What is Inflation?
A simple commonly used definition of the word inflation is simply "an increase in the price you pay or a decline in the purchasing power of money".
In other words, Price Inflation is when prices get higher or it takes more money to buy the same item.
Inflation is measured by the Bureau of Labor Statistics in the United States using the Consumer Price Index.
Inflation Cause and Effect
I often receive letters from students, that demonstrate a fuzzy understanding of inflation and its causes. Unfortunately, I often get the same type letters from teachers and business people too!
It seems that people often confuse the cause of inflation with the effect of inflation and unfortunately the dictionary isn't much help. As you can see in my article What is the Real Definition of Inflation? the modern definition of inflation is
"A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money..."
In other words according to this definition inflation is things getting more expensive.
But that is really the effect of inflation not inflation itself. The American Heritage® Dictionary of the English Language, Fourth Edition, Copyright © 2000 Published by Houghton Mifflin Company goes on to say:
...caused by an increase in available currency and credit beyond the proportion of available goods and services.
In other words, the common usage of the word inflation is the effect that people see. When they see prices in their local stores going up they call it inflation.
But what is being inflated? Obviously prices are being inflated. So this is actually "price inflation".
Price inflation is a result of "monetary inflation".
Or "monetary inflation" is the cause of "price inflation".
So what is "monetary inflation" and where does it come from?
"Monetary inflation" is basically the government figuratively cranking up the printing presses and increasing the money supply.
In the old days that was how we got inflation. The government would actually print more dollars. But today the government has much more advanced methods of increasing the money supply. Remember, "monetary inflation" is the "increase in the amount of currency in circulation".
But how do we define currency in circulation? Is it just the cash in our pockets? Or does it include the money in our checking accounts? How about our savings accounts? What about Money Market accounts, CD's, and time deposits?
"The Federal Reserve tracks and publishes the money supply measured three different ways-- M1, M2, and M3.
These three money supply measures track slightly different views of the money supply with M1 being the most liquid and M3 including giant deposits held by foreign banks. And M2 being somewhere in between i.e. basically Cash, Checking and Savings accounts.
Interestingly, the FED has decided to stop tracking M3 effective March 23, 2006 for some mysterious reason. See the article on M3 Money Supply for what they could be hiding.
But back to the question of the cause of inflation. Basically when the government increases the money supply faster than the quantity of goods increases we have inflation. Interestingly as the supply of goods increase the money supply has to increase or else prices actually go down.
Many people mistakenly believe that prices rise because businesses are "greedy". This is not the case in a free enterprise system. Because of competition the businesses that succeed are those that provide the highest quality goods for the lowest price. So a business can't just arbitrarily raise its prices anytime it wants to. If it does, before long all of its customers will be buying from someone else.
But if each dollar is worth less because the supply of dollars has increased, all business are forced to raise prices just to get the same value for their products.
What is Deflation?
In common usage deflation is generally considered to be "falling prices". But there is much more to it than that. Often people confuse deflation with disinflation or with Depression (as in "the Great Depression"). These three terms are related but not synonymous.
According to Investorwords.com the definition of Deflation is "a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. The opposite of inflation."
What Causes Deflation?
Although everything said above is true it doesn't present the true nature of deflation. It tries to define it by presenting several possible causes. For a true understanding of both Inflation and Deflation we need to understand Supply and Demand. Just like every other commodity there is a supply of and a demand for "Money".
In this article I am not going to address the issues of what true money is, for the sake of this article we will assume money is simply something other people are willing to accept in exchange for goods or services.
Price levels are the direct result of the relationship between the supply and the demand for any given item. But the value of the money used to pay for those items is also subject to the same relationship.
For the sake of simplicity let's assume that we are on an island and there are ten equally desirable goods in our universe and ten $1.00 bills available to purchase them with. We can safely assume that each item will end up costing $1.00 each.
If the quantity of money increases to $20 (without increasing the quantity of goods) the price of the goods will increase to $2.00 - that is inflation.
If, however, the quantity of money decreases to $5.00 the price will fall to 50¢ (deflation). This is what the first part of the above definition is referring to. The money supply can also be reduced if someone on our island hoards half of it and refuses to spend it on anything no matter what. This is the second part of the definition (reduction in spending).
So far we have only looked at part of the equation, the supply of money. But what happens if the quantity of goods available increases? What if instead of having ten items we build ten more? We now have twenty items and only $10. 00 so once again each item is worth 50¢.
This form of deflation is the good type. Everyone assumes that deflation is bad because the last major deflation that we had was during the "Great Depression" so deflation and Depression are synonymous in many peoples minds. In actuality if prices go down because the goods can be manufactured more cheaply this ends up increasing everyone's wealth.
This is exactly what happened in the late 1990s , with cheap productivity available from former Communist countries the quantity of goods is increased while the money supply increased at a slower rate.
What about Demand?
