Inflation refers to the general rise in prices of goods and services, causing money’s purchasing power to fall. Governments and central banks typically manage inflation to maintain a stable economy, often aiming for a rate of around 2-3% annually.
Monetarists, led by economist Milton Friedman, believe that inflation is mainly driven by changes in the money supply. Their model, known as the Quantity Theory of Money, states that the amount of money in circulation directly impacts a currency's value.
A group of economists (led by Milton Friedman) named the Monetarists believed that money supply is the main player in inflation, not markets. For instance, the Federal Reserve (the central bank in the U.S.) can print more money to increase supply or sell Treasury bills to decrease it. Public institutions play a major role in stabilizing their respective currencies through monetary policy. Their ideals are based on the Quantity Theory of Money, which states that changes in money supply will change the value of the currency.
The Equation of Exchange best illustrates this:
MV = PY
Where:
M = money supply
V = velocity of money, defined as how many times a unit of currency is involved in transfers per year
P = price level
Y = economic output of goods and services
In the Equation of Exchange, total spending (MV) is equal to total sales revenue (PY). V and Y are generally considered constant by economists; the number of transactions a currency goes through a year and the total economic output are certainly less volatile than the money supply or price level. By assuming V and Y to be relatively constant, what's left are M and P, which leads to the Quantity Theory of Money, which states that the money supply is directly proportional to the value of the currency.
In the U.S., the Department of Labor is responsible for calculating inflation from year to year. Usually, a basket of goods and services on the market are put together and the costs associated with them are compared at various periods. These figures are then averaged and weighted using various formulas and the end result in the U.S. is a number called the Consumer Price Index (CPI).
As an example, to find the inflation from January 2016 to January 2017, first, look up the CPI for both months. Historical CPI data can be found on The Bureau of Labor Statistics website:
Calculate the difference:
242.839 - 236.916 = 5.923
Calculate the ratio of this difference to the former CPI:
5.923 ÷ 236.916 = 2.5%
The inflation from January 2016 to January 2017 was 2.5%. When the CPI for the former period is greater than the latter, the result is deflation rather than inflation.
While the example given above to calculate CPI might portray inflation as a simple process, in the real world, measuring the true inflation of currencies can prove to be quite difficult.
Take, for instance, the basket of goods and services used to determine inflation from period to period. It is hard to distinguish whether the prices for these goods and services fluctuate based on changes in quality or inflation. For example, did the price of a computer really inflate that much, or was it due to new breakthrough technology that made them cost more?
Dramatic rises or falls in the prices of certain things can destabilize the situation. For instance, hikes in oil prices will lead to higher inflation, but this is temporary and may create false impressions of higher inflation.
People who are part of different demographics can be affected differently by inflation rates. As an example, high oil prices create higher inflation for truck drivers but affect stay-at-home mothers to a lesser degree.
Inflation is most impactful to people who hold large amounts of liquid cash sitting idle. Using the inflation rate of 2.5%, a checking account (that doesn't earn interest) with $50,000 will result in a loss in the real value of $1,250 by the period's end. It can be seen that when it comes to protecting money from inflation, whether moderate or severe, it is generally best to do something other than storing it somewhere that doesn't earn interest.
It is common for people to purchase real estate property, stock, funds, commodities, TIPS, art, antiques, and other assets to hedge against inflation. All these investment options have pros and cons. Investors usually own more than one type of these assets to manage risk. Commodities and TIPS are discussed more often because they are closely related to inflation. However, they are not necessarily the best investment hedge against inflation.
Investing in commodities, which include gold, silver, oil, copper, and many raw materials or agricultural products, is one of the popular ways through which a person can protect themselves from inflation because commodities are items that have intrinsic value. In addition, during times of high inflation, as money loses its value, demand for commodities can increase their value. For many centuries, gold was traditionally viewed as an effective resource with which a person could hedge against inflation because it is a finite resource with value that can be stored easily. While other precious metals can be used to hedge against inflation, gold is the most popular.
In the U.S., there are financial instruments called TIPS, or Treasury Inflation-Protected Securities. These are bonds issued by the U.S. Treasury that specifically provide protection against inflation. Because the principal of a TIPS is proportional to inflation, as measured by indices such as the CPI, TIPS acts as a relatively effective hedge against periods of high inflation. They usually only make up very small portions of people's portfolios, but anyone seeking extra protection can choose to allocate more room in their portfolio toward TIPS. Because they are largely unrelated to stocks, which are usually the bulk of portfolios, they are also great for diversification purposes. Other countries also offer similar inflation-indexed bonds, such as the United Kingdom's index-linked gilt, Mexican Udibonos, or German Bund index.