Thursday, April 22, 2010

INFLATION AND CURRENCY

What is Inflation

1. Inflation = change in the value of money

A ringgit that I had in my pocket in 1969 could have bought a lot more than that same ringgit bill would buy today, if I had kept it in my pocket for 40 years. For example, in 1969 that ringgit would have bought about three comic books, about three times haircut, about three liter of gas, 4 bottles of Cokes, or 2 movie ticket (MATINEE). Today that same piece of paper would buy about one cup of syrup drink, one-fifteenth of a haircut, less than a liter of gas, half can of Coke, or a tenth of a movie ticket.The "nominal value" of that ringgit would have stayed the same --RM1.00. But the "purchasing power" of the ringgit has changed significantly over time. That change in purchasing power of a unit of money is what we call "inflation".

2. Inflation in Economic Terms.

In economics, inflation is an increase in the general level of prices. In particular, general inflation is a fall in the market value or purchasing power of money within the economy. (This is different from currency "devaluation", which is the fall of the purchasing power of a currency relative to the currencies of other economies.)The key concept is that the purchasing power of a unit of currency can change.Prices can also rise for reasons unrelated to the change in the purchasing power of a currency. For example, scarcity of supply may drive up the price of a commodity, such as oil or rice, due to depletion of oil fields or bad weather in paddy-growing regions. This restricted supply will drive up the price (assuming demand remains about the same). This is not quite the same as general price inflation due to a decline in the value of the currency.


3. "Real" vs. "Nominal"

Changes in the value of money make it difficult to compare economic statistics, prices, and so on from one period with those from other times. To compare "apples to apples" the currency units from different years have to be converted into equivalent "real" or "inflation-adjusted" units.For example, the current (nominal, March 2010) price of oil is about $80 per barrel. In 1980 the then-current, nominal price was about $40 per barrel. But in fact the real price of oil was much higher in 1980 than it is today! After adjusting for 29 years of inflation (change in value of the dollar), we see that the price of oil in 1980 was about $120 when expressed in September 2009 dollars. Thus the "real" price of oil is nowhere near its historical peak, though the "nominal" price is at a "record high".

What Causes Inflation?

Increase in the supply of money is thought to be one of the primary reason inflation occurs. If people have more money, the theory goes; they will bid up the price of goods (assuming the supply of those goods is not increasing as fast as the quantity of money in the economy).

There are several ways the supply of money can increase:
  1. Injection of new wealth into the economy
Gold and silver pouring in from the New World caused inflation in Europe that helped to wreck the economy of Spain in the 16th and 17th centuries.
Rapid increases in the value of assets (property or housing "bubbles" or stock market "bubbles" such as the dot-com bubble of the 1990s) give people the feeling that they have more money to spend, so they spend it, often on the same assets that are part of the bubble in the first place. Often they borrow against the increased value of the assets which are part of the bubble.

As a result of the artificial inflated asset price have led to the “Credit Crunch in banking industry in USA.

2. Borrowing

Low interest rates or inflated asset prices encourage borrowing, which puts more spend able money in the hands of the borrowers. This cash can be used to bid up prices for things those borrowers want. Credit cards are a tempting source of additional spending power for many people. (Malaysians currently owe about MYR 27.146 billion in unsecured credit card debt -- and this is only a fraction of the credit that credit card companies have extended to them. (Feb 2010 BNM Figures)

3. "Printing" of money by governments

Governments is always sorely tempted to overcome budget constraints by spending money they do not have. They can either print additional currency (or in earlier ages debase the coinage by reducing the quantity of gold or silver in it), or they can borrow money which they have no intention of paying back.

Deficit spending is usually a sign of future inflation, since governments rarely pay off their accumulated debts. If it is necessary to make the debt go away the government will either just repudiate it, refusing to pay its creditors, or devalue the currency it was borrowed in, by allowing inflation to decrease its worth, so that the old debt can be paid off with new currency that, while it nominally looks the same, is worth much less.

In addition to actual debt (money borrowed), most governments engage in over-promising -- they make commitments to pay out in the future money that they do not have and probably will not be able to obtain. For example, the United States government currently has public debt of about eight trillion dollars. In addition it has committed to make about $45 trillion worth future social security and other payments to its citizens. Since government income (taxes) will never be able to cover these promised expenditures, there is an almost overwhelming need for the government either to repudiate these obligations or to inflate the currency to make them easier to pay.

4. Deliberate inflationary policies

Populist political factions sometimes call for deliberate increases in the money supply in an effort to increase prices and reduce the burden of debts. An example is the “Free Silver Movement” in the U.S. in the last quarter of the 19th century.

5. Changes in people's attitudes toward the currency

If people come to believe that the money they possess will become less valuable in the future, due to inflation, they will try to spend it now rather than saving it. Anything that encourages present spending rather than saving increases the amount of money being spent on the (more or less fixed) amount of goods available, which will lead to bidding up of prices (inflation). This process can become cyclical as increasing inflation drives people to save even less and spend any available funds immediately. This may even result in “hyperinflation”.

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