Inflation, the rise in the price level (or simply put, the increase in prices), is how modern economics presents it to us. But is it really so? What are the impacts of inflation? And why should we even care? In this article, I will attempt to answer these questions and present inflation and its consequences for non-economists (economists, please bear with me).
—Translation of my article written in 2012.
Inflation was originally defined not as a price phenomenon (rising prices) but as a monetary phenomenon – an increase in the money supply or the amount of money in circulation. The rise in prices is its consequence, although it is now referred to as “inflation”. As inflation is like an invisible “tax,” this shift in understanding should not surprise anyone. If we perceive inflation as a price phenomenon (rising prices), it is easy to blame corporations, retail chains, or anything else that influences price increases. We may notice the “inflation” when shopping for everyday items. However, if we stick to the original definition (inflation is an increase in the money supply), our attention would be directed at the true culprits – central banks. Why? So, what is the deal with inflation then?
Introduction to Inflation
To illustrate, let’s imagine money as a regular commodity. After all, it aligns with the evolution of money. Originally, trade occurred through bartering goods for goods, a highly complicated process. Soon, a specific good/commodity was used as a medium of exchange. It could be grain, cloth, or even seashells… gradually, however, precious metals took over as money – gold and silver (they are relatively scarce, their supply doesn’t change much, and they are easily divisible). And today, we have legal tender in the form of paper notes. So, when we buy something, we can imagine constantly exchanging the purchased goods for “goods” in the form of paper (money).
When we approach money as a commodity, let’s now examine how the price of goods changes with an increase in supply. If goods are scarce, their price (value) is high. If there is a large quantity of goods, their scarcity and thus the price decrease. For illustration, I have used a supply (S) and demand (D) graph from Wikipedia (the resulting price of goods at a given quantity is determined by the intersection of the supply and demand curves). For example, if I offer a magazine (supply curve S1) and print more copies (increase supply), the supply curve shifts to S2. The quantity of magazines in circulation increases (shift to quantity Q2), and simultaneously, with unchanged demand, the price of the magazine decreases (shift to price P2).
Similarly, we can apply this to our paper notes (money). We have a quantity of paper notes in circulation, Q1, with a price (value) of P1. Let’s say that at these values, we can buy 10 loaves of bread with one paper note (the value of the note is 10, and the value of the bread is 1). However, if we increase the supply of paper notes (starting the printing presses is not a problem for the central bank at all), the quantity in circulation increases to Q2, and the price decreases to P2. If this price decrease corresponds to 10% (10% inflation), and nothing extraordinary happens to the loaves of bread, we would only be able to buy 9 loaves of bread with one paper note after this intervention (value of the note reduced to 9, value of the loaf still 1). The value of paper notes compared to other goods would decrease. Since we use paper notes for payment (expressing the price of goods in them), the prices of other goods must increase to reflect the decrease in the value of paper notes. The loaves of bread did not lose their value, but the paper notes did, and the change in their value must be reflected in the increased price of the loaves1. So what? Why should we care?
Impact of Inflation
We now know that an increase in the quantity of money in circulation raises the prices of goods and thus reduces our purchasing power. In other words, we can buy less – money loses value. This affects everyone, yet inflation is advantageous for certain entities. It benefits debtors in general and those who are the first to receive the new money.
How does it work then? The central bank prints new paper notes, which are distributed to banks and new debtors (God forbid if the government can also use these notes). These entities benefit from the new paper notes and make purchases at prices unaffected by the increase in money supply (inflation) until the market reacts with rising prices (a consequence of inflation), which takes some time. From that moment on, we all pay for the new money (with higher prices) until wages also adjust, which also takes some time (not to mention how long it takes for pension adjustments or tariff wages – if we even get them at all).
- Debtors have an advantage. They borrow, take advantage of the new paper notes, and when wages increase, loan repayment becomes slightly easier.
- Creditors lose out because they cannot make use of the paper notes during the loan period, and they will be happy if the interest at least covers the loss of value caused by inflation, let alone gaining anything by lending the paper notes. Yet loaning money can still be better than doing nothing with them.
