Sat, 24 Apr 2004

Inflation, causes and results

Inflation is not widely understood. A Friend explained it thusly: "Inflation is when people demand raises, get paid too much, and compete for goods and services, driving the price up, which causes people to demand raises." The cause in that scenario is the demand for higher pay, and the solution is to impose wage and price controls, ala Nixon (God help us when politicians think they understand economics, .... or economists politics!)

That explanation is complete doo-doo. The way to understand money is to think of it as a good unto itself. The fiat currency (the dollar is not backed by anything other than people's willingness to accept it) we use now has no other use than as money. You shouldn't dwell on the arbitrariness of the value of money, though. You should think of it as if it were gold, or silver, or cigarettes, or something else with an intrinsic use. Money evolved from the use of a good of some sort.

If money is a good, then money will have a value which is only partly related to its exchange value. Gold is made into jewelry, silver is made into photographic film, cigarettes get smoked. But the exchange value is itself also something desirable to have. If you have a painting which is worth $200 (to the right buyer), that's not the same as actually having $200. Money, both in its intrinsic value and its exchange value, is a good that has value beyond what you can exchange it for. As a good, it has a value, a supply, and a demand, like any other good.

Yes, the value of money changes. A dollar is not always worth a dollar. In uncertain times, people value exchangability. If you don't know that you can sell your $200 painting for $200, you might just sell it now for $190 and hold onto the $190. That $190 is worth more to you because you have it now, than the $200 might be worth to you later. The demand for money has risen.

Money also has a supply. Only the US Mint can legally issue US dollars. There are also counterfeiters, of course, but the only difference between a counterfeiter and the Mint on the supply of money is who gets to spend the dollar first. And the fact that the Mint exercises some restraint on printing excess dollars. The same goes for private currencies, such as the Ithaca Hour.

In order for money to have a stable value, the supply and the demand should be matched. The Mint prints dollars, but the Federal Reserve controls the supply of money through the interest rate at which it loans money to banks. It has no control over the demand for dollars. It will be reasonably stable and predictable in a peaceful free-market society. If the Fed did nothing or didn't exist, prices and wages would slowly drop as the economy grew. Because of productivity gains caused by capital investment, prices would drop faster than wages and everybody would be richer. However, nobody but nobody wants to see their wages go down, even if prices are going down faster. Therefore, we have the Federal Reserve.

To avoid the unattractiveness of falling wages the Fed is always increasing the amount of dollars. If they increase them too quickly, the supply of money exceeds the demand, and the value of dollars drops. The thing is, though, that when you inflate the currency, you get to spend the money first. That's the attractiveness of counterfeiting. It also explains why inflation is so common and deflation so rare. To deflate the currency, you need to buy dollars with hard goods, and then destroy them. It makes almost zero sense. Governments use inflation as a source of income.

Why dollar inflation is not likely any time soon

People who loan money are concerned about inflation. If they loan $1K, and the government prints up a matching $1K, they'll effectively get paid back only $500. That's why interest rates rise in the face of inflation. Lenders want to be paid back the same value that they loaned even if it has a different number on it. Lenders do whatever it takes to avoid inflation.

The Federal Government raises funds by taxing, selling bonds, and inflating the currency. To a very large extent, foreigners are buying the bonds. That's because they have a lot of dollars because they sold things to us in exchange for dollars. They are holding dollars because they expect that dollars will be worth more in the future. If the Federal Government tries to raise funds by inflation, these dollar-holders will sell off their bonds and buy something else that they expect will hold its value. If they try to convert those dollars into their own currency, the demand for their currency will rise and dollars fall. This is precisely where you see the value of the dollar changing: in the foreign exchange markets.

The trouble with a falling value of dollars is that it makes foreign goods more expensive. Because we buy so much products from abroad, expensive, not cheap dollars, are important. The Federal Government wants to continue this flow of cheap goods into the US, so it will refrain from activities which cause the dollar to fall in value.

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