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Wednesday, 24 February 2010

Inflation: two definitions

Variable real value non-monetary items do not need to be and are not valued in units of constant purchasing power during low inflation because they are valued in terms of SA GAAP or IFRS at, for example, fair value, market value, present value, recoverable value, net realizable value, etc which always automatically take inflation - amongst many other things - into account. Variable items are only valued in units of constant purchasing power during hyperinflation as required by the IASB in IAS 29 since the board regards hyperinflation as an exceptional circumstance.

There is a school of thought that 2% inflation is completely unharmful and that it has no disadvantages compared to absolute price stability. That is not correct. 2% inflation will destroy, for example, 51% of the real value of all monetary items and all constant items never maintained, e.g. Retained Profits, over 35 years – all else being equal – when the stable measuring unit assumption is implemented for an indefinite period of time during indefinite inflation.

It is not necessary for accountants to inflation-adjust by means of the CPI, which is a general price index, variable real value non-monetary items (e.g. properties, shares, raw material, etc.) which are subject to product specific price increases for the purpose of valuing these variable items during the accounting period on a primary valuation basis during non-hyperinflationary periods. These variable items are generally subject to market based real value changes determined by supply and demand.

They incorporate product specific price changes or product specific inflation where the word inflation is, very unfortunately, also used to simply mean a product or product group price increase instead of the general use of the word in economics to mean the destruction of the real value of money over time, i.e. a destruction of the general purchasing power of money which is caused by/results in an increase in the general price level over time. The word inflation thus has two totally different but generally accepted meanings in economics: (1) inflation meaning the destruction of the real value of money and other monetary items over time and (2) inflation meaning any price increase.

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith