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Saturday, 2 April 2011

Inflation is always and everywhere a monetary phenomenon

Inflation is always and everywhere a monetary phenomenon.

Milton Friedman, A monetary history of the United States 1867 - 1960 (1963)

http://books.google.com/books?id=Q7J_EUM3RfoC&pg=PR3&dq=Milton+Friedman,+A+monetary+history+of+the+United+States+1867+-+1960+(1963)&ei=L5A6SYXMBIy4yATAw9ChBw#PPP1,M1

Inflation is a sustained annual increase in the general price level of goods and services in an economy. Prices are generally quoted in terms of money. When the general price level rises more than the annual increase in real value in the economy, each unit of the monetary unit buys fewer goods and services; consequently, annual inflation only erodes the real value of each monetary medium of exchange unit evenly over time. Inflation has no effect on the real value of non-monetary items.

Annual inflation erodes real value evenly in money and other monetary items over time. There are, consequently, hidden monetary costs to some and monetary benefits to others from this erosion in purchasing power in monetary items that are assets to some while - a the same time - liabilities to others; e.g. the capital amount of loans. The debtor (in the case of a monetary loan) gains during inflation since he or she has to pay back the nominal value of the loan, the real value of which is being eroded by annual inflation. The debtor (of a monetary loan) pays back less real value during inflation. The creditor (in the case of a monetary loan) loses out because he or she receives the nominal value of the loan back, but, the real value paid back is lower as a result of inflation. Efficient lenders recover this loss in real value by charging interest at a rate higher they hope will be higher than the actual inflation rate during the period of the loan.

An increase in the general price level (inflation) erodes the real value of money and other monetary items with an underlying monetary nature, e.g. the capital values of bonds and loans. However, inflation has no effect on the real value of variable real value non-monetary items (e.g. property, plant, equipment, cars, gold, inventories, finished goods, foreign exchange, etc.) and constant real value non-monetary items (e.g. issued share capital, retained profits, capital reserves, other shareholder equity items, salaries, wages, rentals, pensions, trade debtors, trade creditors, taxes payable, taxes receivable, deferred tax assets, deferred tax liabilities, dividends payable, dividends receivable, etc.).


Fixed constant real value non-monetary items never updated are effectively treated like monetary items by accountants implementing the stable measuring unit assumption as part of the HCA model during low inflation. Implementing the HCA model unknowingly, unintentionally and unnecessarily erodes their real values at a rate equal to the annual rate of inflation because they are measured in nominal monetary units during low inflation. Inflation only erodes the real value of money which is the nominal monetary unit of account in the economy. This unknowing, unintentional and unnecessary erosion in fixed constant real value non-monetary items never maintained constant during low inflation stops when accountants choose to measure financial capital maintenance in units of constant purchasing power. It is thus the implementation of financial capital maintenance in nominal monetary units in terms of the Historical Cost Accounting model and not inflation that is doing the eroding.

The extremely rapid erosion of the real value of money during hyperinflation is compensated for by the rejection of the stable measuring unit assumption in International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. IAS 29, which has to be implemented during hyperinflation, requires all non-monetary items (variable real value non-monetary items and constant real value non-monetary items) to be measured in units of constant purchasing power by inflation-adjusting them in terms of the period-end CPI. The stable measuring unit assumption is thus rejected in the presentation of restated Historical Cost or Current Cost financial statements but not in operation during the accounting period since the IASB still accepts HC or CC financial statements to be restated with the implementation of IAS 29 during hyperinflation.

PricewaterhouseCoopers state the following regarding the use of the HCA model during hyperinflation:

"Inflation-adjusted financial statements are an extension to, not a departure from, historic cost accounting."

Financial Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, May 2006, p 5.

The main measure of inflation in low inflation economies is the annual inflation rate, calculated from the annualized percentage change in a general price index - normally the Consumer Price Index - published on a monthly basis. The correct measure of inflation in hyperinflationary economies is the parallel rate - where a parallel rate is in use, officially or unofficially. The CPI published a month and a half to two months after the hyperinflationary changes in the real value of the monetary unit actually happened, is completely impractical and totally ineffective as a measure of inflation when the aim is to stabilize the real economy during hyperinflation as Brazil so effectively did with daily indexation during 30 years of high and hyperinflation. This is only possible with daily indexing of all non-monetary items as was done in Brazil from 1964 to 1994 or with measuring financial capital maintenance in units of constant purchasing power in terms of IAS 29 during hyperinflation, i.e. inflation-adjusting all non-monetary items (variable real value non-monetary items and constant real value non-monetary items) on a daily basis applying the daily change in the parallel rate and not the period-end CPI as currently required by IAS 29.

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.