← Money Lessons with Andrew Temte, PhD, CFA
Money Lessons with Andrew Temte, PhD, CFA
Understanding Inflation: When Money Loses its Power
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Foreign hi, I'm Andy Tempte, and welcome to the Saturday Morning Muse. Start your weekend with musings that are designed to improve financial literacy around the world. Today is August 16, 2025. Last month, in late July, we explored how the bank of England revolutionized finance in 1694 with the world's first government backed banknotes. Standardized promissory notes solved many problems that had plagued earlier banking systems. But as we'll see today, even the most sophisticated monetary systems face a persistent challenge that has haunted economies for inflation. Now, Back in our June 21 episode, we discovered how Roman emperors would reduce the precious metal content in their coins to fund military campaigns. When a Roman denarius contained less silver, traders quickly realized that each coin was worth less, requiring more coins to buy the same goods. This currency debasement led directly to higher prices, what we call inflation today. While we can no longer face the literal debasement of metal coins because they don't contain silver or gold anymore, the underlying economic forces that drive inflation remain remain remarkably similar. Whether it's a Roman emperor diluting silver content or a modern central bank increasing the money supply, the fundamental dynamic is the same. More money chasing the same amount of goods and services drives prices higher. Now let's start with a precise definition of inflation. Inflation is a sustained increase in the general price level of goods and services in an economy over time. Notice the word sustained. A one time increase in the price of gasoline due to a pipeline disruption isn't inflation. Inflation occurs when prices across the economy rise persistently over months or even years. Inflation is intimately connected to the concept of purchasing power, your money's ability to buy goods and services. When inflation occurs, each dollar in your wallet loses purchasing power. If inflation runs at 3% annually, which is roughly what it's running today, Something that costs $100 today will cost $103 next year. Your dollar will purchase fewer goods and services next year. So this purchasing power erosion affects everyone differently. If your salary increases by 5% while inflation runs at 3%, you're ahead. Great job. Your purchasing power actually improved. But if you're on a fixed pension that doesn't adjust for inflation, then you're falling behind every year in that purchasing power. Now, what are the primary drivers of inflation? Economists through the years have identified several key causes of inflationary cycles. The first is what's called demand pull inflation. This occurs when demand for goods and services exceeds their supply. Think of concert tickets for a popular band. If everyone wants tickets, but there are only so many seats to go around prices rise. This can happen economy wide when consumers have more money to spend than there are goods available. The second type of inflation is cost push inflation. This happens when the costs of production increase, forcing businesses to raise prices. If oil prices spike, transportation costs rise, making everything that has to get transported more expensive to produce and deliver. Tariffs on imported materials create similar effects. When governments impose taxes on steel imports, for example, domestic manufacturers faced higher costs for raw materials. We saw this dynamic during the 1970s oil crisis when OPECs the oil production cartel, when their embargoes quadrupled petroleum prices, driving up costs for everything from gasoline to plastics heating bills. Companies then pass these increased costs onto consumers through higher prices. Now the third is monetary inflation, and this results from increases in the money supply that outpace economic growth. This is the modern equivalent of currency debasement that we talked about before. When central banks create too much new money relative to the goods and services that are being produced, each unit of money, money becomes worth less. Now, the last type is built in or expectational inflation. This creates a self reinforcing cycle. When people expect prices to rise, they demand higher wages. Businesses then raise prices to cover higher labor costs, validating the original expectation and perpetuating the cycle. This spiral played out dramatically in the United States during the late 1970s, when inflation expectations became so entrenched that union contracts routinely included automatic cost of living adjustments, essentially guaranteeing that wages would rise with prices and ensuring that inflation continued. Now, to understand how monetary policy decisions can disrupt economies, let's examine a fascinating crisis that struck England just two years after the bank of England's founding in 1694. Now, while we've been discussing inflation, the great recoinage of 1696 provides an equally important lesson about deflation, which is the opposite of inflation, where prices fall and money becomes more valuable. This episode shows how government monetary policy can trigger severe economic disruption in either direction. Now, by the 1690s, England had faced a monetary crisis. The silver coins that were circulating throughout the realm had been quote unquote clipped. People would shave off small amounts