Outline:

  • Inflation represents the change in prices over time;
  • The Romans experienced inflationary pressures;
  • Supply-demand metrics underpin inflation readings;
  • Central banks try to control inflation by adjusting interest rates.

Have you ever been talking with someone older than you, and you find them constantly telling you how cheap things used to be? A coke was a dollar, a loaf of bread was 50 cents and a house in Sydney was nowhere close to $1 million?

That price difference is inflation.

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Just like Coca Cola, that was always five cents, until it wasn’t. Inflation has always been around, changing prices.

Even the Romans had inflation issues with their currency, denarius, which was first minted in 211 BC. When the denarius minted, it contained 4.55g of silver at 95-98% purity. By 274 AD, the denarius contained 3.41 of silver at 5% purity.

This is called debasement - it is the process of reducing the value of a currency. By reducing the value of the denarius, it took more money to buy the same thing, and the price of goods in the Roman empire rose by as much as 1,000%.

If we look a bit closer to home, over the past 26 years, Australia has had an average inflation rate of about 2.5%. The RBA says a basket of goods and services valued at $1,000 in 1990 would cost $1,898.17 in 2016. That’s an 89.8% increase.

And now, rather than debasing the coin, the government can place upward pressure on the inflation rate by printing money (which increases money supply) or engaging in quantitative easing (which changes the composition of the money supply).

For those of you who don’t know, quantitative easing is a monetary policy in which the central bank (i.e. the RBA) purchases government securities or other securities from the market to lower interest rates and inject financial institutions with capital that can be used to increase lending and liquidity.

While quantitative easing is considered an unconventional monetary policy, it has been implemented a lot in recent times to encourage economic growth including by the US central bank during the Global Financial Crisis of 2007-08, and, more recently, by the Bank of Japan and the European Central Bank.

Ok, but what is inflation?

Inflation is the increasing price of goods and services, measured as an annual percentage change. During periods of inflation, things get more expensive. A dollar buys less than it did a year before.

Periods of inflation mean decreasing purchasing power. Think of purchasing power as how much you can buy with one dollar. As an example, if inflation is higher, coca cola is more expensive, and you can buy less of it compared to last year. That is, your purchasing power has decreased.

Most modern economists favour a low and steady inflation rate - this has led to many governments setting an inflation target. In Australia, our inflation target is set between two and three percent. Recall, our long-term average inflation rate was 2.5% over the past 26 years.

What causes inflation?

There is no one thing that causes inflation, but there are a few common ideas.

One theory is inflation is caused by an increase in overall demand, causing an increase in price. Economists call this demand-pull inflation.

As demand outpaces supply, suppliers produce more, at a higher price, until demand is met. The below graph outlines this change through the movement from D1 to D2.

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Demand-pull inflation is often seen in high-growth economies. As living standards and incomes rise, so do the demand for goods and services.

Cost-push inflation is caused by an increase in the cost of factors of production (land, labour and capital). This causes the overall supply of goods to decrease. If demand stays the same, then the price will rise until demand is suppressed.

Money like any other commodity is subject to supply and demand, too. What this means is an oversupply of money can cause inflation - as supply goes up, value goes down, all else being equal. That means the price of every other good goes up with it, given that money is our medium of exchange. See the increase in supply below.

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What is the effect of inflation?

Inflation tends to benefit some people at the expense of others. As a property owner, higher inflation rates mean your assets are likely to appreciate in value.

If you have a fixed-rate loan, inflation tends to be great. Imagine your interest rate is 4% a year and your loan is $100,000. You must pay at least $4,000 to service the loan this year. If inflation rises, the real cost of the $4,000 decreases because you can buy less with that $4,000 than you could before. Now imagine if inflation exceeds your interest rate...

Inversely, if you have a lot of money in the bank that isn’t invested, you can suffer from cash-drag. Most bank accounts do not keep pace with inflation, so the real value of your money may actually be decreasing, despite the balance going up. This is because the money in the bank is likely losing purchasing power every year that it isn’t invested.

As inflation rises, employees tend to demand wage increases to keep pace with increasing prices. This can fuel inflation further, leading to a wage spiral, where prices go up then employees demand raises and then prices go up and so on.

Inflation isn’t all bad. The inverse, deflation, where prices fall, can cause people to hoard cash. People don’t want to spend the money today because it can buy more tomorrow, which leads prices to fall even further, then people don’t want to spend money, so on and so on. Economists call this a deflationary spiral.

Summary

Inflation is the increasing price of goods and services over time.

During periods of inflation, things get more expensive over time. A dollar buys less than it did a year before. It is usually measured as an annual percentage change.

We will come back to inflation again, and again because it’s such a central part of our economy and investing.