It’s pretty easy to understand that the more of something you have the less valuable it becomes, and when you have less of something it becomes more valuable.  If your house has one bathroom, that one bathroom is pretty valuable to your family.  If you have 10 bathrooms, the value of any one of those bathrooms goes down a bunch compared to the value represented to the family with only one.

Economists often describe the situation caused by inflation as too many dollars chasing too few goods.  In this situation prices of goods go up to help return the system to balance.  So when the amount of dollars in circulation is going up, the value of any one dollar is going to go down.  Our federal government, however, instead of focusing on the money supply, focuses on core CPI (Consumer Price Index) for measuring inflation.   This index measures the change in price of a basket of goods and services regularly purchased by consumers, but very importantly excludes both food and energy (they are included in the overall index, but stripped from core CPI).

The deceptive thing about focusing on CPI rather than the total supply of money is that goods and services can reflect deflationary forces that mask the true inflationary effects of an increasing money supply.  The biggest deflationary forces we currently see are Globalization and Technology.  Globalization refers to the ability for goods and services to be produced in areas where wages are lower, and therefore companies can lower their prices while keeping similar profits.

Also, technology as it gets better allows us to produce all sorts of things cheaper.  The effect of this has been most pronounced in digital technology which allows for cheaper laptops, ipods, and cellphones that outperform their predecessors.  But you also see technology used to bring productivity gains in other ways. For instance, Wal-Mart’s uses a high-tech supply chain that significantly lowers the cost of managing their inventory compared with their competitors allowing them to lower prices.

Globalization and Technology represent huge productivity gains for the global economy and as such are great for economic growth.  But the point for our topic at hand is that they are playing a significant role in hiding the true levels of inflation from the numbers reported by our government.  Now lets look at some things not included in CPI, and which are not significantly benefitting from Globalization and Technology.  Let’s look at the following list: Healthcare, Real Estate, Education, Food, Energy, and Taxes.   Hmm, aren’t these pretty important items to consider when trying to figure out how much a dollar is worth these days?

The fact that the cost of these are growing exponentially every year, shows a decline of the dollar that is not reflected in the core CPI numbers.  Is it more important that I can get a laptop cheaply or get a higher education at a reasonable price?  Also, remember that not all that long ago, most American families were able to get by financially with only one primary breadwinner.  Now it is considered a luxury to be able to afford to stay at home rather than have both parents work full-time.

What does that say about the value of a dollar relative to goods and services we need to get by.  Perhaps some of this can be explained by us being a good bit more greedy in our idea of what the American dream should be, and our ideas of what an acceptable standard of living is.  But some of that difference is certainly reflective of the effects of inflation, effects not accurately reported to us by the CPI.

Ok, hopefully it’s clear to you why I at least believe we should focus on total money supply rather than core CPI when we try to measure inflation.  So to review, when you have more dollars, a dollar is worth less and we call this inflation, and when you have less dollars a dollar is worth more (deflation).  This is a pretty basic look at the concept and should be easily understood and remembered.  In our next article, I’ll add a few wrinkles that complicate the picture slightly, but given us a more complete view.