UNDERSTANDING MONETARY INFLATION …

                    UNDERSTANDING MONETARY INFLATION
                                   ©2006 Simon R. Mouer III, PhD, PE

                                               General

        Inflation is a real phenomenon but over time tends to be a zero sum game for ordinary
people and organizations. Incomes of most ordinary individuals, working or retired, are
periodically adjusted for cost-of-living factors that are largely inflation adjustments so that real
income remains fairly constant. Sales prices of goods are adjusted periodically to account for the
effects of inflation. The revenues of governments of all levels -- federal state and local, are
largely based on percentage rates (e.g., sales and income taxes) and as such are adjusted
automatically for inflation to maintain constant real revenues. Why then does inflation have
such a bad press?
        Inflation can be a real problem for the wealthy, i.e., owners of capital (currency). Such
owners find their capital wealth (currency reserves) declining in value due to inflation. Such
decline in wealth can be offset by lending out the currency reserves at lending rates greater than
the rate of inflation. Borrowers pay off such loans in deflated dollars while their incomes are
generally indexed to inflation. Astute lenders factor in the anticipated rate of inflation when
establishing lending rates. Unanticipated changes in the rate of inflation from year to year cause
uncertainty in currency markets. 55

                                       Monetary Phenomena
        Inflation is a phenomenon well understood in high financial circles though perhaps little
understood outside those circles. Inflation is a monetary phenomenon. That is -- it is the
currency that changes in value, not the goods purchased. Technically, what we call inflation
is actually deflation of currency value. The term inflation applies to the price of goods and is the
commonly used term because it is directly observable. The deflation of currency value can only
be determined indirectly by observing the apparent inflation of the prices of goods and services
over a period of time. 36, 55, 60 To complicate the issue of identifying and measuring inflation, not
all price change is inflationary. Prices on individual commodities vary according to seasonal
supply and demand, uniqueness or obsolescence,
        While inflation is a concern for capital owners and lenders, it is a boon to borrowers in
that the payback over time is with increasingly deflated currency. The biggest borrowers tend to
be governments, including the US federal government. As such, governments tend to promote
inflationary policies. Central banks, on the other hand, tend to represent capital owners and tend
toward anti-inflationary policies. 55

                                         Price Changes 55, 60
        Inflation is reflected in a change in the price of goods but it is not the only factor involved
in price changes. Price changes occur for reasons other than inflation such as supply and
demand, regional surpluses and shortages, season, and obsolescence.
        While inflation is a monetary phenomenon, that is -- it is the currency that changes in
value, not the goods purchased -- it can only be determined indirectly and after-the-fact. Before
inflation can be estimated, season, demand, supply, inventories, and other factors must be
accounted for. In the US, the Bureau of Labor Statistics, under the US Department of Labor,


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estimates inflation from a "basket" of several key commodities. Price changes are tracked for the
entire basket and a consumer price index (CPI) calculated from the aggregate of all price
changes, assuming that temporary non-inflationary price adjustments for individual items cancel
each other out.

                                           Rate of Inflation
       Inflation is normally expressed as an annual rate calculated from the CPI from year to
year. The comparison points can be any month of the year, the December "end-of-year" value,
the annual average value, or even a semi-annual average value. The example below calculates
the end-of-year annual inflation rate for 2005:
        CPI2 Dec 2005:     196.8                Rate of inflation:  = (CPI2 ­ CPI1) / CPI1
        CPI1 Dec 2004:     190.3                                    = (6.5) / 190.3 = 3.4%
        Difference:          6.5
       Some experts, including Alan Greenspan, the recently retired Chief of the Federal
Reserve Bank, advise that the CPI slightly overstates the rate of inflation, and other formulas
using other financial data are also used to estimate inflation.

                                         Real Rate of Interest
Once a businessman has a handle on the rate of inflation is, He can calculate the real rate of
interest or set an appropriate contract rate of interest to protect himself. The relationship
between the rate of inflation, , the real rate of interest, r, and the contract rate of interest, i, was
defined by Irving Fisher in his 1933 publication Inflation, as follows:
        (1 + i) = (1 + r)·(1 + )        where i = the contract rate of interest
                                              r = the real rate of interest, and
                                               = the rate of inflation
The Fischer equation can also be written in more familiar form as
        i = r +  + r ·
The cross-product r · can be discarded for values of r and  below 10%, which reduces the
relation to:
        ir+
which is what we might have intuitively concluded.

                                       Money as a Commodity
          Money is more than just the medium of exchange for labor, goods and services. In and of
itself, it is also a commodity. Large projects typically need much more money than available on-
hand to fund a project. The additional cash is used to obtain labor, materials, equipment,
supplies, and services to turn into facilities and enterprises to earn profits. Since there is a finite
quantity of money available at any one time, demand for use of the money affects the "price" of
money. The price for the use of money is the premium we pay for the use of it ­ commonly
called "interest."



