In a fiat currency monetary system, inflation is inevitable. The elected officials print money to create an illusion of the wealth for political gain. Inflation is a corrosive disease that eats away the purchasing power of the fiat currency as time goes by.
Consider a closed isolated economy with 10 residents. There are 10 identical homes in this economy. The residents use dallor as the fiat currency for buying and selling goods. The total money supply circulating in this economy is 100 dallors. Assuming no other needs we price 10 identical homes at 10 dallors each because 100 dallors are going after 10 identical homes. No home in this closed economy will ever go up or down in price because they are all identical and there are exactly 100 dallors available to buy them.
Now, all of a sudden, some outside entity introduces 20 extra dallors in this economy. The money supply grows 20% to 120 dallors overnight. Since the residents of this economy finds out about this newly injected dallors they immediately price the homes at 12 dallors each instead of 10 dallors. Why? This is because, there are now 120 dallors going after 10 identical homes.
Inflation went up by my 20% in our dallor economy. Why? Because the money supply was increased by 20%. What happened to the original dallors? The 10 dallors cannot buy a house any longer; those 10 dalllors have lost their purchasing power.
Let’s look at the real economy of the United States. The Federal Reserve runs the printing press and can print money at any time they want. The money supply has been growing by leaps and bound in the United States. There are three measures of the money supply that economists use:
M1: Currency, travelers checks, demand deposits and other checkable deposits.
M2: M1+ Retail MMMFS, savings and small time deposits.
M3: M2 + Large time RPS, Euro-dollars, and institution only MMMFS.
The table lists the M1, M2 and M3 from 1959 to 2005. As you can see, the M3 went from less than $300 billions in 1959 to close to $10 trillion today.
According to my calculations, the M3 has grown about 8% annually from 1959 to 2005. This is called corrosion of the money folks. This M3 growth can also explain the 6.26% annual rise in US median house prices as described in one of my previous posts.