Friday, May 11, 2012

A quick primer: Inflation vs. Devaluation

Following a conversation I had tonight on twitter, I'd like to write a quick little guide on the difference between devaluation and inflation, as they do look quite similar.

Let's say you have an apple and I have an apple, and we'd like to buy a orange. Lets say an apple costs an orange. So I can trade my apple, for an orange. Now, devaluation is usually done by producing more certificates for apples than there are actual apples, but for the sake of simplicity we will say instead you get a wage reduction. You now only earn half an apple for your energy you put in to work, but an orange still costs 1 apple as the number of apples being produced hasn't changed, only your wage has (boss is probably keeping the second apple as a "bonus"). What is key here is that the value of your work (or energy) has been devalued. The cost of an orange in terms of your wealth has now doubled but the value of the orange is the same, 1 apple. The effect of a wage "decrease" occurs in the real world when wages do not keep up with "inflation" - which in modern central bank money printing terms is really devaluation.

As I mentioned, to better reflect the real world you would be paid in "apple certificates" and the devaluation would occur by the number of "apple certificates" doubling over the actual number of apples. Thus 1 apple certificate becomes worth half an apple. * UPDATED AND ADDED FOR CLARIFICATION *

Real inflation works like this. You and I get a wage increase, now we both make two apples for the same amount of work as some new magical efficient apple producing technology came along and doubled production. There are now twice as many apples in existence. Since there are now more apples than oranges, the cost of an orange goes up. An orange is now worth two apples.

In both scenarios the "cost" doubles, but in 1 your wealth is cut in half, and in the other your wealth has doubled.

If people seem poorer today, its because - they are. Trillions in new currency have been produced, but an equal increase in real global wealth hasn't occured. The result is every dollar produced takes a little bit of existing wealth from existing dollars.

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Richard Fantin is a self-taught software developer who has mostly throughout his career focused on financial applications and high frequency trading. He currently works for CenturyLink

Nazayh Zanidean is a Project Coordinator for a mid-sized construction contractor in Calgary, Alberta. He enjoys writing as a hobby on topics that include foreign policy, international human rights, security and systemic media bias.

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