Although I confess that this isn’t exactly on-trend in the news right now, I’m trying to understand deflation after reading an old post on on the disadvantages of Gold Currency:
>The reason it’s actually bad is because the government can’t mess with the money supply. The supply becomes tied to some shiny metal. Now, if you have a society with 100 people, and 1,000 dollars (each person having 10 dollars), then this is fine. **But in 20 years, those people will have children that will grow up and be part of the economy. But there’s still 1,000 dollars, only for 150 people now. That means each dollar is worth more, which is called deflation.**
***Source –*** u/yellowjacketcoder
The post is now 9 years old, so I thought to make a post on it here as I’m confused on the sentence in bold.
I’m not understanding the point with regards to when 150 people now exist, the same 1,000 dollars are worth more now. I understand that after 20 years, this hypothetical population goes up by 50 to 150. My intuition led me to believe that due to supply-demand economics, the same 1,000 dollars (linked to a fixed exchange rate for X ounces of gold) would be needed by more people so it would be worth more (given the supply of gold is fixed).
However, what didn’t make sense to me is how this would then be linked to the idea of deflation where spending goes down as consumers would think that prices are about to fall further (which they would, in a deflatory economy) etc.
How are the two ideas (the increased demand for the same fixed supply of dollars and the falling prices) linked, if by any means they are? Appreciate any answers as always, community (and sorry if it seems so obvious to anyone – I’ve been struggling to wrap my head around it for years)!
In: 4
There is a hidden assumption that additional people will have same kind of stuff as old people, or even that everybody has better stuff (due to technological progress and investment)
So there is more/better stuff in the economy, but same amount of money used to buy and sell it. So every gold coin buys more than before.
but if that’s the case, then holding gold coins is better than investing into new technology. Investment can fail, but gold coins are guaranteed to increase in value. So no investment happens, and quality of life actually decreases.
Well, let’s look at this in two pieces and start with the second one.
People have different behaviors in inflation and deflation. During inflation, you know the money will be worth less later, so you buy that water heater now when it costs $500 rather than in a year with it costs you $600. In deflation the opposite happens, you put off buying things because it will cost less later. So if the water heater can keep running, you don’t replace it because what costs $500 now will be $450 in a year. If people expect deflation, it is rational to put off purchases as much as possible to take advantage of the cheaper prices in the future. Thus a lot of economic activity gets postponed and the economy contracts.
So now lets look at the first piece. If there are 1000 water heaters and $10000 dollars then each water heater would cost $10. But our supply of gold dollars is fixed (or grow much slower than population growth) and our supply of water heaters has gone up. There are now 1500 water heaters, so each one costs $6.66. So we got the deflation and once that expectation kicks in for the general populace, we get the situation talked about in the previous paragraph.
Ok, you understand how a fixed supply of money tends to cause deflation, which is a great start. An expanding economy without an expanding money supply means falling prices.
Now, just to be clear, the *cause* of deflation doesn’t really matter here. It could be a fixed money supply and expanding economy, it could be a shrinking money supply, it could be a rapid fall in the costs of production (eg. a crash in energy prices), a fall in the velocity of circulation of money, or whatever.
So let’s say prices are falling by 5% a month (unrealistic, but gets the point across). I’ve saved up $1,000 and am thinking of buying a car. I could buy it now for $1,000. Or I could hold on to my money and wait until next month, when it will cost $950.
I might need that car now and not have a choice – but the longer I wait the cheaper it’ll be. You may have experienced this yourself when buying a phone, a games console, computer parts or some other item that tends to fall in price fairly quickly. Yes, you want it now, but the longer you wait the cheaper it’ll be…
Just to make things worse, if I’m holding those dollars in cash (or the equivalent), they’re not in circulation in the economy. I’ve effectively made the supply of dollars *even smaller*. This is the velocity of circulation – how fast money is being spent and moving around the economy, and the faster it is, the higher the rate of inflation.
The prevailing economic thought is that a small amount of inflation is good for the economy. This can all be traced back to the very fundamentals of economic theory which is *trade is the basis of economic prosperity.*
When you work for a paycheck at Taco Bell, you are selling labor (which has value) to your employer. When you spend your paycheck on tacos, you are buying goods (which have value). This exchange of goods and services underpins all economies.
To facilitate this trade, we use a standard currency (dollars) to represent the relative value of these goods and services. Ideally, we want to maximize trade (and thus economic prosperity) so we encourage people to spend or invest their dollars instead of holding onto them. We do this by slightly devaluing the dollar each year through inflation.
Ideally, the price of everything would rise at a consistent rate. Your hourly wages would rise 2% per year, and the price of tacos would rise 2% each year. The relative value between your labor and your taco hasn’t changed, but it does punish the person who is hoarding their dollars under the mattress and *not using them for trade*.
Contrast that with deflation. If your currency becomes MORE valuable each year, then the relative value between your labor and your taco hasn’t changed, but it rewards the person hoarding dollars under their mattress. Why should I spend my dollar on tacos, when I can just keep it under my mattress and buy more tacos next year?
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