I've chosen an image by Escher for today's post because I hope it will provide you with a different way of looking at something, namely inflation.

Inflation is most often defined as the rise in price of goods and services over time. However, its less often quoted meaning is the loss of value of the currency. It's this second meaning that is more representative of what inflation truly is. I strongly believe the first definition is misleading, perhaps deliberately so, as we shall see.

We have become so accustomed to living in a society that uses money that we often take its units of measurement, be they Pounds, Dollars or Euros, as fixed, much like distances like metres and weights like kilograms. In reality, they are units of exchange and are thus subject to the laws of supply and demand.

Think back to a time before money. Perhaps a wheat farmer wanted some meat for his meal. He might exchange a bushel of wheat in the local town for a pig. One year, pork is particularly popular (demand has increased) and the pig farmer can command a higher price - the wheat farmer will need to exchange two bushels of wheat. Another year, the wheat crop across the country is poor (supply has gone down) and so this time the wheat farmer has the upper hand - he only needs to give the pig farmer half a bushel.

Money simply makes exchange easier - if the pig farmer didn't want any wheat, the wheat farmer would have to find someone with whom to exchange his wheat for something the pig farmer did want.

You can quickly see that money itself has no value - it is simply a piece of paper or cheap metal and has very little practical use. Things like pigs, wheat, computers, cars and houses have practical use and inherent value. The "value" in money comes from the fact that everyone agrees to exchange it for goods and services - hence the term fiat, from the Latin for "it shall be".

Money is simply a common unit of exchange and is therefore subject to increases and decreases in value depending on its supply and its demand.

Two of the unfortunate side effects of inflation being thought of in terms of "prices going up" rather than "value of money going down" are:

Blame for the prices can be misplaced. People grumble about how suppliers or perhaps "speculators" are pushing prices up. In reality, the mismanagement of the supply of money, primarily by the government and banks, is responsible for pushing the value of money down. The following graph shows how the value of the pound has fallen:

Reported prices of some goods are distorted. Because prices are usually reported in "nominal" terms (i.e. without factoring in the falling value of the currency), it can appear that price changes are constantly rising. Compare the curves on the following graph:

If you were following the announcements in the press about house prices between 1990 and 1996, you might think the value of a home had only fallen by about £10,000. In reality, because the value of the currency had also been falling during that period, the home would really have lost £80,000. The same will happen over the coming years but people who think in terms of "prices go up" rather than "value of money goes down" won't see it.

Rising house prices are often portrayed as a good thing in the media. They make home-owners feel good - their wealth is increasing and so they feel confident about spending today, rather than saving for the future. People who don't own a home see the rising prices and want to join in to benefit. As prices go up, demand falls and so the inevitable boom-bust cycle is formed. This is somewhat hidden when looking back at nominal pricing.

Hopefully, you'll never see money the same way again...


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