"In the End, we will remember not the words of our enemies, but the silence of our friends." -MLK

Thursday, March 15, 2012

Understanding Inflation

Inflation is commonly understood as prices going up. Price increases, however, are only the result of inflation. Actual inflation happens when the value of a currency, in this case the US dollar, goes down.  Meaning it will now take more dollars to buy the same quantity of a given product. Economists describe this process as more dollars chasing fewer goods and services. It is important to understand that the innate value of a particular good or service does not change in an inflationary occurrence, only the amount of paper dollars needed to acquire them.  Consider the following example:

While shopping with her dad Jill found an old 1942 silver dime.  In 1942 a loaf of bread cost $.09 (or 9/10 of a dime).  Today, however, a loaf of bread costs around $2.50.  That's a difference of $2.41 or 28x more than in 1942.  It's interesting to note that with silver currently trading at $36.65 per once that 1942 dime that Jill found has $2.62 worth of silver in it.  If you take 9/10 of that $2.62 (the amount of "dime" needed to purchase a loaf of bread in 1942) you wind up with $2.36, exactly what you'd need to purchase a loaf of bread today.  What this illustrates is that 64 years later it still takes the same amount of silver to buy the same amount of bread.  The only thing that has changed is the amount of dollars needed to make the same  purchase.

Bread is not the only item affected by a devaluing dollar.  Consider also John.  John invested $6500 into the stock market in March of 2001 when the market average was 10,300.  In March of 2011 when the market average was 12,086, he sold his stock for a gain of $962.  In addition to his positive investment return, John's yearly income was increased by 19.2% to $52,335 per year.  

On the surface a 14.8% investment gain and a $10,000 raise appears to be a step in the right direction.  However, a positive return on investments and increase in income are not necessarily accurate indicators of an increased ability to purchase goods and services.  In March of 2001 gasoline cost $1.46 per gallon.  Today a gallon of gasoline cost $3.52.  That's an increase of 58.5%.  During that same 10 year period the price of a bushel of wheat went from $3.55 to $8.55, also an increase of 58.5%.

Oil and wheat are just two of the many commodities that are priced in U.S. dollars.  As the value of the U.S. dollar continues to decline, the number of dollars needed to purchase these commodities will conversely continue to rise.  That means that even though John increased his investments by 14.8% and his yearly income by 19.3% over a ten year period, the value of the dollars he's acquired in 2011 are worth 58.5% less when it comes to filling his gas tank and buying a loaf of bread. Put another way, even though John has 17.05% more money than he had 10 years ago, it is going to be 41.5% harder for him to purchase the things he needs.  This is the destructive nature of inflation.

These concepts are very clearly illustrated in, "The Kingdom of Moltz", a graphic novel dealing with inflation.  It is a must watch for understanding how our money system works and where inflation comes from.

"By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens."
-- John Maynard Keynes

As a note, both Fed Chairman Ben Bernanke* and Treasury Secretary Timothy Geithner** subscribe to Keynesian economic theory. 

--Originally posted on March 28, 2011


  1. How much longer can this continue? I mean, really? This is going to be like driving off of the edge of the world...

  2. That is the $39 Trillion question: http://www.economist.com/content/global_debt_clock