Improving Our Standard of Living (Wattpad Edition)

Chapter 30: Monetary Policy

Recall that inflation means prices are going up. It has two causes:

One cause is a sudden increase in the scarcity of resources. This happened in the 1970s when the price of oil temporarily quadrupled due to the Arab oil embargo. The price of energy soared, increasing the cost of producing and transporting things. That's why prices went up.

The other cause of inflation is when the amount of new money added to the economy exceeds the number of goods and services produced. If hundreds of trillions of dollars were created, businesses would have to raise prices drastically. Otherwise, they would be bought out with dirt-cheap money.

If, however, hundreds of trillions of dollars' worth of new products were added to the economy, prices wouldn't go up at all. But society would be much wealthier. That's because, for every new dollar created, there's a new product for it to be spent on.

But if there isn't a new good or service for a new dollar to be spent on, then that dollar will just add to the prices of currently existing products.

In other words, inflation occurs when too much money is chasing too few goods.

If a country creates a bunch of currency and then stops, the inflation will be temporary. Prices will stabilize, even if everything costs more than before. Eventually, wages will catch up too. That's fine.

Take the Japanese yen for example. One dollar is worth about 100 yen. So everything in Japan costs 100 times more units of currency than in the United States. But Japanese workers earn 100 times more units of currency as wages. Perhaps Japan will one day use a new denomination as the new base currency and do away with the "low-value" yen altogether. Similarly, the US may get rid of the penny one day because its value drops every year. The nickel would become the new penny.

Inflation is always temporary unless too much money is continuously printed into circulation. Or unless resources become scarcer. Excluding scarcity, a nation can easily solve an inflation problem by printing less money. Prices and wages will stabilize. But if a country creates large quantities of money often, inflation will continue. Wages will never catch up, and loaning and borrowing will become difficult.

A slow but steady rate of inflation isn't necessarily bad. A poor country may hardly ever print money and therefore never experience inflation, but the people there are still poor. On the other hand, a rich country may experience inflation, but its population is wealthy despite the constant rise in prices.

Just because prices rise every year doesn't mean a nation's quality of life is falling. If prices rise, but wages go up by roughly the same amount, then people's purchasing power won't fall.

Rising prices are okay as long as money creation and inflation occur at a slow, steady, predictable rate.

According to the US Bureau of Labor Statistic's online CPI inflation calculator, in 1916, $5 was worth $110 today. In other words, someone with $5 in 1916 could buy $110 worth of goods and services today.

Some people hear that statistic and think, "Oh my! The dollar has collapsed!"

That's nonsense of course. There are simply more dollars in circulation today than there were in 1916. The prices of goods and services were lower back then, but so were wages.

Americans are much wealthier with today's "devalued" dollars than they were in 1916. Even though each dollar buys fewer goods, people have more dollars to spend. As a percentage of income, the average person can buy more goods with today's plentiful, devalued dollars than the number of products they could buy with rarer, higher value dollars in 1916. That's because there are more goods per person today, which means everyone is wealthier. When the number of products produced per person rises, people can always buy more stuff. (After you adjust for inflation and income inequality.) A basket of groceries took up a larger percentage of one's income in 1916 than it does today.