Today we’ll talk about inflation! I’m hoping you’ve read my article on deflation and depression and my primer on currency. If you haven’t read those two posts, go read them and then come back and continue here!
In the deflation article we established that deflation is an overall decline in price, or increase in the value of a given currency unit. In other words, your dollar goes farther. We also established that inflation is the opposite of that. Pretty simple, right? Your dollar buys less and less the higher inflation goes.
We generally measure inflationary rates according to one or more price indexes. The one everyone is familiar with is the Consumer Price Index, also called the Cost of Living Index. Other indices are useful as well when measuring inflation in narrow parts of the economy but we’ll use the CPI for the purpose of this article. The annual inflation rate is simply the annualized percentage change in the CPI as measured by the federal government.
Inflation is bad, isn’t it?
Not inherently. Just like deflation, inflation is not good or bad in and of itself. In fact most economists believe that low steady rates of inflation are a good thing for an economy. The key is that the inflation rate should stay below the growth rate of the economy at large, or the Gross Domestic Product as we call it here in the United States. Mild inflation is also key to getting out of a depression or recession. Mild being the key word there.
On the flip side, inflation can do some bad things. If inflation begins to rise too high there is a natural response by consumers to spend their money on tangible durable goods before that money is devalued too much. If you recall in the deflation article we talked about supply and demand and how it drives prices. If consumers begin buying durable goods, prices go up as demand goes up and that has a circular effect I’m sure you can all see.
Another negative side effect of inflation is something called Cost Push Inflation. It’s basically the concept that as consumer prices rise, employees demand more and more cost of living increases to keep up. This is particularly negative with collective bargaining agreements like union contracts and the like which are tied to the CPI. It can trigger a wage spiral which has the further effect of increasing the inflation rate as businesses raise prices to compensate for higher employment expense, leading to higher wages, ad inifintum.
What happens to debt in an inflationary period?
That depends on the type of debt. A fixed interest loan, such as a standard mortgage or a contractual loan will become cheaper to pay off. A variable interest loan will stay about the same in compensated value, but there is a real danger to variable interest rates. The interest rate will ALWAYS rise faster and farther than your wages will. Always.
Rudy’s Tip: Inflation adjusted interest rates on fixed interest loans are called ‘real’ rates. It’s defined as the nominal rate minus the inflationary rate. So if your fixed interest rate is 8% and inflation is 3% your effective rate is 5%. If inflation jumps to 8% then you’re essentially paying no interest. Beyond that and the bank is essentially paying you for the loan. Funky!
What causes inflation?
Well, if you’re an economist this is where you start talking about the Quantity Theory of Money, the Velocity of Money, Currency Debasement, and other interesting things. Since we’re in a fiat money economy we’ll limit our discussion to that. There are really two things that matter in the long run. The money supply and economic output. If the supply of money increases too quickly compared to the economy at large that inevitably leads to price inflation based on the law of supply and demand.
Interest rates also play a part here as higher interest rates lead to lower inflation rates and vice versa. This is why you see a reduction of the federal funds rate in an attempt to kick start the economy. The theory here is that if money is cheaper to borrow more people will take advantage of that leading to more economic growth and thus higher inflationary pressure.
Great Ceasar’s Ghost!
A random final bit of information here. I talked about currency debasement in the last section. Debasement in its purest form is when you take a commodity currency (like a gold coin) and melt it down, then recasting the coin with a lower commodity content. Most historians believe that debasement was one of the leading causes of the fall of the Roman Empire. The Roman silver denarius was 95 percent silver when introduced. Over a one hundred year period it was debased so far that it only contained 0.5% silver. Yowza.
Couldn’t happen here, right, since we’re in a fiat system? Nope. Debasement basically takes a unit of currency and reduces it’s value. What do you think the Fed printing presses running overtime does to our currency values?
That’s it for inflation! Conceptually pretty simple, especially after reading the deflation article I wrote. Next we talk about Inflation Gone Wild. Also known as Hyperinflation or Something That Keeps Rudy Up At Night. Stay tuned!