Ever wondered what causes inflation, why prices generally increase over time? It is not, as is widely believed in Australia, anything to do with wage increases. The sole cause of inflation is the continued, gradual increase of the amount of money on issue.
Ignoring for a second exceptional circumstances and annual fluctuations, money is fed into the economy by the Reserve Bank at a fairly constant rate, to keep the dollar value of items increasing. There is actually a reason for this; it makes money more valuable today than tomorrow, and so encourages our tendency to spend money sooner rather than later. This keeps money moving around the economy more than it otherwise would, promoting growth. Of course this same effect takes away from the value of that growth, so keeping inflation positive but low is vitally important.
The following chart shows the amount of ‘notes on issue’ in Australia over the last 15 years or so. Some fascinating features for those who care to look. (Data sourced directly from rba.gov.au). Note that the vertical axis shows notes on issue in millions of dollars, horizontal axis shows the year.
The reserve bank adds money into the economy through the banks on a consistent basis, working to maintain inflation in their ‘target band’ of between 2 and 4% per annum. This is not actually a simple matter, and there is an evident degree of mastery in managing the supply to maintain a relatively constant rate of perceived inflation. Note how the money supply spikes a couple of times every year to cover periods of increased spending (the big spike each year is at Christmas time, the smaller one in March/April), reducing the seasonal pressure on prices. But outside of that there is consistent rate of growth maintained. The trendlines I’ve added are pure exponential curves and fit the data very well, as would be expected if the rate of increase was in constant proportion.
The most notable features on the chart however are the two step jumps in monetary supply. Trace back the dates, and these represent the dotcom crash and the first wave of the global financial crisis. What can be seen is that the money pumped in during these periods to keep the economy moving is largely removed after 2 years, but the amount remaining at the end of the 2 years period persists in the economy for the medium term; i.e we suffer a significant ongoing inflationary effect from each of these instances.
Another aspect of this to realise is that there is a delay between the addition of new funds and the reaction of the economy to those funds; what we actually experience as inflation. The reason costs have risen so much in the last year is simply because that pulse of money added in 2008 is now washing through and affecting prices (in some product categories, by 10-20%). Even though it has already been largely withdrawn, the effects are still taking hold.
So how does one avoid or take advantage of inflation? By remembering to hold your wealth in items of tangible and ongoing value, rather than in dollars. Dollars are for being spent; they are designed solely and specifically for that. They are not intended for storing wealth over time, and you only do yourself a disservice by using them in that fashion. The government and banks already takes a large enough portion of your income through tax; no need to give them an annual percentage of the wealth you do manage to store up.