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        But there can also be a fundamental
change in the value of money due to the law
of supply and demand. If demand is fairly                                                 +
constant, and the supply is significantly                                                           S2
increased from Q1 to Q2, as shown in the
figure to the right, the result can be that the
entire supply curve shifts to the right from S1
to S2, and the value of money drops, from P1
to P2. If this occurs over a sustained period,
the result can be a permanent change in the
value of the monetary unit. An inordinate
increase in the supply of money is the classic
cause of inflation, and it is typically the
result of a government deliberately printing
additional currency in a vain attempt to
create wealth. History has demonstrated over and over through the centuries that such tactics
always result in inflation (a deflated currency.)
        Inflation can also be caused by a restriction in the supply of an essential commodity such
as crude oil. Oil is an energy source, and energy need is pervasive in a modern economy. The
high inflation rates in the US and Europe in the '80's is attributed to the oil cartel's success in
limiting production and raising crude oil prices. 55
         The supply and demand example explained above is a simplified model. In the real
world, both supply and demand can interact in a vicious cycle. As government increases the
supply of its currency in a vain attempt to create wealth, the currency falls in value, the demand
for the currency decreases, which prompts the government to print even more currency to make
up its loss in value, and so the cycle of increasing the supply and the fall in value of the currency
repeats until the currency becomes worthless or the economy collapses into a recession.

                                        Controlling Inflation
        As explained above in the Law of Supply and Demand model, the cause of inflation is
generally related to an unjustified expansion of the money supply 36. Money supplies are always
fluctuating to some degree, because worn out currency needs to be retired from circulation and
replaced with new currency, because some individuals and subgroups within a society tend to
hoard currency rather than let it circulate, and because currency is held in the foreign exchange
reserves of other countries.
       The money supply can be increased without causing inflation only if demand increases.
If demand falls, deflation can be avoided by decreasing the money supply. In the United States,
the money supply is typically controlled (or attempted to be controlled) by the Federal Reserve
Bank (central bank, in other countries) by varying the interest rate at which it loans money to its
member banks. The theory behind this is that the Federal Reserve Bank is the sole source of its
currency supply (for US dollar), and the rate of interest it charges affects the supply and demand
for US dollars ­ if the price of borrowing increase, the demand for currency will decrease.
        However, because the US dollar is the de facto international currency, and so much of it
is held by foreign markets, they can have more influence on its supply or demand than the
Federal Reserve Bank.


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                                          Inflationary - Deflationary Cycles
        Our experience over the centuries is that inflationary cycles are a permanent part of a
capitalistic economy. If left unchecked and unattended, inflationary cycles tend to spiral out of
control and end in a brief but brutal period of deflation we call a depression. A temporary
collapse of the economic system is the end of the cycle, with a permanent loss in the illusory
wealth created in the inflationary period.
         The positive effect of inflation is that it requires capital owners to invest in profit-making
ventures in order to counter the wealth-robbing effects of inflation. In an inflationary period, the
economy tends to expand as capitalist look for more opportunities to invest as a hedge against
inflation. However, investment in and of itself does not guarantee that profits exceeding the loss
to inflation will actually occur. There is a risk of losing money in an investment or capital
venture. In an inflationary period, the specter of reduction in capital value due to inflation is
what drives the potential investor to take the risk.
        So long as inflation occurs at a constant or low rate, or changes slowly, lenders and
investors can factor it into their decision-making process, and inflation is not a big concern.
Inflation becomes a concern when it begins to increases rapidly or unexpectedly. It is the
uncertainty of future inflation rates that cause inflation to be such a concern for long term
investments.
                                                Typical Inflationary Cycle                 Deflationary
                          160
                                             as reflected in the Stock Market                period

                          140

                          120
     Stock Market Index




                          100
                                                                     Inflationary period
                          80

                          60

                          40
                                        Real rate of growth
                          20

                           0
                                0   5             10              15               20               25    30
                                                              Time, years


         Stock market indexes can be useful in visualizing an inflationary cycle, as they represent
a significant segment of investments capitalists make to avoid losing out to inflation. The typical
inflation cycle is depicted in the figure above. In this depiction the start of an inflationary period
is at the bottom of depression, when the economy is finally starting to improve. Stock values
increase in little jerks of over-speculation followed by small corrections of sell-offs, gradually
increasing in speculation courage and retreats. Somewhere along the peak of inflationary cycle,
with the rate of inflation increasing ever more rapidly, investors begin to realize they may be
substantially over-committed. This realization seems to occur rapidly in the investor population,
and as a result there is a sudden divestment or abandonment of risky ventures. Capitalist begin

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to sell off even their solid capital assets in favor of holding cash or buying gold. There is an
investment retrenchment, production is reduced, jobs are eliminated, labor becomes cheaper as
unemployment grows, wage-earners have less income to buy goods and services, and the entire
economy contracts suddenly, spiraling into a depression ­ another name for the deflationary
period. For the ordinary man, it is indeed depressing, but for capitalist ­ their money increases in
value automatically, and there is no need to incur the risk attached to investment or capital
venture. Eventually, the economy begins to recover, production slowly begins to increase, and
the inflationary cycle begins again.

