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Tuesday, 26 June 2012

Inflation

Inflation



Inflation is always and everywhere a monetary phenomenon.



Milton Friedman



              

Inflation is a sustained increase in the general price level of goods and services within an economy over a period of time. During inflation an entity pays more money for the same real value. Inflation is generally accepted to refer to annual inflation. All prices are normally quoted in terms of unstable money. During inflation each unit of the unstable monetary unit buys fewer goods and services. Inflation has no effect on the real value of non–monetary items.

                

Inflation erodes real value evenly in money and other monetary items. Under the Historical Cost paradigm under which the stable measuring unit assumption is implemented, there are, consequently, real hidden monetary costs to some and real hidden monetary benefits to others from this erosion in purchasing power in unstable monetary items that are assets to some while – a the same time – liabilities to others, e.g., the capital amount of a monetary loan. Under the HC paradigm the debtor generally 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 pays back less real value during inflation. The creditor 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 attempt to recover this loss in real value by charging interest at a rate they hope will be higher than the inflation rate during the period of the loan.

              

Capital inflation-indexed government bonds overcome this problem for lenders.


Nicolaas Smith

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