What about the demand for goods? If everyone on our island already has one of the items available and no one needs any more, naturally the price will also fall as sellers try to find someone to take them off their hands.
So far we have dealt with the supply of money, the supply of goods and the demand for goods, but what about the demand for money?
Is it possible that the demand for money could increase or decrease? Generally, the demand for money is measured by how much people are willing to pay to borrow it (i.e. interest rates). If inflation is high, interest rates will have to be higher to compensate for the loss of purchasing power. But also if the demand for money rises banks can charge more to loan it. Conversely, if the demand for money falls interest rates will also fall.
So there are four causes for Deflation.
Decreasing Money Supply
Increasing Supply of Goods
Decreasing Demand for Goods
Increasing Demand for Money
Note:
Increasing demand or decreasing supply of money have the same result i.e. "tight money" either way people want more money than is available.
Both could also result in (or cause) higher interest rates. But the higher interest rates should also tend to balance (or decrease the demand for money because it is now more expensive).
In other words as interest rates rise at some point the demand drops off because people don't want it bad enough to pay such high rates.
Is Deflation Good or Bad?
Actually, deflation itself is neither good nor bad. It depends on the cause of the deflation whether people will suffer or rejoice. As I said, if the cause is increasing supply of goods that would be good. Another example of this is in the late 1800's as the industrial revolution dramatically increased productivity.
However, if deflation is caused by a decreasing supply of money as in the great depression, that would be bad. The stock market crash sucked all the liquidity out of the market place, the economy contracted, people lost their jobs and then banks stopped loaning money because people were defaulting. The problem compounded as more people lost their jobs and money supply fell further causing more people to lose their jobs, etc. etc.
Note: During the Depression demand for money was high (but no one could afford it) because supply was low.
So deflation can be caused by several different things and thus can be good or bad depending on the cause.
How Do I Calculate the Inflation Rate?
The Formula for Calculating Inflation
The formula for calculating the Inflation Rate using the Consumer Price Index is relatively simple. Every month the Bureau of Labor Statistics (BLS) surveys prices and generates the current Consumer Price Index (CPI). Let us assume for the sake of simplicity that the index consists of one item and that one item cost $1.00 in 1984. The BLS published the index in 1984 at 100. If today that same item costs $1.85 the index would stand at 185.0
By looking at the above example, common sense would tell us that the index increased (it went from 100 to 185). The question is how much has it increased? To calculate the change we would take the second number (185) and subtract the first number (100). The result would be 85. So we know that since 1984 prices increased (Inflated) by 85 points.
What good does knowing that it moved 85 do? Not much. We still need a method of comparison.
Since we know the increase in the Consumer Price Index we still need to compare it to something, so we compare it to the price it started at (100). We do that by dividing the increase by the first price or 85/100. the result is (.85). This number is still not very useful so we convert it into a percent. To do that we multiply by 100 and add a % symbol.
So the result is an 85% increase in prices since 1984. That is interesting but (other than being the date of George Orwell's famous novel) to most people today 1984 is not particularly significant.
calculating a specific Inflation Rate
Normally, we want to know how much prices have increased since last year, or since we bought our house, or perhaps how much prices will increase by the time we retire or our kids go to college.
Fortunately, The method of calculating Inflation is the same, no matter what time period we desire. We just substitute a different value for the first one. So if we want to know how much prices have increased over the last 12 months (the commonly published inflation rate number) we would subtract last year's index from the current index and divide by last year's number and multiply the result by 100 and add a % sign.
The formula for calculating the Inflation Rate looks like this:
((B - A)/A)*100
So if exactly one year ago the Consumer Price Index was 178 and today the CPI is 185, then the calculations would look like this:
((185-178)/178)*100
or
(7/178)*100
or
0.0393*100
which equals 3.93% inflation over the sample year.
(Not Actual Inflation Rates). For more information you may check the current Consumer Inflation Rate and Historical Inflation Rates in table format. Or if you believe a picture is worth a thousand words you may prefer the Annual Inflation Rate plotted in Chart format.
What happens if prices Go down?
If prices go down and we experienced Price Deflation then "A" would be larger than "B" and we would end up with a negative number. So if last year the Consumer Price Index (CPI) was 189 and this year the CPI is 185 then the formula would look like this:
((185-189)/189)*100
or
(-4/189)*100
or
-0.021*100
which equals negative 2.11% inflation over the sample year. Of course negative inflation is deflation.
How Does Inflation Affect You?
When people go the the grocery store and see ever higher prices they know how inflation affects them. But when they are feeling more philosophical they might reason that if all wages and prices increased at the same rate it would all balance out in the end right?
Well theoretically yes but in reality it never works that way. Prices of various items all increase at different rates so some people are benefiting while others suffer. Those on fixed incomes suffer the most because the cost of things they are buying increases but their income stays the same.