                                    General Effects of Inflation
       As stated in the introductory paragraph to this article, inflation over the long run is a zero
sum game for the society as a whole. In and of itself inflation is neither good nor bad, but an
auto-correcting mechanism for balancing money supply with currency value. Once created,
money takes on a life of its own, and obeys rules independent of the government that created it.
         But inflation can have a very pronounced effect on classes of currency users. Inflation
affects borrowers, lenders, and currency deposits differently. Owners of currency, particularly
individuals and institutions that have accumulated large amounts of currency (capital), suffer an
automatic wealth loss due to the deflation of the currency. That loss of wealth suffered by
capital owners is transferred as a wealth gain to borrowers, who repay loans in deflated currency.
It is an axiom that capital owners consider inflation as evil, while astute borrowers consider
inflation as a boon.
       Another class of currency user who is severely affected by inflation is the retiree on a
fixed pension. Every year such retirees see their fixed incomes decreasing in value and buying
less. Conversely, governments generally see their tax revenues rise, as most taxes are a
percentage of the price of goods, which increase with inflation.

                             Effects on Capital Construction Projects
        Inflation may adversely affect a fixed-priced construction project already under contract
with a very long duration because the contractor would be paid in increasingly deflated dollars
over the life of the project. Contractors bidding on such contracts must anticipate the effects of
inflation in their bid. Owners rarely include an adjustment for inflation as part of the contract
terms. More commonly, bidders price inflation into their bid by applying an estimated inflation
factor to the mid-point of construction. Most construction estimating manuals, such as Means 51,
include tables and charts for estimating inflation.
        Capital projects in planning are not affected by inflation in real terms. They are routinely
estimated in one year's currency (e.g., 1980 dollars), and if delayed, recast in another year's
dollar (e.g., 1990 dollars). The cost in original dollars (e.g., 1980 dollars) does not change unless
additions or deletions in project scope or made. What changes is that inflated costs (actually
deflated dollars) must be accounted for 51, 55.
        A cost estimate for a future project is generally priced at published prices for labor,
equipment and materials current at the time the estimate is prepared, but project costs can be cast
in any year's dollar value. If a future project is deferred from one year to the next (e.g., 1990 to
1991) during a budget processes, future project costs might need to be adjusted for the new



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intended time frame of execution. Such a recast is not a construction cost growth over the
original estimate, but merely an adjustment for anticipated inflation.
        Construction cost-estimates are normally adjusted for the effects of inflation, by applying
the estimated inflation rate at the mid-point of construction. Construction estimating manuals,
such as Means 51, contain graphs or numerical data for estimators to adjust project costs
accordingly.
        Means Estimating Manual cautions that comparisons of one project to another must be
made in the same dollar base 51. Comparisons of project A to project B must be made in the same
dollar base. For example, suppose project A occurred in 1990 at a cost of $19901 million, and
project B occurred in 1991 at the cost of $19911.05 million. If the rate of inflation from 1990 to
1991 was 5% then project A and project B both cost $1 million in 1990 dollars. The effect of
deflated dollars on project B is not a construction cost growth over project A.

                                             Summary
         Inflation is neither good nor bad for society as a whole, but classes of currency users do
feel its effects. Capital owners suffer loss of wealth, while borrowers enjoy a corresponding gain
in wealth. Individuals on fixed incomes suffer a reduction in buying power, while tax authorities
enjoy a rise in tax revenues as a result of rising prices on the goods taxed.
        Inflation gets its name by the price increase of goods and services, but the real
mechanism is the decrease in value of the monetary unit, which is reflected as an increase in
price of goods and services. The classical cause of inflation is a significant increase in the supply
of money without any corresponding increase in demand. Since money obeys the law of supply
and demand, the effect of the increase in supply is to decrease the value of the monetary unit,
other factors held constant.
        Inflation can be controlled by limiting the infusion of new money into the economy
consistent with the rise in demand, and removing currency from circulation when demand falls.
Governments which increase the money supply to create wealth will find that inflation will
automatically follow to negate their attempts.
        Central banks, including the US Federal Reserve Bank, attempt to control inflation by
increasing the rate at which they loan money to their member banks. This is only partly
successful in the US because the US dollar is the de facto international currency, and US dollar
reserves held by other countries can significantly affect supply and demand.




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