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Monday, 30 April 2012

Two per cent inflation also erodes real value



Two per cent inflation also erodes real value



There is a school of thought that the effects of two per cent inflation are not more harmful than zero per cent inflation.  This school of thought is incorrect in two of the three valuation processes in our current HC economy and would also be mistaken in one of the three valuation processes under continuous financial capital maintenance in units of constant purchasing power, i.e., the Constant Item Purchasing Power paradigm during low inflation.  The three valuation processes in our economy under both the HC and CIPP paradigms are the valuation of monetary, variable and constant items.



Variable items are valued in terms of IFRS under both the HC and CIPP paradigms with the stable measuring unit assumption being applied under HCA. The stable measuring unit assumption is never implemented under the CIPP paradigm. The two paradigms are fundamentally different paradigms.



The view that a high degree of price stability of a positive inflation rate of up to two per cent per annum is completely unharmful and that it has no disadvantages compared to absolute price stability is never true in the case of monetary items under any accounting model, either the HCA model or the CIPPA model, since inflation always erodes the real value of monetary items. A high degree of price stability of two per cent per annum in this case erodes two per cent per annum of the real value of money and other monetary items which equates to the erosion of 51 per cent of real value in all current monetary items over the next 35 years. It will over a long enough time period lead to all current monetary items arriving at the point of being completely worthless in economies with continuous two per cent inflation. The five cents coin was recently withdrawn from the South African money supply since it was practically worthless. South Africa has an inflation target of three to six per cent per annum. Swedish rounding whereby the cost of a purchase paid for in cash is rounded to the nearest multiple of the smallest denomination of currency is implemented in a number of countries.



In the case of monetary items we can thus confidently disagree with those who assume that a high degree of price stability of above zero and up to two per cent per annum is unharmful in all respects and that it has absolutely no disadvantages compared to absolute price stability or zero inflation.



The assumption that two per cent inflation is unharmful and that it has no disadvantages compared to zero inflation is acceptable in the case of variable real value non–monetary items valued continuously in terms of IFRS (excluding the stable measuring unit assumption) under the CIPPA model. The nature of the valuing processes in valuing variable real value non–monetary items continuously, for example, at fair value or the lower or cost and net realizable value or market value, etc., in terms IFRS (excluding the stable measuring unit assumption), allows this idea to be justifiable under CIPPA.



The above view is acceptable in this instance, because, in principle, any level of inflation or deflation – high or low – is automatically adjusted for in determining the price of a variable real value non–monetary item at the moment of a transaction in terms of IFRS, excluding valuation in nominal monetary units, under CIPPA.



The above assumption relating to two per cent inflation is acceptable under the HC model with the valuation of variable items in terms of IFRS accept in the case where the stable measuring unit is implemented. It is thus not acceptable per se with reference to variable items under the HC paradigm.



Two per cent inflation erodes two per cent per annum – i.e., 51 per cent over 35 years – of the real value of constant real value non–monetary items never maintained, e.g., retained profits, etc.  under the current HC paradigm. The only constant items generally maintained constant with annual measurement in units of constant purchasing power under the HC paradigm are certain (not all) income statement items, e.g., salaries, wages, rentals, etc. They are, however, paid monthly at the same value after being updated annually. All existing constant real value non–monetary items´ real values would automatically be maintained constant with continuous measurement in units of constant purchasing power at any level of inflation or deflation under the CIPP paradigm for an unlimited period of time in entities that at least break even in real value – ceteris paribus.



We can thus safely disagree in the case of constant real value non–monetary items under the HC paradigm too, that the effects of two per cent inflation is completely unharmful. Two per cent inflation – in fact, any level of inflation or deflation – would be the same as zero inflation as far as the valuation of constant real value non–monetary items under the CIPPA model is concerned.


Nicolaas Smith

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