Money does weird things doesn't it? Things used to be cheaper, you can exchange your dollar for a bajillion bulungi bulungs, things will cost way more in the future. Why does this happen, and how true are these tropes? Read more to find out.
Money in Economics
Both inflation and exchange rates are results of using money. People who study how money works (economists, financial people, historians) define it as something that fills three roles:
- A medium of exchange: Money is used to buy and sell things. You give money to someone, they give you a good or service. Or you get paid money to give someone else a good or service. Other ways to do this exist: favors can be owed, barter used, or economies can run as gift based economies (as an example). But favors can be hard to keep track of in too big a society, and keeping track of bartered goods can get complicated. Well accepted money simplifies this process enormously.
- A measure of prices/unit of account: Money is used to compare prices. How many cows is a yoga class? How many knives is fixing a roof worth? It is possible to use a single base good to do this, but money also works well.
- A store of value: You can be paid something now, save the money, and spend it later. Other systems can fill this role: things like favors owed or records of debts/payments due, but money again makes these things much easier.
All of these properties obviously relate: using money to pay for things means measuring prices in it make sense, money can only store value because it can be exchanged for useful things, etc. However, some things fill some but not all of these roles: ownership of a house can store value, but not be easily used in an exchange. Sometimes the boundary gets blurry, certain types of bank accounts store money with limitations, so whether they count is up in the air.
For this useful notes, some other properties of money are important:
- It has value because people using it agree it does. This could be because it is made of something valuable (precious metal currencies), because you have to pay taxes using it, because someone will give you precious metals for it (some banknotes and paper currency originally worked this way), or just because everyone around you uses it so you do as well. If people take the money for payment and expect to use it in the future to buy things, it has value. If not, the money doesn't.
- Related to this, money is assumed to have value only for its role in transactions and saving. Money is not a useful good on its own that people would want outside these two roles. Most modern money is like this, stored as electronic deposits or paper money that is far cheaper than its face value, but with coins and precious metal money in the past this is not strictly true. In economics this leads to a separation of the "real" economy, the actual production and use of goods and services, from whatever is happening with money. (In measurement, you get "real" and "nominal" measures of things, described later on this page.)
- In modern times, almost all money is produced by governments, either through printing cash or minting coins, or by typing some things in a computer. The total amount of money can be controlled relatively closely by governments.
- It is assumed in this useful notes that each economy mainly uses 1 currency of its choice, unless said otherwise. Unless a country has very untrustworthy money, this is generally a good assumption, though some border regions, areas with visitors, or areas without trusted currencies, this is not the case.
Weirdly, some very abstract theoretical fields of economics ignore money completely. Some are models of an entire economy, modeling the production and use of goods: exchange within this highly simplified economy is ignored, so money can be ignored also. Theoretical models of how markets work (highly theoretical, instead of producing cars, doctor visits, or even food, health care, etc., they just go with good 1, good 2, input 1, etc.)can ignore money by measuring prices using a base good: only the ratio matters, not the actual numbersnote . in most field of economics, money fills the same role it fill in day to day life: you get paid in in, spend it, budget it, etc. Only a specific subfield studies the things described in this useful notes.
What is inflation, and where does it comes from
Inflation is a general increase in prices of most goods in an economy. You may sometimes hear about "cost inflation" of various things (healthcare, college), but increases in price of a single thing are a very different idea with very different causes. In theory, if nothing else changed in an economy, inflation would show as all prices increasing at the same rate, together (actual measurement will be described later.) General price decreases are called deflation, they are rare in modern times, more common before the early 1900's. If you flip "price increase" to "price decrease" or think "negative inflation", most of what is written here applies just fine.
Another common way to describe inflation is a decrease in the value or purchasing power of money. In this description, money is the thing you exchange for other goods, and inflation makes that money able to buy less goods.
One simple but generally accurate explanation for how inflation is caused is "too much money chasing too few goods". This gets at the most common cause of inflation: an increasing amount of money per economic activity in an economy. One of the strongest correlations in economics is money supply growth to inflation rate minus economic growth rate. Generally, an economy with certain prices and a certain amount of production seems to require a certain amount of money to function: less money than this and prices drop, more money and prices rise.
