Pages

Saturday, 25 June 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)

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. During inflation 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.

Inflation erodes real value evenly in money and other monetary items over time. There are, consequently, hidden monetary costs to some and hidden 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 a loan. The debtor (in the case of a monetary loan) gains during inflation since he, she or it (a company) has to pay back the nominal value of the loan, the real value of which is being eroded by 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, she or it 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 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 as monetary items when the stable measuring unit assumption is implemented 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 financial capital maintenance is measured in units of constant purchasing power during low inflation; i.e., implementing the CIPPA model. 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 generally accepted measure of inflation in low inflationary 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 a hyperinflationary economy is a Brazilian-style daily index value almost entirely based on the daily parallel rate (normally the US Dollar 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 during hyperinflation, i.e. updating 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.


Nicolaas Smith

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