Inflation And The Money Supply (Guide)

Inflation is primarily caused by an increase in the money supply that outpaces economic growth. Ever since industrialized nations moved away from the gold standard during the past century, the value of money is determined by the amount of currency that is in circulation and the public’s perception of the value of that money. 

Whenever the Federal Reserve decides to put more money into circulation at a rate higher than the economy’s growth rate, the value of money can fall because of the changing public perception of the value of the underlying currency. As a result, this devaluation will force prices to rise due to the fact that each unit of currency is now worth less.

In 1980, in the United States – just few decades ago – a new home cost an average of $76,000, and the median income was $17,710 per year. Compare that to 2011, when even after the recession, the median home price stood at $139,000, and median household income was $50,233 per year according to the US Census Bureau.

Why the vast difference in prices? One word: Inflation. Like aging or weight gain, the effects of inflation are both gradual and profound. Inflation creeps up on us over time, and as we continue our normal spending and consumption habits, the almost imperceptible increase of consumer prices doesn’t seem to make a huge difference in our day to day finances – which means it is all too often vastly underestimated.

But the effects of inflation are huge. And it doesn’t just affect areas like our salaries and the cost of purchasing a new home. Inflation hits us from every angle. Food prices go up, transportation prices increase, gas prices rise, and the cost of various other goods and services skyrocket over time

To put it simply, inflation is the long term rise in the prices of goods and services caused by the devaluation of currency. Inflationary problems arise when we experience unexpected inflation which is not adequately matched by a rise in people’s incomes. If incomes do not increase along with the prices of goods, everyone’s purchasing power has been effectively reduced, which can in turn lead to a slowing or stagnant economy.

All of these factors make it absolutely essential that it account for the huge impacts that inflation can have on your long-term savings and ability to fund your golden years of retirement. One way of looking at the money supply effect on inflation is the same way collectors value items. The rarer a specific item is, the more valuable it must be. 

The same logic works for currency; the less currency there is in the money supply, the more valuable that currency will be. When a government decides to print new currency, they essentially water down the value of the money already in circulation. 

A more macroeconomic way of looking at the negative effects of an increased money supply is that there will be more dollars chasing the same amount of goods in an economy, which will inevitably lead to increased demand and therefore higher prices.

National Debt can also course inflation. We all know that high national debt is a bad thing, but did you know that it can actually drive inflation to higher levels over time? The reason for this is that as a country’s debt increases, the government has two options: they can either raise taxes or print more money to pay off the debt.

A rise in taxes will cause businesses to react by raising their prices to offset the increased corporate tax rate. Alternatively, should the government choose the latter option, printing more money will lead directly to an increase in the money supply, which will in turn lead to the devaluation of the currency and increased prices as discussed earlier.

Similarly, demand-pull effect which states that, as wages increase within an economic system (often the case in a growing economy with low unemployment), people will have more money to spend on consumer goods. This increase in liquidity and demand for consumer goods results in an increase in demand for products. 

As a result of the increased demand, companies will raise prices to the level the consumer will bear in order to balance supply and demand which result in inflation. An example would be a huge increase in consumer demand for a product or service that the public determines to be cheap. For instance, when hourly wages increase, many people may determine to undertake home improvement projects. 

This increased demand for home improvement goods and services will result in price increases by house-painters, electricians, and other general contractors in order to offset the increased demand. This will in turn drive up prices across the board. Another factor in driving up prices of consumer goods and services is explained by an economic theory known as the cost-push effect. 

Essentially, this theory states that when companies are faced with increased input costs like raw goods and materials or wages, they will preserve their profitability by passing this increased cost of production onto the consumer in the form of higher prices. On a day-to-day basis, we as consumers may not care what the exchange rates between our foreign trade partners are, but in an increasingly global economy, exchange rates are one of the most important factors in determining our rate of inflation.

When the exchange rate suffers such that a local currency becomes less valuable relative to foreign currency, this makes foreign commodities and goods more expensive to consumers while simultaneously making goods, services, and exports cheaper to consumers overseas.

This exchange rate differential between our economy and that of our trade partners can stimulate the sales and profitability of corporations by increasing their profitability and competitiveness in overseas markets. But, it also has the simultaneous effect of making imported goods more expensive to consumers.

Strategies To Combat Inflation’s Effects

If you are planning to retire in 2050, a rate of inflation approximating 3% per year will result in $1 million dollars having the purchasing power of $325,000 of today’s dollars. How long will $325,000 carry you? If your current cost of living is around $50,000 a year, you can see that $1 million will only carry you through about 6 years in retirement assuming you do not have supplemental sources of income.

