As we unpack and deconstruct the subject of inflation, there are many aspects ranging from what is inflation, how is it calculated, and what is hurtful about it. The direct impact it has on our currency is what this article will primarily focus upon.
We must also do our best to delineate the underlying causes of inflation, for even across economics textbooks we lack consensus, with theories such as monetarism and Keynesian views of our money supply largely inconsistent. Theories are invented, some later discredited, others partially validated, and even others—such as the recent Modern Monetary Theory—used primarily as a justification for monetary and fiscal stimulus that grew our money supply far faster and higher than our economic (GDP) growth and ended up mostly debunked as a political ploy seeking to justify direct economic intrusion during the Great Financial Crisis and the pandemic.
Let’s try a thought experiment to get a clearer picture of money vis-à-vis inflation. If I could magically, tomorrow, double the amount of money in every location, all the wallets and purses, bank accounts, even mattresses, what do you suppose would happen to the prices of goods and services? While it might be uneven, the prices would generally double. Money supply growth should be collared approximately around GDP growth. If the money supply grows faster than the output of all goods and services (GDP), we get inflation. That is it in a nutshell. The currency is degraded and diminished in terms of its purchasing power, and unless wages rise at least as high as the rate of inflation, people are buying less than they used to with the same amount of money.
Thinking for a moment about who is hurt—the poorest of the poor are hurt the most, as they must spend all their money on necessities, which as prices increase, their standard of living decreases. The wealthy, on the other hand, are not hurt to the same proportion, as their small percentage of income going to necessities is not going to place them in dire financial straits.
- High inflation weakens a currency because it erodes its purchasing power.
- Low inflation strengthens a currency.
How Is Inflation Measured?
The Consumer Price Index (CPI) measures inflation by calculating the weighted average of prices for a basket of consumer goods and services, including transportation, food, and energy. To calculate the CPI, you can follow these steps:- Gather prices for common products or services in the past.
- Collect prices for current products or services.
- Add the product prices together.
- Divide the current product price total by the past price total.
- Multiply the total by 100.
Common Causes of Inflation:
- A growing economy that surpasses the long-run trend rate is likely to lead to inflation. When demand increases faster than supply, there isn’t a sustainable rate of growth.
- The federal government or central banks can add fiat currency to the economy. As we discussed earlier, money supply growth faster than economic growth can lead to inflation. The government monitors economic conditions and will create fiscal and monetary policies accordingly. Sometimes these expansionary policies misfire.
- If the government has a high debt-to-gross domestic product (GDP) they can’t pay off debt without gaining more debt. If the national debt is on the rise and output is lowering, inflation can occur as an attempt to pay off this debt with devalued money. Currently, with high interest rates and high federal deficits, the debt is growing faster than the economy, a dangerous situation that must be corrected with both increased taxes and decreased spending.
We mentioned that the poor suffer the most during times of inflation. But those on fixed incomes are also going to see that their money no longer stretches to purchase the goods and services they were accustomed to buying in the past. Social Security is adjusted each year for the rate of inflation, so those payments are not in the category of “fixed.”
The U.S. Dollar is considered the currency of currencies in the world, oil is priced in dollars, for example. If we fail to maintain the integrity and strength of our currency, we lose not just purchasing power, but our dominance among world reserve currencies. This problem was visited by both the Dutch and the British in the past. First their currencies, the Guilder and then the Pound Sterling, lost their value precipitously relative to other world currencies, then the nations themselves weakened to become a small sliver and a shadow of their former greatness on the world stage.