How does this process work? Imagine one day you wake up, and all money stored on people has doubled. Cash in your wallet, under the sofa, piggy banks, money suitcases, or any other place you store it has doubled. Your checking and saving accounts, or any other such places, have doubled as well, as has all of the above for everyone else. Awesome, Free Money! What to do with it? There's a lot of options, but overall the extra cash will either be saved or spent.
The extra spending will be seen by sellers as an increase in demand for goods, and sellers will respond the way they always do to an increase in demand: a combination of increasing prices and increasing production. The price increase is itself inflation: it is a price increase for goods throughout the economy. Increasing production requires more resources, hiring more people, buying more equipment, etc. With industries throughout the economy competing for more resources and people, prices of these and wages will increase also: this increase means more spending money, which increases demand further. Saved money in banks is loaned out, combined with direct investment, and it encourages more demand for business equipment, houses, and other things that require loans.
This cycle of price increases continues to cycle: economists expect it to end when prices are about twice as high as they were before the money doubling started. At that point, the amount of stuff that money in the economy can buy is the same as it was before the magical doubling. Given enough time, wages and all prices will all double, so the economy functions the same, with the same ratios between prices, as it did before. (There may be some distribution effects: People who happened to have more cash when the doubling happened may be better off, loans will be affected, see later in these notes for more)
In practice, money (almost) never doubles like this, and new money in an economy isn't given directly to everyone. However, the general idea works the same: extra cash at the same prices increases demand, the money cycles through the economy as do price increases, and prices increase evenly with money growth.
Other changes affect inflation as well, either by affecting the size of the economy, or rate that money circulates. If an economy produces more, the same amount of money must be used to buy more goods, decreasing prices. If an economy produces less, the opposite happens. Normally, the effect is small, but can contribute to inflation after wars or mismanagement: A historical example of this is after the Black Death in Europe.
Regular changes in demand for goods can affect inflation by changing how fast money circulates in an economy. Increased demand, whether from increased investment, more confident buyers, or such increase the rate money flows through an economy, increasing the amount of goods the money can buy and sell, and raising prices as a result. Changes of this sort, of consumer confidence, investment, or other such spending are the main cause of business cycles, as a result recessions tend to go along with lower inflation.
These two causes rarely create as strong inflation as creating money can. Economies don't usually grow or shrink by more than a few percent a year, and changes in demand and circulation tend to also be small and even out over a few years.
Because inflation isn't limited by a physical process: just use different ink and print more digits on paper, or change some keystrokes/clicks for electronic money, it can occur at fantastically absurd rates. Extremely high rates are called hyperinflation, the most recent famous example was Zimbabwe in the late 2000's, as in this graph
. Notice the logarithmic scale in addition to the absurdly large growth rates, on this type of graph, exponential growth such as bacteria reproducing or the grains on a chessboard
story would be an upward sloping straight line.
Costs of inflation, and when does it get ridiculously high?
If the rate of inflation is perfectly predicted ahead of time, it doesn't have too much of an effect. Contracts and agreements that need to will pay more in the future to account for it, interest rates and investment returns will increase to cover the increase in prices. If possible, payments will be "indexed" to inflation, changing future payments to account for inflation after it has been measured. The big costs are transaction difficulties: people will not want to hold money, and will try to spend it more quickly or switch it for better investments or physical goods. with too much inflation, people will stop using the inflating money and switch to other things, which can interfere with keeping track of things and just generally make life more difficult. This can provide some benefit, however, encouraging people to invest the money instead of keeping it as cash, investments properly used can increase the productivity of an economy, and also increase demand for goods more immediately.
This is an area where deflation is worth mentioning: deflate money too hard and people will spend less and remove money from investment, since cash becomes more valuable over time and itself becomes a worthwhile investment. Doing this reduces demand for goods, which can cause further deflation, etc. When an economy is in a recession, deflation can make it worse, especially since investments and bank account interest are already often lower during one, making keeping cash even more valuable.