So, what can be done to combat inflation’s detrimental effects on savings? How do you adjust your portfolio for inflation?

Contrary to public belief or opinion, we aren’t helpless in combating the role inflation can play in our lives. Many strategies can act as a hedge against inflation, but these techniques must be employed strategically and effectively in order to take advantage of their benefits. The best ways to combat inflation are as follows:

Gold, silver, and other precious metals have an inherent value that allows them to remain immune to inflation. In fact, gold used to be the preferred form of currency before the move to paper currency took place. Moreover, real estate has historically offered an inflationary hedge. The old saying goes: “land is the one thing they aren’t making any more of.” Investing in real estate provides a real asset. 

In addition, rental property can offer the landlord the option of increasing rent prices over time to keep pace with inflation. Plus, there’s the added alternative of the ability to sell the real assets in the open market for what normally amounts to a return that generally keeps pace with or outstrips inflation.

Commodities, like oil, have an inherent worth that is resilient to inflation. Unlike money, commodities will always remain in demand and can act as an excellent hedge against inflation. You can consider commodity-based Exchange Traded Funds (ETFs) which offer the liquidity of stocks with the inflation hedging power of commodity investment. Just be careful and watch out for the problems of ETFs.

Although investing in bonds may feel safer, historically, bonds have failed to outpace inflation, and have at times been crushed during hyper-inflationary periods. Over the long term, the only source of inflation-beating returns has been the stock market. Equities have historically beat bonds because of the ability of corporations to pass price increases along to their consumers, resulting in higher income and returns for both the company and its investors.

At close on Dec. 12, 1980, a share of Apple Inc. (AAPL) cost $29 in current (not inflation-adjusted) dollars. According to Yahoo Finance, that share would be worth $7,035.01 at close on Feb. 13, 2018, after adjusting for dividends and stock splits. The Bureau of Labor Statistics' (BLS) CPI calculator gives that figure as $2,449.38 in 1980 dollars, implying a real (inflation-adjusted) gain of 8,346%.

Dividend stocks on the other hand, offer a hedge against inflation because dividends normally increase on an annual basis at a rate which outpaces that of inflation. This almost guarantees stock price appreciation at a similar pace, while offering the further benefit of compounding when dividends are reinvested. 

Exhaustive research by Wharton School of Business economist Jeremy Siegel reveals that, large cap dividend paying stocks have provided an inflation-adjusted 7% per year return in every period greater than 20 years since 1800. If you have the investment risk tolerance for the volatility and a time horizon of greater than 20 years, consider dividend-paying securities.

You can also combat inflation by buying and selling collectibles. This can actually offer great inflation-adjusted returns, while also being a fun and interesting hobby. The strategic acquisition of photography, paintings, sculptures and other art can often provide inflation-beating returns, though certainly not always. Find the best of both worlds, a valuable piece of fine art that you truly appreciate and will not be in a hurry to sell.

The fact is that you are probably going to need a lot of more money as you grow older than you think you will. There are two ways to get to your new benchmark: Save more, or invest more aggressively.

In order to beat inflation, you can also consider TIPS. Treasury Inflation Protected Securities (TIPS) are guaranteed to return your original investment along with whatever inflation was during the lifetime of the TIPS. But TIPS do not offer the opportunity for significant capital appreciation, and therefore should only make up a portion of your personal investment portfolio allocation.

Like it or not, inflation is real. Ignoring the effects that inflation can and will have on your long-term savings is probably one of the biggest mistakes that many investors make. Understanding the detrimental causes and effects of inflation is the first step to making long-term decisions to mitigate the risks.

Each month, the Bureau of Labor Statistics (BLS) publishes a press release that reports recent changes in the CPI by product category and for several large metropolitan areas in the United States. Another measure of inflation is the Personal Consumption Expenditure Chain Price Index or PCE Price Index. The PCE price index is published by the Bureau of Economic Analysis and measures inflation across the basket of goods purchased by households.

The September 1999 Ask Dr. Econ question notes that inflation is commonly measured by "either a Gross Domestic Product Deflator (GDP Deflator) or a Consumer Price Index (CPI) indicator. The GDP Deflator is a broad index of inflation in the economy; the CPI Index measures changes in the price level of a broad basket of consumer products."

The sharp rise in the price of imported oil during the 1970s provides a typical example of cost-push inflation. Rising energy prices caused the cost of producing and transporting goods to rise. Higher production costs led to a decrease in aggregate supply and an increase in the overall price level.

