Sunday, 5 May 2013

Money Trees, and their effect on inflation

An introduction to inflation

Inflation has the effect of increasing the level of prices for goods and services over time. One benefit of inflation is that the government don't have to worry about those large loans they took out years ago, because that $100k has become easy to get hold of.  

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Negative effects of inflation include an increase in the cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation is rapid enough, there will be a shortage of goods, prices may change on a daily basis. Positive effects include ensuring that central banks can adjust their real interest rates, making debt cheaper, and encouraging investment in non-monetary capital projects. 

Inflation is the rate of increase in the general price level, so a 10% inflation rate means prices overall are 10% higher than a year ago. One example would be post war Germany. 

After world war 1 german was ordered to repay all the debts they had accumulated in funding the war machine. By November 1923, the American dollar was worth 4,210,500,000,000 German marks. Because war reparations were required to be repaid in hard currency and not the rapidly depreciating Papiermark, one strategy Germany employed was the mass printing of bank notes to buy foreign currency which was in turn used to pay reparations, greatly exacerbating inflation rates of the mark. 

Today the popular way to cause inflation is to get the Central Bank such as the United States Federal Reserve or the Bank of England to hike up interest rates thus promoting savings and reducing the velocity of the money (how quickly it changes hand)and thus prices. This could have the adverse effect that as many people have debts, their expenditure increases with a interest rate rise, yet their cutting out of unnecessary items still doesnt meet the usurious rates, so the wages have upward pressure applied and this would fuel inflation itself.

At one time there was the 'gold standard' in practice in many countries. This is where the price of money is linked directly to the gold it is worth, in effect the Federal Reserve technically would have to keep the gold equivalent to the cash in circulation. During the Great Depression every major currency abandoned the gold standard. The earliest to do so was the Bank of England in 1931 as speculators demanded gold in exchange for currency, threatening the solvency of the British monetary system. This pattern repeated throughout Europe and North America. In the United States, the Federal Reserve was forced to raise interest rates in order to protect the gold standard for the US dollar, worsening already severe domestic economic pressures.

Today most currencies adhere to the fiat system (latin for let it be) which means the cash is unbacked by any physical asset. A holder of a federal reserve note has no right to demand an asset such as gold or silver from the government in exchange for a note. Consequently, some proponents of the theory of value believe that the near-zero marginal cost of production of the current fiat dollar detracts from its attractiveness as a medium of exchange and store of value because a fiat currency without a marginal cost of production is easier to debase via overproduction and the subsequent inflation of the money supply.

The inflation rate is widely calculated by calculating the movement or change in a price index. The consumer price index measures movements in prices of a fixed basket of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price index over time. The Retail Price Index is the term of measure in the UK. It is broader than the CPI and contains a larger basket of goods and services. The one thing that remains the same is the amount you can work in a day, so a persons time is the only certainty in the prices of items.

Most countries' central banks will try to sustain an inflation rate of 2-3%.

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