Unexpected inflation distorts an economy in other ways. Anyone who receives money in a long term contract (loan repayment, wages, disability/social security/lottery/insurance payments, rent, for some examples) loses out: the money they get buys fewer goods than they expected. Whoever pays the money (debtors, renters, etc.) gains, the money they have to pay is less, which increased income from more flexible sources can more easily reach. Inflation has been used as a strategy at points in history to reduce debts.
There are various arguments for what rate of inflation to aim for. To keep transactions easiest, zero inflation would make the most sense. Some economic models suggest a deflation rate equal to a typical return on a savings or investment in that economy: the math is way to much to describe in this sort of useful notes article, but the logic is to reduce the cost of keeping money (vs. investing or saving it) to nothing. However, since saving and investing generally makes an economy more productive (by allowing business to invest more, businesses and governments to do more research, etc.), this also argues for a positive inflation rate, to encourage people to save or invest.
In practice, most well managed economies will aim for a low positive rate of inflation. The main benefit of this is to make stabilizing business cycles easier, which brings the article to the first reason inflation can get higher,
As mentioned above, economies go through periods of increased and decreased demand for various reasons: people/businesses get more or less confident and willing to spend, values of things like houses or stocks can rise and fall, the financial system may make loans more or less available, etc. These changes cause employment to increase and decrease, and at worse can cause recessions. Increased demand, as mentioned earlier, also causes somewhat higher inflation.
How to respond to these changes? Two main methods are used: national governments can change spending and taxes to directly buy more/less things, or tax the rest of the economy less and allow it to demand more or less things. Also, whoever controls the amount of money in an economy can add more or less than expected. If in a recession, adding money can get an economy out: instead of simply returning to the same economy with increased prices as the three paragraphs described, the higher demand produced hires people for longer hours, uses unused raw materials, and otherwise results in more production that wasn't happening before. The money supply can than be grown more slowly or reduced in a booming/inflating economy to keep inflation low.
Money based stabilization is usually used to handle short term/smaller changes in an economy: it can usually be put into practice much faster than changing spending and taxes. However, if monetary policy tries to permanently keep employment too low, it instead creates very high inflation. As with the money doubling example above, at first adding more money creates increased demand in an economy, and satisfying that demand leads to more production, more hiring, etc. However, as the economy adapts, it produces less, and prices rise. If more money is added to further stimulate the economy, prices will continue to increase. As people in an economy get used to such increases, they will expect a certain amount of inflation, and increase prices/make contracts and loans with price increases built in. when this happens, the increasing money supply only keeps up with the expected price increases instead of further stimulating the economy, and an even larger increase in money is needed to actually stimulate an economy.
The end result is steadily increasing high inflation. This happened in a number of richer countries in the 1960's and 70's, and inflation was slowed in a number of ways. some used agreements between large unions, businesses, and central banks (who create the money), to slow increases. In the U.S., the money supply was cut, creating a recession and slowing inflation over several years.
The second reason for high inflation, and the one responsible for most hyperinflations, is printing money to fund a government. Governments can be funded in four main ways. Taxes are the most common, you can also include directly taking goods (or even time as in conscription) as a type of tax. Governments can run profitable industries and take the profits: this is a small source of income for most governments, oil producers are an example of the few governments that can largely fund themselves this way. Governments can borrow money. Finally, most national governments can print money.
If the first three sources of money do not produce enough, and a government cannot spend less for whatever reason, it ends up printing money to fund itself. Lack of natural resources or some other economy that a government could run limits the second method. A poorly organized and run bureaucracy/political opposition/not enough economy to tax can prevent taxes being raised. Spending similarly may not be cuttable due to political reasons, or health/safety/etc. may demand it. Borrowing money requires being trustworthy enough for others to loan it at low interest rates, or even loan it at all, and whoever runs the government may not want to take on debt and become dependent/owe money to the loaners.
This type of inflation as a result can be common in politically unstable or disorganized countries. "Politically unstable" often meaning "violence" this disrupts a government's ability to function normally, makes an economy less productive, and may require spending (for security or fighting wars, as an example): the combination makes it hard for a government to get income, the shrinking economy also itself contributes to inflation. It may also occur in te aftermath of instability: a government is established, a war is over, but there is rebuilding work to be done, a smaller economy, and a not as established government, leading to the same conditions. Even established governments can have similar problems, if they are simply not organized well or not trusted well, or if the politics of a country demands more spending than income can produce fr whatever reason.