This is where COLA or "Cost Of Living Allowance" comes in it is an adjustment that is made to compensate for the increase in prices due to inflation.
But even if costs are adjusted they are adjusted after the fact so that you have already been paying the higher prices for a year before your income is adjusted.
One side of inflation that most consumers appreciate is the fact that they can pay off their debts with "cheaper dollars". So as you borrow the value of the money you borrowed goes down so it takes fewer hours of work to pay back the lender.
This is one reason why debt is so prevalent today. Unfortunately, this is a subtle but insidious poison because it trains us to feel good about cheating others. In the past a man's honor was tied to his ability to repay his debts but today inflation has taught us that it is good to try to cheat lenders out of their due. This has led to a higher rate of bankruptcies and if the trend continues it could lead to the breakdown of commerce.
Once lenders can't be assured of getting repaid they will stop lending (or have to charge exorbitant interest rates) and as interest rates increase the economy grinds to a halt. So even the "good" side of inflation is really "bad" for the economy in the long run.
Who Does Inflation Hurt Most?
When we first think of inflation we assume that it will affect all people equally. After all if everyone is using the same dollars wouldn't everyone be affected equally? The fact of course is that everyone isn't affected equally.
Our second assumption might be that the poor would be hurt the worst because they earn minimum wage and everything they buy is getting more expensive. However, if the minimum wage is indexed to inflation they would about break even. So interestingly if the minimum wage earners are also deep in debt inflation actually helps them.
The reason for this is that debtors borrow valuable money and the number of dollars they must repay is fixed. So over time the value of the dollars they must repay is less and less (so they are easier to obtain than if the value of the dollar wasn't inflated away.) This is called repaying with "cheaper dollars".
However, bigger beneficiaries would be the average middle class person with a large mortgage because the debt is for a longer term so inflation has longer to work it's "magic".
On the other hand, the biggest losers due to inflation are those willing to loan money. An extreme example would be during the hyper-inflation of 1923 in Germany. If you had loaned a friend enough money to buy a car in early 1923 and he had repaid it at the end of 1923 you might have been able to buy a box of matches with it. So it is easy to see that the borrower got a car and he was able to repay it with pocket change. The lender of course was the big loser.
At first this looks like the ultimate Robin Hood scheme, robbing from the rich bankers and giving to the poor borrowers. However, the other big losers those on fixed incomes like the elderly and anyone whose income isn't indexed to inflation.
Inflation affects them especially hard because the prices of things they buy go up while their income stays the same. In addition, the poor are generally renters so they don't even benefit from a "cheaper" mortgage while they are paying higher prices for their groceries.
Also even though their wages may be indexed to inflation there is a time lag since it is usually only re-indexed once a year. During this time they are on the old wages while prices for things they buy have already gone up.
Interestingly the biggest debtor in the world is the US government and thus it is also the biggest beneficiary of inflation.
And not coincidentally the Government is also the one who controls the money supply and thus inflation.
In a way, inflation works as a hidden tax because the government borrows money from investors. It spends this valuable money and then gets to pay back its debt with cheaper dollars.
The poor unsuspecting investor who is convinced that Government notes, bonds and T-Bills are "Low-Risk investments" accepts these dollars at face value but before long realizes that they won't buy as much as the dollars they loaned to the government in the first place.
Generally, the Government walks a tightrope though, it can't inflate all its debt away too quickly, without destroying the economy, so it faces a constant balancing act.
One big disadvantage of inflation is the fact that it discourages lending (smart banks need more interest to make up for the lost value). This prices some borrowers out of the market making loans too expensive.
Inflation also makes planning for the future more difficult, so businesses are less likely to take risks. No risk means no advancement which stifles the entire economy.
On a small scale lenders are the losers from inflation and borrowers are the winners but on a bigger scale the biggest beneficiary is the Government and the overall economy is the biggest loser.
Other losers are those on fixed incomes and those who are priced out of the loan market.
Inflation and Financial Services
What is the Impact of Inflation on Financial Services Performance?
The most obvious effect of inflation on financial services is that an investment has to perform that much better just to remain even. For instance, under normal circumstances 10% is considered a good rate of return. However, if inflation is 100% and you only earn 10% you have not made any money you have actually lost 45% of your purchasing power.
The calculations are as follows:
100 + 10% = 110
110/200 = 55%
55% of the original value is a 45% loss.
But you would need to earn at least 100% just to stay even with inflation and you would need to earn 110% to earn a good rate of return. But in areas of high inflation investors generally require higher rates of return to compensate for the higher risk associated with the higher inflation. So they might require 120% or even 200% to account for the higher risk.
In Zimbabwe, where inflation rates are often 1000% all kinds of economic distortions take place and investing becomes a matter more of concern for return of capital rather than return on capital. So investors will often switch to real physical goods like Gold or in more extreme cases even food in order to protect themselves from loss of purchasing power. Or even worse a lack of availability of critical goods.
