’s dollar is worth in the 1950’s we can calculate that it is would have been worth 9 cents (1 divide by 10.8). One dollar would have bought many more things back then!

Why Debate the Definition of Inflation?

A lot of individuals nowadays think of inflation by the new definition. This is because there are a lot of Keynesian economists in prominent economic positions in the west who go by this definition.

Peter Schiff, an Austrian economist, says the reason why the definition got changed in the first place is because governments did not want people to know that inflation was a result of the increase in money supply.

Money is printed by central banks with government approval. The definition got dumbed down to say inflation was the rise in the price of things, which could enable the government or the central banks to blame inflation on whatever was convenient for them at the time and deflect blame from themselves. You can have a look at Schiff’s rational here on this YouTube video.

Central Bank Calculated Rate of Inflation

Government and central banks say they want to maintain a 2% inflation target. They mostly have managed to keep inflation at around that rate, however the measures they use for calculating inflation are inaccurate.

Over time central banks changed the way they measure inflation, partly because of the change in definition. Although, the past few decades they have been taking a handful of items which have largely remained the same price, slightly increased or decreased. If they had to include a broader range of items like they used to, we would have a more accurate inflation rate.

Imagine if the inflation rate had to include housing which has been going up drastically. It is a very real basic need to have a roof over your head, in this case the inflation rate would be much higher.

Why would central banks produce inaccurate inflation rates?

Governments have their own expenses which they need to honour. By saying the inflation rate is low they can pay their own government employees in accordance to the lower inflation rate. Also, there may be more questions posed to the government if there are higher inflation numbers from concerned individuals.  

Does the Government Benefit from Inflation?

Governments make a lot of promises to their populations which they have to keep. They go about spending money on public works, social programs and other things to keep everybody happy. In so doing they keep increasing the amount of debt. So they peg (or keep) the interest rate at a low level while they inflate the currency so it is quicker to pay off the debt.

How to Calculate the Inflation Rate

Calculating the inflation rate is done using a lot of tools and measures. A Professor called William Barnett does this work. Professor Barnett is the world’s leading authority when it comes to the board measure of money (made up of cash and deposits). He developed a measure that calculates the broad money percentage results and can be accessed from the Centre of Financial Stability called the Divisia M4. Unfortunately, he only covers the United States.

In the December 2020 report the board measure of money “grey by 28.9% in December 2020, on a year-over-year basis. In contrast, CFS Divisia M4 increased by 6.7% in December 2019 over the preceding year.”

Is Inflation Good or Bad for You?

The broad measure of money grew considerably in the US, but also elsewhere. This is because governments shut down economies in response to the ongoing health crisis. After shutdowns governments have been requesting more money printing to stimulate their economies.

Whether this is a good or bad thing is up for debate. The unfortunate thing is that the stimulus is going to result in higher everyday prices. Prices tend to lag by several months before it shows up in the real economy. Prices that have been noticed to be on the rise are in commodities and food prices.

How Long have Central Banks Been Printing Money?

The central banks have always been printing money, but it has been in greater quantities since the financial crisis of 2008. They wanted to support the financial system so they embarked on money printing which they called Quantitative Easing.

Will central banks continue to print money and inflate?

In short – yes. Central banks tend to follow each other and if one takes a stand the others follow suit. Janet Yellen the secretary of the treasury and previous Fed chair from the US has encouraged lawmakers to “act big” and take monetary stimulus up to its limits.

She also mentioned that they will worry about the effects of the stimulus (higher prices) later on down the road. This is not good new for anyone living in the US or anywhere else around the world.

Could there be chaos?

Most likely there will be. Remember how people all over the world were frantically rushing to supermarkets and emptying shelves? Think of that as a taster of what is to come.

What is the Solution to Inflation?

At the moment the problem is that central banks are going to print currencies until they are worth much less or even worthless. Governments are able to do this because the US came off the gold standard in 1971. As a result since all other currencies were tied to the US Dollar it enabled all the worlds governments to print unlimited amounts of money. Thanks to this they also granted themselves a great increase in power.

One solution would be to constrain government spending. They will not do this willingly but their hands will be tied and they will be forced to do so by the financial markets. There was a time when this was exactly how it was before 1971.

Another ‘solution’ some observers think that we are heading for is detailed in an article on The Great Reset.

Governments at that time were constrained as they were on a gold standard, this could possibly happen again. Otherwise there could be a shift into digital currencies. There could be several ways in which the situation could unfold.

How to Protect Yourself from Inflation

There are ways to protect yourself from inflation especially high inflation which is coming to people around the world. Historically there are ways to do it. We tackle this topic in the article How to protect yourself from inflation.

Further Reading

There is a well-produced series called The Hidden Secrets of Money by GoldSilver. They spent a lot of money creating each episode of the series. The team at GoldSilver are truly dedicated to teaching people about how things work in the financial system. There are a lot of topics covered including monetary history, central banks and inflation. It is a very fascinating and is presented in an easy to understand format.

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