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THE TWO FACES OF INFLATION

Most people know inflation because they experience the effects of steadily rising prices for goods and services. Even a relatively modest inflation rate can drive prices up to unthinkable levels.

A basket of goods costing $100 will cost almost $400 after 40 years of inflation – even when the average annual rate of inflation is just 3.5% Over forty years, inflation has resulted in a fourfold increase in prices!

Inflation hurts people who must live on a fixed income, lenders of money, and investors trying to save for retirement. In planning for retirement one must achieve a rate of return on investments that is in excess of the underlying inflation rate in order to build real wealth. For example, if the nominal rate of return on investments is 7.5% per year, while the underlying inflation rate is 3.5% during the same investment period, the real rate of return is just 4% -- the difference between 7.5% and 3.5%

Of course rising prices are not the cause of inflation but rather the effect. A general increase in prices for goods and services is the effect of an increase in the supply of money. If the money supply was kept constant, prices over time would tend to decline as the quantity of goods and services increases. This can be demonstrated by the following equation: M*V = P*Q, where M is the supply of money, V is Velocity (or the number of times money changes hands from seller to buyer), P is the general price level for goods and services, and Q is the total quantity of goods and services available for sale in the economy. We can solve for P by dividing both sides of the equation by Q.

This rather simple example will suffice to illustrate the relationship between money and inflation. On a small (and imaginary) island in the Pacific called Thera, the only items for purchase are pineapples – which must be imported from Hawaii. The people on Thera are self sufficient, growing or making what they need for themselves – everything that is except pineapples, which are universally desired by the island’s inhabitants. Fortunately, the island has lined up a local supplier. What do pineapples cost on Thera? That depends on the supply of money and the quantity of pineapples. If the total supply of money on the island is $1,000, and the supply of pineapples is 1,000, then each pineapple will sell for $1 (assuming V = 1). If, however, the next year the supply of money grows to $2,000, with no increase in the supply of pineapples, then each pineapple will sell for $2.

All this talk about rising prices ignores the flip side of the inflation coin – that inflation has less to do with rising prices and more to do with a depreciating currency. The more dollars pumped into the economy the less each dollar is worth! That is why the government can’t make us all rich by simply printing more money. It can only make us feel rich, at least for awhile until we try to spend our windfall. If the government gave each resident on the island of Thera $100,000, it would drive the price of pineapples through the roof. Each pineapple would now cost $10,000 (($100,000 *1)/1,000). Our new found wealth would disappear into the thin tropic air. After forty years, the dollar has lost almost 80% of its value. Is it any wonder that prices have risen fourfold during the same period? It had to in order for all the sellers of goods and services to stay in business!

But inflation may exist even when prices are not rising!

Stable prices can mask underlying inflation if, absent an increase in the money supply, prices would actually have declined. In fact, for most of the nineteenth century, at a time of great industrial and agricultural expansion, prices did decline. Price declines were then considered normal—the result of greater efficiencies in production—and a benefit of the industrial revolution.

Today we have come to see price increases as normal and fret when, in rare instances, general price levels actually decline. As Murray Rothbard pointed out, any increase in fiat money over the quantity of gold is inflationary. As a result, even when prices are stable, inflation may be at work robbing us of the benefits of improvements in technology and production.