of silver from the edges of coins before spending them, and over decades, this practice had reduced many coins by nearly half of their original weight. Additionally, counterfeit coins constituted approximately of the nation's currency. This chaotic currency situation contributed to rising prices, particularly for food and necessities. As merchants struggled with coins of uncertain value, merchants began refusing lightweight coins or accepted them only at a reduced value, creating chaos in daily commerce. Now, King William III's government, advised by philosopher John Locke and scientist Isaac Newton decided on a radical solution. They would recall all old silver coins and mint new ones with fancy milled edges to prevent clipping. You see milled edges today on quarters and dimes. The policy seemed logical, but its execution proved disastro asterisk. The government, the English government at the time announced that after a certain date, old coins would no longer be accepted at their face value. This created immediate panic as people rushed to exchange their clipped coins before the deadline. Many people engaged in a final round of clipping to extract as much silver as possible before turning in their coins. Meanwhile, the mints in England couldn't produce new coins fast enough to replace the old ones being withdrawn. The result was a severe shortage of circulating currency, just as England was fighting an expensive war against France called the Nine Years War. The estimated value of money in circulation fell from around 26 million pounds in December of 1695 to under 17 million pounds six months later. To address this liquidity crisis, and we'll talk more about liquidity crises later. In later episodes, people increasingly relied on credit transactions and the few gold coins that were still in circulation, rather than causing inflation. This recoinage initially created deflation and economic contraction. In the second half of 1696, England's essentially stopped and the ensuing monetary contraction led to massive unemployment, poverty and civil unrest. As you might imagine, the crisis caused a run on the bank of England and one of history's first stock market crashes. Now, the government's attempt to solve a monetary problem through well intended policy created severe economic disruption. This episode, the Coinage, demonstrates how even sound economic reasoning can lead to disastrous outcomes when implementation is poorly managed. And how monetary policy changes can have far reaching unintended consequences. Now why does this matter today? The great recoinage of 1696 teaches us several crucial lessons about monetary policy that remain relevant today. First, monetary policy decisions do have these far reaching consequences that policymakers don't always anticipate. When central banks adjust interest rates or the money supply, they're essentially conducting economic experiments on a massive scale. Second, whether dealing with inflation or deflation, monetary disruptions directly affect your daily life. Every trip to the grocery store, every rent payment, every tank of gas reflects the cumulative impact of monetary forces. Understanding these dynamics help you make better financial decisions. And that's what this show is all about. Making better financial decisions. In today's economy, we face similar challenges to those 18th century policymakers. Actually, the late 17th century is the late 1600s. Supply chain disruptions create cost, push inflation. Government spending programs can fuel demand, pull inflation. Central bank policies influence monetary inflation, and once inflationary expectations take hold, they can become self fulfilling prophecies. Now the key insight is that monetary crises rarely rarely have simple solutions. And boy do politicians like to come up with really simple quick fix solutions. They typically Solutions to monetary crises typically require multiple approaches working together, and they're wildly complex. The Great Recoinage crisis ultimately ended not through any single policy success, but through the conclusion of the Nine Years War in 1697, the expansion of credit systems to substitute for scarce coins, and England's gradual transition toward a gold standard. So those banknotes that we talked about before were a solution. Now, understanding inflation empowers you to protect your purchasing power through smart saving, investing and career decisions. When you see inflation rising, you can adjust your financial strategy accordingly, perhaps by choosing inflation protected investments or by negotiating salary increases that keep pace with rising prices. Most importantly, remember that monetary stability depends on both sound policy and public confidence. The Great Recoinage showed how even well intentioned monetary reforms can create severe disruptions with when poorly executed, reminding us that the complexity of monetary systems typically requires careful gradual changes rather than dramatic big bang overhauls. Now, until next week, I wish you grace, dignity and compassion. My name is Andy Tempte. This is the Saturday Morning Muse. You can find the show on all the major streaming services as well as out on YouTube. Please like, subscribe, rate and most importantly, share this public good with your friends, your neighbors, your colleagues, and that family member that you might like and enjoy. The show was produced by Nicholas Tempte and we'll see you next time on the Saturday Morning Museum.