Inflation caused in this way can accelerate for a couple reasons. First, people expect it, and a government must print more money, as described earlier, to keep up. Lack of trust in governments can increase this: people who don't trust money or a currency will expect more inflation, or use the money for fewer transactions, meaning the same amount of money is being used for a smaller fraction of the economy. At the same time, increasing prices mean a government must print more money to buy the same amount of goods. When combined in the right way, these sources of inflation lead to the absurd rates of hyperinflation described earlier. (Though high to very high, steady, inflation rates are more common.) Inflation in these cases is not a major cause of problems in such a country, but is a sign that problems of some sort exist.
Inflation in RPG's
Inflation in the actual world is well and good, but this is a wiki for media. Well, lucky you, there is a type of media that lends itself very strongly to having inflation: multiplayer RPGs. Very differently from Real Life, money is constantly generated by individuals in the economy, by a mix of direct loot from enemies, and from selling Shop Fodder to merchants with an infinite store of money to buy whatever the endless stream of adventurers wants to get rid of. Since these games are mostly based around fighting, and items should in theory be accessible to just about everyone, most common items are one time purchases or low cost, as a result little money is actually destroyed from the economy by base gameplay.
The result is usually fast growth in the amount of money in game, resulting in ridiculously high prices. A steadily increasing supply of money means, not surprisingly, that almost anyone in the game long enough has gobs of money to spend, and prices for non fixed goods in game currency can get ridiculously high. This may make it difficult for newer players to access some items in the game, and create a big split between sections of the economy.
To avoid a big split between newer and longer time players, or to just generally keep prices lower, game designers need a way to remove money from a game economy, thus the Money Sink. For a money sink to work well, it must be some combination of cost and regular purchase, which destroys large amount of money regularly to keep up with money creation. Some common examples of money sinks are:
- Expensive vanity items: Expensive, obviously, usually not much better or the same as regular items for gameplay, but cool in some way.
- Auction fees: Takes a percentage out of all trades by players on an auction house. The money exchanged between players remains, but the auction fee is destroyed. Simulates an actual exchange (if usually much more expensive), and the money removed scales with prices, so if prices inflate, so does the money destroyed in the auction house.
- Consumables: temporary items that are often expensive. Players will buy them for gameplay boosts to help just that little bit more, and because they are used up, they will be bought over and over. If traded in an auction house, will also destroy auction fees.
- In theory, repairs on expensive items could serve this role. In practice, using items and combat are the main source of fun, so designers would likely not make them too expensive, reducing gold sinks effectiveness.
Not inflation of prices, but closely related, is MUDflation. The person who chose that name was clearly familiar with inflation, because the metaphor is spot on: A game adds items with better stats, with better stats characters desire more challenges, which are added to the game. With greater challenges are usually expected better stats on loot, which required more challenges, etc., leading to an increase in stats with no actual gameplay changes (because the higher stats are balanced by higher stats of stuff to fight against) Not too far off from increased money supply leading to increased demand for goods, higher prices, more money needed to continue stimulate an economy, etc.
Exchange Rates
If money in one country is fun enough, money in multiple countries must be even more fun. Exchanging currency comes into play whenever money moves between countries: the most common reasons are international trade and international investment, but gifts/family remissions, reparations, robberies, or a number of other examples can also apply.Currency exchange can be thought of as a market, where instead of a good or service, one type of money of the thing being bought or sold, and the "price" is the amount of some other type of money exchanged for it. Like any other supply and demand situation, the exchange rate is whatever leads to equal amounts of a type of money being bought and sold. Exchange rates are usually given between two currencies (dollars/Euro, Pesos/Renminbi, Ruritanian Rurits/Bulungian Bulungs, etc.), but in modern, fast moving financial markets, all exchange rates will change in a consistent way.
Like any market, anything that increases desire for a currency will increase its price, requiring more of other currency to buy it. Anything decreasing desire will do the opposite. Foreign currencies are used to buy goods from another country (tourism, foreign student university tuition, media subscriptions, and other services like these are included here), invest in that country, or of money is sent as gifts and will be used in that country: an increase in these things will strengthen that country's currency, requiring more people to buy it, a decrease in these things will weaken a currency, requiring less of other currencies to buy it.