While the differences in inflation noted above may seem simple, the cause of price level changes observed in the real economy are often much more complex. In a dynamic economy, it can be especially difficult to isolate a single cause of a change in the price level.

In the 1980s, the UK experienced rapid economic growth. The government cut interest rates and also cut taxes. House prices rose by up to 30% -fuelling a positive wealth effect and a rise in consumer confidence. This increased confidence led to higher spending, lower saving and an increase in borrowing. 

However, the rate of economic growth reached 5% a year – well above the UK’s long-run trend rate of 2.5 %. The result was a rise in inflation as firms could not meet demand. It also led to a current account deficit. In 2011/12, the UK experienced a rise in cost-push inflation, partly due to the depreciation of the Pound against the Euro.

Conversely, rising house prices do not directly cause inflation, but they can cause a positive wealth effect and encourage consumer-led economic growth. This can indirectly cause demand-pull inflation. There are five circumstances that create demand-pull inflation. The first is a growing economy. As people get better jobs and become more confident, they spend more.

As prices rise, they start to expect inflation. That expectation motivates consumers to spend more now to avoid future price increases. That further boosts growth. For this reason, a little inflation is good. As a result, the Federal Reserve sets an inflation target to manage the public's expectation of inflation. It's at 2 percent as measured by the core inflation rate. 

The core rate removes the effect of seasonal food and energy cost increases. The third circumstance is discretionary fiscal policy. The government's ability to spend more or tax less increases demand in some areas of the economy. Marketing and new technology create demand-pull inflation for specific products or asset classes. The asset inflation that results can drive widespread price increases. Asset and wage inflation are types of inflation.

Over-expansion of the money supply can also create demand-pull inflation. The money supply is not just cash, but also credit, loans, and mortgages. When the money supply expands, it lowers the value of the dollar. When the dollar declines relative to the value of foreign currencies, the prices of imports rise. In the long run, it can also trigger cost-push inflation. 

Companies that import materials may need to raise their prices to cover the increased cost of their supplies.

How Does The Money Supply Increase?
  • Through expansionary fiscal policy or expansionary monetary policy.
  • The federal government executes expansionary fiscal policy.

It expands the money supply through either deficit spending or printing more cash. Deficit spending pumps money into certain segments of the economy. It creates demand-pull inflation in that area. It delays the offsetting taxes and adds it to the debt. It has no ill effect until the ratio of debt to gross domestic product approaches 90 percent.

The Federal Reserve controls expansionary monetary policy. It expands the money supply by creating more credit with the use of its many tools. One tool is lowering the reserve requirement. It's the amount of funds banks must keep on hand at the end of each day. The less they have to keep on reserve, the more they can lend.

There are five contributors to inflation on the supply side also known as cost-push inflation. The first is wage inflation that increases salaries. It rarely occurs without active labor unions.

A company with the ability to create a monopoly is a second contributor to cost-push inflation. That's because it controls the supply of a good or service. The Sherman Anti-Trust Act outlawed monopolies in 1890.

Moreover, natural disasters create temporary cost-push inflation by damaging production facilities. That's what happened to oil refineries after Hurricane Katrina. The depletion of natural resources is a growing cause of cost-push inflation. For example, overfishing reduces the supply of seafood and drives up prices.

Government regulation and taxation also reduce supplies. In 2008, subsidies to produce corn ethanol reduced the amount of corn available for food. This shortage created food price inflation. When a country lowers its currency's exchange rates, it creates cost-push inflation in imports. That makes foreign goods more expensive compared to locally produced goods.

In most cases, the urge to spend and invest in the face of inflation tends to boost inflation in turn, creating a potentially catastrophic feedback loop. As people and businesses spend more quickly in an effort to reduce the time they hold their depreciating currency, the economy finds itself awash in cash no one particularly wants. In other words, the supply of money outstrips the demand, and the price of money – the purchasing power of currency – falls at an ever-faster rate.

When things get really bad, a sensible tendency to keep business and household supplies stocked rather than sitting on cash devolves into hoarding, leading to empty grocery store shelves. People become desperate to offload currency, so that every payday turns into a frenzy of spending on just about anything so long as it's not ever-more-worthless money.

Another way of looking at central banks' role in controlling inflation is through the money supply. If the amount of money is growing faster than the economy, money will be worth less and inflation will ensue. That's what happened when Weimar Germany fired up the printing presses to pay its World War I reparations, and when Aztec and Inca bullion flooded Habsburg Spain in the 16th century. 

When central banks want to raise rates, they generally cannot do so by simple fiat; rather they sell government securities and remove the proceeds from the money supply. As the money supply decreases, so does the rate of inflation.

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