Engineers and Inflation
Part of the job of engineers and architects is to provide a cost estimate with our design products. For projects where construction will be delayed for a year or more, we typically include an inflation factor in the cost estimate to account for an increase in prices for the future construction. Usually this inflation factor is between 2 and 4 percent. But, what actually is inflation and where does it come from?
Most people equate rising prices with inflation. However, rising prices are only a symptom of inflation, not inflation itself. Most economists agree that inflation is an increase in the supply of money. The United States Federal Reserve (the Fed) is the entity responsible for creating, or, in some cases, destroying dollars. The Fed has the authority to create money ex nihilo, or out of nothing. They can then use this new money to purchase assets, such as United States Treasury Bonds. When the Fed engages in these "Open Market Operations" to buy assets, it is adding money to the economy. The Fed states that its objective is to achieve 2 percent inflation each year. But why?
When the supply of money is increased, it has the effect of devaluing the existing stock of money. As an example, if a candy bar costs one dollar today and the Fed achieves its goal of 2 percent inflation, then next year, the same candy bar will cost you a dollar and two cents. The following year, it would increase again by 2 percent to a dollar and 4 cents and so on. Each year, the value of the dollar falls by the rate of inflation. A long term example of inflation is the price of gold. In the early 1900's, an ounce of gold would cost you 20 dollars. Today, it costs about 1290 dollars. That is some serious inflation. But, why do we as consumers want our dollars to be worth less?
The truth is, inflation is not good for the average consumer. Inflation is sometimes called the "hidden tax" because it continually eats at the purchasing power of one's wages. Because new money enters the economy at discreet points, those at the top of the money supply chain benefit from inflation. Those at the top of the money chain include banks and governments. They get the use of the new money before it has entered general circulation in the economy and caused prices to rise. Additionally, inflation benefits debtors as it makes past debts easier to service since often times wages will rise with inflation. As people "feel" richer from the increase in their wages, their past debts look "smaller" in comparison. But, the problem with this is that wage inflation rarely keeps up with price inflation and so the result is people actually end up poorer. At the same time, inflation tends to "punish" savers since the value of the money they save continues to fall over time and the interest that they earn on their savings is usually much less than the rate of inflation.
Some would argue that the money supply has to increase with the increase in the population. But, the truth is that any fixed amount of money will do in an economy. If the amount of money is fixed, then over time prices would slowly drop, not increase, because the value of the money would increase.
As an example, most people see the cost of housing as increasing over time. But why should housing go up in value? A house is in many ways like a car. It needs maintenance over time. It will need new paint, carpet, appliances, roof replacement, etc. So, why should it go up in value? If one was to chart the long term trend in the value of housing against the value of the dollar, what becomes evident is that housing isn't necessarily becoming more valuable, it is simply holding its value against the sinking value of the dollar (a comparison like this ignores local impacts to housing such as new industry moving into an area or an industry moving out of an area which can have a tremendous impact to local house prices).
So, this is a brief introduction on inflation. What about deflation? What things are deflationary? That is a topic for another time.
- Keith Brookshire