Inflation interacts with exchange rates as well, meaning that Ridiculous Future Inflation will cause Ridiculous Exchange Rates. If a currency inflates, than prices in that country will increase. If exchange rates do not change, and prices in other countries do not inflate, than the large amount of inflated currency floating around can buy a lot more goods from foreign countries. Meanwhile, people in other countries must pay a lot more of their money to buy goods at the inflated currency's prices. This would cause the inflating country to import a lot more and export a lot less, decreasing demand for its own currency and increasing demand for the foreign currencies, leading to a weakening of the inflated currency. This effect goes away if exchange rates track inflation, so exchange rates and inflation tend to go together.
The main effect of exchange rates changing is exactly how you experience it in day to day life: foreign goods become either more or less expensive. Overall, this makes it easier or harder to export goods: a country whose currency weakens exports more, its exports become cheaper to buy with foreign currency, while it must pay more of its own to import goods. The opposite happens when a currency appreciates. Currencies also act as investment opportunities, buying and selling can make money if changes in exchange rates are accurately predicted. This effect means that, over time, the same amount of currency can buy approximately the same amount of stuff in different countries.
Something that looks like ridiculous foreign exchange, but isn't, is being able to buy a lot of services or a lot of cheap goods in poorer countries. The effect is exaggerated in media, but can happen. The actual cause for this sort of thing comes from the countries being poor, meaning that they produce few goods per person. In general, different resources that contribute to production (labor, equipment, land, etc.) receive returns/payment (wages/salary or service fees or other payments to people, profits + stock returns+ other investment returns and such, land rents or profits on land, etc.) based on how productive they are. Poor countries by definition produce less per person, probably also less per land area, and other so called factors, this is where the low wages mostly come from, possibly low land costs or other costs to buy certain things as well. For purchases that rely on these resources: personal services that use labor are an example, the low payments mean cheaper goods.
Controlling Exchange Rates
Remember those paragraphs above about how central banks control recessions and inflation? Well, throw all that out, because foreign exchange messes everything up. Well, not completely, in a smaller country, or more connected country, managing money becomes a lot trickier, for a larger country (such as the U.S. where a lot of this is studied) foreign exchange matters less (Or for a closed country).
There are a few tools to control exchange rates, all working either by changing the amount of exports and imports, or by changing investments crossing a border. Central banks can directly buy or sell foreign currencies. They can also directly buy and sell investments from other currencies (usually government bonds): buying foreign investments increases demand for the foreign currency and increases supply of the home currency, depreciating the home currency and appreciating foreign ones. Doing the reverse has opposite effects. Governments can directly control exports and imports, and foreign investment: usually these controls are for some other purpose, but they affect exchange rates also. Manipulating interest rates directly effects exchange rates: higher interest rates make a country more worthwhile to invest in, increasing demand for the currency and appreciating it (or the opposite if interest rates decrease.)
Keeping exchange rates constant, or even using the same currency might seem like the most obvious thing to do, but doing this is actually quite involved. Economies are constantly adjusting to outside factors, including exchange rates, and whoever controls exchange rates must as a result constantly respond to keep things constant. The techniques to control exchange rate affect domestic monetary policy and/or the rest of the economy. Buying/selling foreign investments and currency also increases or decrease the domestic money supply, with resulting effects. Adjusting domestic interest rates affects the domestic economy. direct export, import, and investment controls affect the structure of the country's economy, possibly cutting out desired transactions. A country that fixes its exchange rate to a foreign currency, or uses a foreign currency (the two are actually the same in economics models, apart from a pegged currency having the option to let exchange rates freely change) loses control of its monetary policy: if using a different currency it gives direct control to whoever controls that currency, if pegged, its government must use monetary policy to maintain the exchange rate, losing control as well.
There is a general tradeoff: countries can have 2 of 3 at most of fixed exchange rates, free investment and trade with others, or its own monetary policy.
