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Monday, 30 January 2012

Inflation only affects bank notes and coins

Inflation only affects bank notes and coins

Inflation and deflation have no effect on the real value of non-monetary items.

‘Inflation is always and everywhere a monetary phenomenon,’ per Milton Friedman.

Purchasing power of non monetary items does not change in spite of variation in national currency value.’

Gucenme, U. and Arsoy, A. P. (2005). Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 – 2005. Special Issue Accounting for the Global and the Local: The Case of Turkey. Critical Perspectives on Accounting, Volume 20, Issue 5, July 2009, p. 568–590.

Inflation erodes the real value of only monetary items not inflation-adjusted in terms of a Daily Consumer Price Index. Deflation creates real value in only monetary items not deflation-adjusted in terms of a Daily Consumer Price Index.
‘Assets and liabilities linked by agreement to changes in prices, such as index linked bonds and loans, are adjusted in accordance with the agreement in order to ascertain the amount outstanding at the end of the reporting period.’

IAS 29, Par. 13

Inflation in many different countries has no effect on the real value of monetary items inflation-adjusted in terms of a Daily CPI, for example the more than 2.68 trillion US Dollars (2009)1 of government inflation-indexed bonds currently inflation-adjusted daily in the world economy in terms of a Daily CPI which is a lagged, daily interpolation of the monthly published CPI.

1 (Standard Life Investments. (2012). An Investor´s Guide to Inflation–Linked Bonds. Retrieved 7 January 2012, from Standard Life Investments’s Web site.)

According to the Banco Central de Chile, 20 to 25 per cent of the broad M3 money supply in Chile is currently inflation-adjusted daily in terms of the Unidad de Fomento (Written communication. (2011)) which is a monetized daily indexed unit of account started in 1967 and published daily by the Banco Central de Chile since 1990.

The above are all monetary items that exist in a zero cost of inflation (not zero inflation) space. They are all monetary items, but, their real values are not affected by inflation. Inflation-adjusting the entire money supply (excluding bank notes and coins of the fiat functional currency created by means of fractional reserve banking within an economy) under complete co-ordination would result in zero cost of inflation (not zero inflation) in only the complete money supply (as qualified) in an economy.

It is currently (2012) impossible to inflation-adjust or deflation-adjust bank notes and coins of fiat money created by means of fractional reserve banking within an economy. Their real values are always affected by inflation and deflation.
Bank notes and coins make up about 7 per cent of the broad M3 money supply in an advanced economy.
At an inflation target of 2 per cent per annum annual inflation the erosion of real value by inflation can be limited to 2 per cent of 7 per cent of M3 under complete co-ordination; i.e. 0.14 per cent of the money supply.

The inflation dragon has been cut down to size as evidenced in the US economy.
Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.