What causes inflation of money?

Inflation is a universal experience in the modern day and yet very few can tell you why it happens! The hint lies in the word itself 'inflate' which you will be able to understand by the end of this article.

Let's for the sake of this discussion define inflation as the continuous loss of purchasing power of money.

As illustrated below, dollar has lost more than 95% of its value since the beginning of the 20th century.

The loss of purchasing power in Rupees is even more dramatic.

In 1947, 1 INR = 0.3 USD. In 2024, 1 INR = 0.012 USD. In terms of the Dollar, Rupee in 2024 is worth 4% of what it was worth in 1947.

But Dollar itself is losing value. So in absolute terms Rupee today is worth 0.2% of what it was worth in 1947.

In other words the Rupee has lost 99.8% of its value since 1947.

But why does this happen? To understand this, let's understand what money truly is.

Barter trade and the absence of money

The earliest trade between human beings was barter trade.

One person grows bananas. The other person grows cotton. x grams of bananas can be exchanged for y grams of cotton. This works out to the benefit of both people.

The need for money and its invention

However, trade conducted in this manner presents significant challenges. For instance, if an individual growing cotton does not wish to exchange their product for bananas but rather desires oranges, the trade cannot proceed. Both parties are left waiting for someone who is selling exactly what they wish to purchase while simultaneously wanting to buy exactly what they are selling.

To address this dilemma, humans devised an ingenious solution: the use of a widely demanded commodity as a medium of exchange. For example, let us consider salt. In this scenario, the individual selling bananas may accept a specified quantity of salt in exchange for their bananas. Subsequently, this individual can then use the salt to trade with the cotton seller, thereby facilitating the desired exchange without the need for a direct barter.

Here the salt serves the role of commodity as well as money.

So just like that, money is invented.

Salt money and inflation?

Now it would an interesting question to ask: what would it mean for this 'salt money' to be inflated?

If salt extraction technology improves, then it would be easier to produce salt and since there would be more salt available, then by the law of supply and demand, salt will get cheaper relative to other commodities, so you could say that this 'salt money' has become inflated.

So earlier you could buy a kilogram of rice with 3 kilograms of salt, now you would need 4 kilograms of salt to buy 1 kilogram of rice.

But even as there is possibility for this slight inflation, a continuous loss in purchasing power of salt is not really possible.

Metals as money

As time passed, people would need something more durable to play the role of money. So they turned to precious metals like Gold and Silver. It's a bit easier to pay with a gold or a silver coin than salt. Imagine buying a house with salt.

Now let's again ask the question, what would it mean for this 'gold money' to get inflated? Let's suppose there is a large gold mine that get's discovered somewhere and since the market is now flooded with this new gold, by 'the law of supply and demand' the value of gold vis-a-vis other commodities comes down and you can say inflation has occurred.

But it's not typical to find very large mines to affect the price of gold. So inflation as far as gold is concerned is not something you would have to worry about.

The image below will illustrate the point. If Gold was being used for money, there really is no inflation. You would need roughly the same amount of Gold to buy a house today as you would have needed in 1929.

Invention of paper money (backed by gold)

Now we reach the topic of paper money, which is different from earlier forms of money because it can lose value over time due to inflation. Let’s look at how paper money came about.

People who have a lot of gold or silver coins can be at risk of theft if they keep their valuables at home. So, they usually store their gold and silver in banks, which are safe places.

When they deposit their assets, the banks give them receipts called bank notes. These notes show that the person owns the gold or silver and can be used to get their money back when needed.

If a bank is known for being safe, people can use these receipts (bank notes) to make payments instead of using gold or silver.

For example, if someone deposits X grams of gold at a bank, the bank gives them a bank note that represents that amount of gold. This note can be used by the depositor to buy goods or services from others. The seller can then take the bank note to the bank and exchange it for the gold, completing the trade.

Thus, paper money is born. Paper which for now is backed by gold.

Overtime many banks would be setup to serve this purpose and they would all issue their own notes.

Even then, only the form of money has changed, as ultimately this paper money is redeemable in gold or silver.

Inflation still hasn't entered the picture.

Creation of central banks

As multiple banks began issuing their own bank notes, a phenomenon known as a bank run became increasingly common. A bank run occurs when numerous panicked clients simultaneously attempt to redeem their deposits in gold. If the bank is unable to meet the heightened demand for redemption, it becomes insolvent, often leading to its closure. This insolvency can trigger widespread panic, potentially causing other banks to collapse in a similar fashion.

To address this instability, central banks were established. Their primary role was to serve as the lender of last resort, providing emergency liquidity to banks facing the risk of a run. In addition, central banks gradually assumed exclusive control over the issuance of currency, prohibiting individual banks from issuing their own bank notes.

The bank notes issued by central banks remained backed by gold and could still be redeemed for gold under this system.

Legal tender, going off the gold standard and the creation of fiat money

After assuming the exclusive authority to issue paper money, central banks further extended their control by establishing legal tender status for their notes. This designation meant that only the currency issued by the central bank was recognized as valid for the settlement of debts and the exchange of goods and services, thereby prohibiting the use of any other form of currency for trade.

The ultimate shift occurred when central banks abandoned the gold standard, meaning that the currency they issued was no longer redeemable for gold.

If one carefully reflects on the implications of this transition, it becomes evident that the intrinsic value of the bank note was originally derived from its redeemability in gold. Without this backing, the note itself is reduced to little more than a piece of paper.

However, due to the public's established familiarity with paper currency and the government's enforcement of its legal tender status, this marked the point at which paper, devoid of any intrinsic value, became accepted and used as money.

This is known as fiat money.

Unlimited printing of fiat money and unlimited inflation

It is essential to recognize that if a central bank's currency is redeemable for gold, the issuance of bank notes is constrained by the quantity of gold it possesses. This limitation ensures that the bank can only issue notes equivalent to its gold reserves.

However if it is off the gold standard, the central bank can issue as many notes as it wants without any limits. And that's exactly what has happened.

The base money supply in USD has increased 100 fold from 50 billion dollars in 1960 to 5 trillion dollars in 2024.

The literal meaning of the word 'inflate' is to expand/increase.

Consequently, when the money supply is expanded, the principles of supply and demand dictate that this will lead to a devaluation of currency due to its oversupply.

This devaluation reflects in a reduction in the purchasing power of money and this explains the modern phenomenon of inflation.