Therefore, it is a certain redistribution of wealth, and that’s why we can consider inflation as a hidden “tax”. It is not imposed by the state and does not go into the public budget, but it fulfils some other characteristics of a tax – involuntariness, irreversibility, lack of equivalence (we are not entitled to any benefit), lack of purposefulness (we cannot influence the purposes for which the new paper notes are used).
Measurement and targeting of inflation
To determine how much this inflation taxation costs us, changes in the price level are monitored (the “inflation rate” – tracking the rise in prices, not the money supply) using so-called price indexes. For example, the Consumer Price Index (CPI) – tracks the price increase of a somewhat artificially created consumer basket (products and services consumed by an average household). Let’s leave aside the question of the CPI’s validity or how it is constructed. When we look at ShadowStats, where they calculate “inflation” in the US using an alternative index based on values from 1980, suddenly “inflation” is up to 7% higher. Interesting.
According to the Czech Statistical Office, the year-on-year increase in consumer prices in March 2012 was 3.8% in the Czech Republic. Well, no wonder, as one of the goals of the central bank is directly targeting “inflation”. Since January 2010, the inflation target has been set at 2% (the central bank makes sure that we have inflation). Admittedly, we do slightly exceed that target. It seems we can’t get rid of the motto “catch up and surpass”. If prices didn’t rise, it would probably indicate some unimaginable catastrophe (in a growing economy, on the contrary, prices would decrease, and the paper notes would suddenly gain value instead of losing it). That’s why inflation targeting is so important. In fact, you can convince yourself of the importance of controlling inflation by watching this beautiful video by the European Central Bank (watch at your own risk).
Inflation in practice
If you’re not sufficiently discouraged yet, let’s apply inflation in reality. Let’s take the payslip for March and reduce the net income by 3.8% (the inflation tax for March calculated by the statistical office, which in reality could be even 6% higher). No one will visibly deduct this amount from our paycheck (it’s just for illustration), but we will pay it in the price of purchased goods, which increases due to the increased supply of paper notes (inflation), or simply as the “mere” loss of paper note value if we let them lie idle.
Now, let’s look at how these paper notes beautifully serve as a store of value in the following example. Let’s put 100,000 paper notes in a safe today and check them after 10 years. Well… with an inflation target of 2%, the value of our deposit after 10 years will be 100,000 * 0.9810 = 81,707 (it will still be 100,000 in notes, but it will be like we have only 81,707 with today’s prices – the paper notes lose 2% of their value annually, and we haven’t even accounted for the actual “inflation” values, only the targeted 2%). Isn’t that great? Finally, now that you know how inflation works, imagine the potential impact of the action taken by the European Central Bank, which “printed” an additional 530 billion euros (530,000,000,000 €) in February. Yes, it’s exactly the same institution that boasts about controlling inflation in the video mentioned above.
Finally, a brief summary of what we should always remember about inflation:
- Inflation is not the rise in prices. According to the original definition, it is an increase in the money supply (money printing), which results in rising prices. With a stable supply of goods, prices of different products may rise or fall differently (depending on other influences), and it does not constitute inflation/deflation.
- Inflation is caused precisely by the apparent fighters against inflation – central banks – through the increase in the money supply.
- Due to inflation, our savings in money lose value instead of gaining value over time.
- Through inflation, we secretly finance entities that are the first to benefit from the new money.
- Inflation benefits borrowers at the expense of creditors.
It would be appropriate to propose an elegant and guaranteed solution to the situation at the end of the article, but I won’t do that. I am not capable of such a thing, and it probably wouldn’t make sense anyway. The goal is to inform, to pull you out of apathy, and to generate interest in this topic. As long as everyone remains indifferent, nothing will change. Therefore, let’s spread this information. Let’s not allow ourselves to be robbed!
- The price (value) naturally changes with changes in demand. In the case of paper notes, it would be the demand for purchasing power (I want to hold enough money to afford goods of a certain value). However, this demand is relatively stable and does not change much.