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UNDERSTANDING MONETARY INFLATION

©2006 Simon R. Mouer III, PhD, PE

General

Inflation is a real phenomenon but over time tends to be a zero sum game for ordinary people and organizations. Incomes of most ordinary individuals, working or retired, are periodically adjusted for cost-of-living factors that are largely inflation adjustments so that real income remains fairly constant. Sales prices of goods are adjusted periodically to account for the effects of inflation. The revenues of governments of all levels -- federal state and local, are largely based on percentage rates (e.g., sales and income taxes) and as such are adjusted automatically for inflation to maintain constant real revenues. Why then does inflation have such a bad press?

Inflation can be a real problem for the wealthy, i.e., owners of capital (currency). Such owners find their capital wealth (currency reserves) declining in value due to inflation. Such decline in wealth can be offset by lending out the currency reserves at lending rates greater than the rate of inflation. Borrowers pay off such loans in deflated dollars while their incomes are generally indexed to inflation. Astute lenders factor in the anticipated rate of inflation when establishing lending rates. Unanticipated changes in the rate of inflation from year to year cause uncertainty in currency markets. 55

Monetary Phenomena

Inflation is a phenomenon well understood in high financial circles though perhaps little understood outside those circles. Inflation is a monetary phenomenon. That is -- it is the currency that changes in value, not the goods purchased. Technically, what we call inflation is actually deflation of currency value. The term inflation applies to the price of goods and is the commonly used term because it is directly observable. The deflation of currency value can only be determined indirectly by observing the apparent inflation of the prices of goods and services over a period of time. 36, 55, 60 To complicate the issue of identifying and measuring inflation, not all price change is inflationary. Prices on individual commodities vary according to seasonal supply and demand, uniqueness or obsolescence,

While inflation is a concern for capital owners and lenders, it is a boon to borrowers in that the payback over time is with increasingly deflated currency. The biggest borrowers tend to be governments, including the US federal government. As such, governments tend to promote inflationary policies. Central banks, on the other hand, tend to represent capital owners and tend toward anti-inflationary policies. 55

Price Changes 55, 60

Inflation is reflected in a change in the price of goods but it is not the only factor involved in price changes. Price changes occur for reasons other than inflation such as supply and demand, regional surpluses and shortages, season, and obsolescence.

While inflation is a monetary phenomenon, that is -- it is the currency that changes in value, not the goods purchased -- it can only be determined indirectly and after-the-fact. Before inflation can be estimated, season, demand, supply, inventories, and other factors must be accounted for. In the US, the Bureau of Labor Statistics, under the US Department of Labor,

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