The year is 2045 and life bears little resemblance to today. The modern economy collapsed following the destruction of the American empire in the depression of the 2030s following the third great war in 2026. Pockets of humanity have begun to rebuild from the ashes as feudal societies emerge in the craters of ancient cities. You are a high-ranking official put in charge of overseeing the economic growth of your new community. You immediately identify a problem that may potentially hamper growth – your town utilizes a barter system, trading goods for services directly.
You, an intrepid sort, take it upon yourself to find a more efficient system of exchange, and invent a monetary system around units of currency called dulers (unfortunately, literacy rates aren’t what they used to be. For the sake of efficiency, we’ll call it a dollar.) As with the birth of any new currency, you must first create the value this dollar represents. Lacking both the metal gold itself and a use for shiny nonsense, you choose instead to utilize a fiat system, meaning currency is backed by governing decree. This allows for the store of value to exist because, in times of scarcity, dollar value is not tied to a finite good (commodity money), but represents a claim on its own value (representative money).
At first, your experiment is a great success – the simplified medium of exchange no longer requires individuals to cede tracts of land for services rendered. But a problem emerges when the village experiences a shortage of cows, and the price of beef rises to unbearable heights. All of a sudden, the value of a cow skyrockets while the value of money fails to rise accordingly. You scramble to adjust, raising interest rates to make money more expensive to borrow, and therein more valuable, but it is too late: your precious duler has lost all semblance of sensibility, and you must watch as villagers push wheelbarrows of paper currency to stores in an effort to buy a quarter pound of grazing grass fed German Angus.
Inflation, the rate at which the value of goods and services rises and the purchasing power of a single unit of currency falls, is inherently difficult to understand and even tougher to manage. Inflation is marked by an inflation rate, measured via thorough examination of goods included in the Consumer Price Index (CPI), an index that measures the market price level of a basket of consumers goods and services purchased by households. This index excludes volatile goods, such as food and energy prices, to ensure that data is not skewed. The relationship goes that as goods and services become more expensive, the relative value of a dollar falls. It is the responsibility of the Central Bank to ensure that dollar inflation, or deflation (where the value of goods decreases relative to the value of the dollar) is managed to prevent a positive feedback loop that sees wheelbarrows full of currency being needed to purchase pieces of short horned cattle.
Central banks manage a variety of tasks, all of which centre around creating long-term, stable growth and creating wealth for the highest possible number of people. The key word is stable – maintaining a consistent inflation rate means focusing on the supply of money itself. Preventing large volumes of capital from entering or exiting the financial system at any one time is the simplest measure of doing this – history is abound with examples of empires going bankrupt from acquiring too much wealth at any one time, flooding the market with value and reducing the value of the dollar as a unit of currency (what is the use of one dollar when you are surrounded by piles of gold?). Examples also exist of the opposite – the recent demonetization of 86% of distributed rupees in India saw consumer spending nosedive and inflation hit it’s lowest rate in two years (an economy with 7% growth targets can scarcely afford lack of inflationary stability).
This swift entrance and exit was a bigger problem when currencies were backed by precious metals. But given that fluctuations in money supply still impact value, and money is created via government decree, policymakers can use these fiscal policy tools to fluctuate value when desired. Pulling the value of money in one direction versus another has its benefits: inflation, manifesting in the form of increased investment or economic growth, can be an indicator of a strong economy, is a prompt to adjust wages and pricing, furthering economic growth for all parties and avoiding stagnation. It is also incredibly useful for borrowers, ensuring that the value of cash rises with interest rates, meaning they can ideally be repaid without direct loss. Deflation, the decrease in the value of goods relative to a dollar, can be advantageous for consumers in the short-term, but is indicative of a lack of spending or investment overall, meaning that there is no wealth being created, and that a salary paid to an individual will be actually be worth less in the long run than it was when they started (given that the price of goods fluctuates in the short run, this is not a good thing for individuals or economies).
A typical target rate for inflation for Central Banks the world over is 2%. Inflation or deflation at extremes see the word Hyper added to each. Hyperdeflation can see the value of goods being driven so low that each unit of money becomes incredibly expensive to acquire, fuelling such periods as the Great Depression and the Asian Tiger Crisis in the late 1990s. Hyperinflation, where the value of goods skyrockets corresponding to the value of a dollar, has resulted in scenarios such as late 2000s Zimbabwe, where in 2008 a single US dollar could be converted to the local currency for the measly sum of $2.6T ZWD. Comical images and economic collapse aside, the country fully switched over to utilizing the American dollar in 2015.
Inflation has such wide-ranging impacts, we often fail to recognize that it is the fundamental reason why our economy can exist: Investment into equity, such as housing, or debt, such as bond purchases, would be non-sensical were it not for the tendency of money to increase in value over time. Hyperinflation sinks entire nations, and hyperdeflation can cause depression that sinks entire regions. The very nature of economics and money having value itself is tied to this concept – without it, stagnant currency would have long ago been done away with, as it would have failed to suit the needs of today’s economy and present value would be all there was to financial calculations. All you would have is cash without the cows.