Do not ignore this about inflation Leave a comment

Do not ignore this about inflation

In a progressive healthy economy where production is constantly growing, all goods and services are represented by all the currency in the system. Therefore, the value of the total quantity of currency must be equal to the value of the total quantity of goods and services bought which are represented by the gross domestic product. Here is the equation that describes the relationship, being nominal GDP the multiplication between the average price and the quantity of products:

In the equation, velocity of currency “V”, indicates the number of transactions per amount of currency. For example, when someone uses 10$ to purchase some product and latter the seller of goods spends the same amount to buy other products, in this case velocity equals to 2 as the same amount is used in different transactions. To simplify complexity, we are going to suppose that velocity is constant and equal to one. Then equation shows that the value of currency unit must vary exactly and inversely with the amount put into circulation. Keeping in context, adding currency supply in an existing circulating amount through credit spending or fiscal stimulus, devalues all the existing currency against all goods and services.

To understand how the process is carried out. Suppose, for example, that the Central Bank lows interest rates and many corporations and individuals reconsider to borrow to purchase real state. The first effect of this expenditures will be to raise the prices of housing as the demand increased, this is described in the second equation. Real state agencies and their employees, then, will have higher revenue and they will spend more for the goods and services they want. The sellers of this goods and services will be able to raise their prices because of this increased demand, here velocity starts to grow describing the first equation. Those who have increased currency income will be willing to pay higher prices rather than do without the goods, for them, a dollar will have a smaller subjective value than before.

Basically, this purchase-chain process spreads among the economy and assuming production of goods and services has not incremented, its prices will have increased correspondingly. However, the state is not richer than before. Credit used in a non-productive way, creates fake demand in the sector involved distorting its prices. Other sectors and people not related will basically see prices raising and their incomes will keep being the same but with less purchasing power. This is how inflation expands through the economy and it is not an average standard of 2% as we are told. Depending on the consumer goods and services purchased our currency value could be much more exposed.

For a better understanding let’s simulate the value of a dollar over time so it will be easier to realize the scope of an inflationary currency. At first, let’s simulate the historic US currency since 1913, more than a hundred years of currency devaluation:

Since then, the dollar has devalued 96% of its initial value. What people were able to buy in 1913 for 4¢ you can buy it now for one dollar, or what is the same, one dollar back then had the same purchasing power as 26.05$ today.

Remember that the dollar devaluation is calculated using the inflation on consumer prices (CPI). Inflation generally caused by an increase on currency supply against production as it has been described before.

In the chart you can see how the dollar almost permanently goes down in value. During this century, specially since the federal reserve was created in 1913, monetary policies have been constantly manipulated to spend and add currency supply in the economy. In 1933 Roosevelt implemented the executive order 6102 which required all persons to deliver all but a small amount of gold coins to the Federal Reserve in exchange for 20.67$ per oz. Then the price of gold was fixed to 35$ per oz. This expanded gold reserves and as them grew and had more value, allowed commercial banks to expand currency supply through credit. Realize that the gold standard was a constrain for the government power because always limited credit.

In 1971, already in the dollar standard placed in 1944 after Bretton woods agreement, President Nixon detached the dollar from gold and currencies became fluctuant in the market . Basically, US was creating more dollars than gold reserves permitted and borrowing countries claimed the gold that was backing their dollars. This made significant change in the banking system as credit lending became not limited by the amount of gold hold as reserves but for the dollar reserves known as base money.

The main reason of not having a gold standard is to allow government and central banks to spend and print currency, limited only by monetary policies dictated by themselves. This can be used to stimulate the economy during a recession period, natural disaster, a pandemic or even to subsidize war. At the end, this gives control of the currency value to a centralized entity and power to choose which sector to expand.

So, as you can see in the chart below, it shows the commercial and industrial loans issued by commercial banks. Specially after monetary policies easing, commercial banks have brutally expanded their business:

Back in the dollar devaluation simulations, here is the last 20 years of US chart inflation based on BLS data, which is an average of 2.35% inflation per year and is going to give us a first vision on how effects our savings:

One-dollar bill in the early 2000 today is valued in 0,64$, for this 20-year period the dollar has devalued 36%. If some responsible person wants to save 100000$ in the early 2000, right now this 100k$ savings can buy only what they were able to afford 64000$ back in 2000. This last statement could sound a little complex at the beginning but its key to understand how the system shapes human behavior, as it shows how generations are susceptible to spend instead of saving because the system incentives for it. if you spend more right now you can consume more goods and services than in the next year, that’s the message behind. It’s a high time preference mindset that incites to spend and consume instead of saving and investing into something productive.

Now, it is important to analyze how CPI is measured. We mentioned before the standard inflation of around 2% does not apply to everyone as we consume different products and brands. The chart below is from and measures the CPI as if it were calculated using the methodologies in place in 1980 (blue line) and right now by the Bureau of Labor Statistics (red line):

Back in that times inflation was determined comparing the price of a fixed basket of goods and services, the CPI was a cost of goods index (COGI). However, over time was changed to reflect changes in the cost to maintain a constant standard of living. Consequently, the CPI has evolved into a cost of living index (COLI) allowing the government to report a lower CPI.

A cost of living index basically measures the inflation on the generic goods and services that people consume, it reflexes the potential consumer substitution in response to relative price changes. For example, an ecologic orange juice priced 2$ which its price is incremented to 2.20$. The CPI should indicate a 10% inflation rate but being able the option to purchase a generic orange juice (with extra sugar) for 2$ which its price has not incremented, then the CPI is rated 0%. This is how a CPI based in a cost of living index rates inflation. Now, you may have a better idea on how inflation can affect your cost of living or at least influence to buy lower quality products.

Putting numbers in inflation rates above 2%, here is a table on how a dollar is devalued for 10 years in different constant rates, expressed in % and its actual purchasing power. Additionally, I encourage you to visit to see real inflation in the 50 largest cities in US.

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Do not ignore this about inflation

from Bitcoin – The Currency of the Internet

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