Inflation and Purchasing Power

Inflation and Purchasing Power

  • Different goods and service have different inflation rates
  • Inflation usually refers to Consumer (or Producer) Price Index which is a broad-based measurement of inflation across goods and services

Inflation measures the increase in price of goods or services.

If $1 could buy an apple last year and inflation was 50%. This year, the same $1 would only be able to purchase the equivalent of half an apple.

There are two perspectives to this situation. 

The price of the apple had gone up or the value of the dollar had went down.

Either way, it could be said that the purchasing power of the dollar had decreased as it is able to buy less things.

How is Inflation measured?

If an apple had its own inflation rate, it would make sense that other goods and services would also have their own inflation rate.

The inflation rate for an apple, TV, car, iPhone and haircut is all different.

These individual inflation rate does not mean much for consumers. As the price increment of an item could be matched by a price decrement of another.

There needs to be a broad-based measurement of inflation rate across goods and services. In this way, consumer would be able to know how much purchasing power the currency loses yearly.

Consumer Price Index (CPI) is a measurement of inflation across the various goods and services. There is also an inflation index, Producer Price Index, for goods and services that producers purchase.

However, there are some criticisms to the CPI. 

Firstly, it understate the actual inflation rate as takes into account the increase in ‘usefulness’ of the product. 10 years ago, phones used to cost $300 and today it is common for it to cost $1000+. However, some of the price increment is treated as the increase in ‘usefulness’ — better camera, touch-screen, apps — and not due to inflation.

Secondly, it does not include all types of expenditure. It includes medical expenses that are paid by consumer but not those that are covered by insurance.

Regardless, it is still used as the main measurement for inflation.

Causes of Inflation

In economics, it is common to mistake correlation with causation. In fact, many of these relationships are bi-directional and would reinforce one another.

Therefore, it is near impossible to distinguish them as indicators or causes of inflation.

Anyway , what is more important is the empirical evidence, whether the data agrees with the logic.

If they do not agree, it is likely that there are some nuances missed or flaw within the narrative. This method of probing one’s knowledge would allow investors to steer clear of noises from media or commonly propagated knowledge, and closer towards reality.

Increase in Money Supply

In an economic expansion, the public tend to have a positive economic outlook.

Consumers borrow from banks to make new purchases, new car, good food.

Business borrow to increase their production capability. They believe that the debt incurred could be paid off in the future either by an increase in wages or sales.

These borrowing mechanism injects more money into the system.

Demand for goods and services, driving prices up.

M2 vs CPI Graph

Empirically, the correlation between money supply and inflation is relatively weak as shown in the graph.

In my opinion, the difference between what should be the logical relationship between money supply and inflation could be a result of where the extra money supply go.

The money supply needed to go into the real economy in order to cause inflation. However, there are times when the money supply enter the financial market more than it does the real economy.

The stock market and the real economy had been growing more detached in recent times.

There are many mechanisms that affect the money supply. Fiscal policies (stimulus), Quantitative Easing and interest rate (refinancing of debt).

Therefore, it is best not to jump to conclusion with this false ‘indicator’ of inflation.

Increase in Money Velocity

An increase in money velocity have a similar effect to an increase in money supply.

A dollar spent on the purchase of an apple would be a dollar more in sales for the store owner. It is likely that he use it to buy more goods to stock up or increase the wages of his employees.

The dollar would circulate around the economy. A dollar could be spent multiple times by passing hands to the next person.

This is also known as the multiplier effect and is measured through money velocity.

M2V vs CPI Graph

The money velocity is more closely correlated to inflation than money supply.

Money supply could be up or down during recession as a result of policies implemented. While money velocity mostly decrease during recession.

Money velocity is a reflection of consumer’s confidence. If consumer is confident in the economy, they would spend more. Money would circulate more and inflation would go up.

Decrease in Interest Rate

I would start with the common knowledge of interest rate and its relationship with inflation.

A decrease in interest causes a rise in inflation. Consumers and businesses are encouraged to borrow and spend when interest rate fall.

A consumer that is looking to purchase a house might delay it as interest rate (mortgage) is too high. When interest rate falls, the loan would be more appealing and more people would borrow.

Logically, that makes a lot of sense. But how does it fare against the data?

Interest Rate vs Inflation Graph

Interest rate instead of being negatively correlated to inflation, it is relatively positively correlated.

Perhaps it is the decreasing inflation rate that pushes interest rate down? The causal relationship might be opposite from conventional knowledge.

Some economists even suggest that the rising interest rate would spur inflation!

It is best not to jump to any conclusion about causality between interest rate and inflation. Interest rate does not have clear causal relationship with inflation against what most think.

Just remember that they are positively correlated.

Decrease in Supply of Goods & Services

All previous factors affect the price of goods through the demand side of things.

However, it is also possible to cause inflation by having a lack in supply of goods. Its just that technology pushes the world’s production capability higher.

Conclusion

Inflation could be seen as the currency losing its purchasing power. A dollar would be able to purchase less things (in aggregate) the next year.

The main measurement that investors use to measure inflation is CPI. Producer Price Index could also be used though not as common.

Increase in money supply does not necessary cause inflation as it depends on where the money goes to. Real economy, financial market or saved up in bank deposit.

Increase in money velocity has been shown to have quite a close positive correlation with inflation. They tend to go up and down together. One reason might be that money velocity measures the ‘flow of money’ in the real economy, not taking into account the financial market.

Interest rate also has a positive correlation with inflation. Though the causal relationship is a bit complicated.

Inflation could also happen from the supply side of things, through a decrease in supply.

In the next article, we would touch on the assets that tend to perform during inflation.

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