In practice, what do most countries do? Most let exchange rates float freely (within a large range, fast changing exchange rates often suggest something weird in the involved economies), some with histories of inflation peg to another currency (giving up monetary policy is considered somewhat good here: it builds trust that a country's own system won't inflate like it had been.). Some heavily manufacturing countries (Germany, several East Asian ones in the past) keep currency somewhat depreciated, among other policies designed to stimulate exports. Usually, their exchange rates are allowed to change within a range that still encourages more exports than a free exchange rate would.
Measurements
O.k., so all this description is wonderful and all, but how do you actually measure these things? It's not just a question of the exchange rates and inflation themselves - measuring these things is important for measuring other things in an economy.
Measuring exchange rates is simple to do: just go to a currency exchange, see how much it costs to buy one currency with another, bam, done. Inflation is trickier: Inflation measurements needs to capture a general increase or decrease in all prices together, but in any economy prices are changing all the time for a variety of other reasons. To work around this, inflation is usually measured using a "market basket" approach: take a representative collection of things for sale, add up the total cost, and see how much the total cost changes over time. A TV Tropes market basket, for example, might consist of a months maintenance and fuel for one Alleged Car, a months worth of Unconventional Smoothie ingredients (say, 40 pounds of blueberries, 40 bars of chocolate, 80 bananas, 40 boxes of pencils, and 10 rolls of aluminum foil), plus a month's rent for a "Friends" Rent Control apartment or Volcano Lair. Add together the cost of these goods each month or year, calculate the percent change over the period of time, and you have your inflation rate. (Real world market baskets are of course different from this, they have more goods) If, say, blueberries get cheaper, but mechanics get more expensive, these changes get averaged together in inflation measurements.
In the United states, there are a few such collections of goods. Consumer Price Index is probably the most well known, here a collection of goods that is roughly what a "typical"/"normal" household would buy. Other indexes include the GDP deflator (measuring a sample of all goods in they economy) and Billion Price Index (using goods from online sellers). In practice, these tends to mostly track each other, a good signal for economic theories. Other countries will have similar types of market baskets.
Of course, even doing this has complications: the types of goods people buy change over time (smartphones, for example, would make sense in a 2010's market basket, but not in the 1980's because they didn't exist), and good change in quality (a personal computer from 1990 is almost certainly less powerful than even the cheapest stuff available today). Usually, goods in such baskets will be updated at points, ending an older series and beginning a new one. The people who design an maintain such measurements simply have to check that what they are capturing is consistent, and do the necessary checking, to make sure inflation measures are sensible and are not getting skewed by these issues.
Measuring exchange rates and inflation is useful not just for its own sake, but also for measuring other things in an economy. Want to compare how rich a Bulungian waiter in 2000 is to a Ruritanian waiter in 1950? To do an effective comparison, you must compare across currencies, and compare a likely inflated wage (larger number, but being used to buy higher priced/inflated goods) later to a less inflated wage earlier. At the highest level, these two measures are important for comparing GDP, the most common method for measuring the size of an economy.
For inflation, the most common method is to use whatever inflation measure you prefer, figure out how much total inflation has occurred in particular year(s) of interest from a base year, and divide prices in that year by the amount of inflation. (If the year of interest is before the base year, figure out how much inflation occurred from the year of interest to the base year, and multiply the year of interest by that number) Doing this with, say, wages or prices is called measuring in constant (dollars for the U.S., other currency for whatever country is being measured), doing so with GDP is called measuring Real GDP. The base year in this setup doesn't matter as long as all measurements being compared at a particular time use the same base year.
For comparing across currencies, a couple methods can be used. Exchange rates can be used in the obvious way: converting a price, wage, GDP, etc. in one currency into another using whatever the exchange rate at the time is. Also used is something called purchasing power parity: this measures much much currency is needed to buy a standard set of goods, and than using the ratio between different currencies to compare them. These will be roughly similar, as mentioned above exchange tends tend towards a point where equivalents amount of stuff can be bought in two countries. However, different countries have different amounts of foreign investment, which means exchange rates don't exactly match the purchasing power parity measurement. Measurements adjusted by purchasing power parity are usually listed as such, measurements done directly by exchange rates may not be described as anything, or may be described as 'exchange rate basis".
