Why does money lose value?
You often hear in the media that money is losing value. But what does that really mean? Money loses value when the same amount of money buys you less than it did a few years ago. That’s the effect of inflation, the general rise in the prices of goods and services. But inflation is only one of the factors that affect the value of money.
Alongside the title question – why does money lose value? – another one arises: how can you protect yourself against it? Let’s take a closer look at the subject.
Co tu znajdziesz?
- 1 From the gold standard to paper money
- 2 Planning to take out a mortgage?
- 3 Why was the gold standard stable? Because of the Law of Market Equilibrium
- 4 Money printing and the monetary base
- 5 Inflation – what it is and how it works
- 6 Or maybe you know someone thinking about a mortgage?
- 7 Examples of hyperinflation
- 8 How to protect your money against inflation?
- 9 The impact of inflation on loans
- 10 Summary
- 11 In brief
- 12 Key concepts
From the gold standard to paper money
To start with, it’s worth understanding what the gold standard is. Or rather, what the gold standard was…
Do you remember from the chapter on what personal finance is that money originally consisted of pieces of gold and silver, and later coins struck from them? In time, people came up with the idea of not lugging around purses heavy with coins, but depositing them in a bank instead. The proof of that deposit was banknotes. Every banknote had its “backing” in gold, which meant it could be exchanged for physical gold. A person would go to the bank with their banknote and exchange it for real gold bars. Thanks to this, paper money had a stable value and inflation was rare. The system gave people a sense of security and stability, guaranteeing that the value of money would be preserved.
I don’t want to bore you with the history of economic policy, so I’ll simply say that over time the world began moving to fiat money. Its name comes from the Latin fidus, meaning trusted. Fiat money is a means of payment issued by an issuer (e.g. the state) whose value is by convention. The value of fiat money is conventional, meaning that the market (that is, the body of all its users) has to accept it.
Even though it has no intrinsic value, it is accepted as a means of payment because of trust in the issuer – usually the government. Fiat money gives governments greater flexibility in controlling the money supply, which is hugely important in dynamically changing economies. The switch to paper money allowed for more flexible monetary policy, but it also became one of the main causes of inflation and of the falling value of money.
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Why was the gold standard stable? Because of the Law of Market Equilibrium
The stability of gold’s value was and is beyond dispute. Gold has always been valued and provided solid backing because of a fundamental economic principle: the Law of Market Equilibrium. The law of market equilibrium is a basic economic principle. It states that the price and quantity of a good on the market settle at the point where demand for that good equals its supply. Complicated? Let me try to put it more simply. It’s important to understand the Law of Market Equilibrium, because that’s when you’ll also start to understand why prices rise.
The Law of Market Equilibrium
The Law of Market Equilibrium means that producers (sellers) want to sell a lot when the price is high, and little when the price is low. Clear? And consumers (the ones buying) are the opposite: they want to buy a lot when it’s cheap, and don’t want to buy when it’s expensive.
We can draw this on a graph – the function showing the quantity (Q – quantity) of products that producers will want to sell at a given price (P – price) is called the supply curve and is marked with the letter S (supply). The function showing the quantity of products that consumers want to buy is marked with the letter D (demand) and is called the demand curve.
The supply curve (the sellers’ one) rises – at a price of 10 sellers don’t really want to sell, so the quantity will be 10. At a price of 90, sellers want to sell everything they have. The demand curve (the buyers’ one) is the opposite, so it falls. At a price of 10 buyers would like to buy everything (quantity: 50); at a price of 90 they no longer really want to buy. But if we overlay these two curves on a single graph, we’ll see that there is a certain point where the two curves meet. For example – at a price of 40, both sellers and buyers want to sell/buy 30 units. That is the equilibrium price.
And that’s exactly what the Law of Market Equilibrium is about: in a free market with no outside interference, the quantity of goods that producers want to sell corresponds exactly to the quantity that consumers want to buy at a given price. And when we wonder why prices rise, what we have in mind is precisely the equilibrium price, which has changed because of a shift in the demand curve or the supply curve.
Differences between fiat money and the gold standard
The Law of Market Equilibrium sets the value of gold very effectively and stably for a simple reason: the supply of gold is heavily limited. The amount of this metal is fairly small, and you can’t create gold out of nothing (or at least it isn’t profitable). That’s why, since the supply doesn’t change much, the value doesn’t change much either.
“Mr Smarty-pants, then why does the price of gold keep rising?”, you’ll ask. Well, the thing is that the price of gold isn’t actually rising. Its value doesn’t change – it stays the same. It’s the value of money (dollars, euros, złoty) that keeps falling, which is why the price of gold expressed in those falling currencies appears to rise. But it’s not gold getting more expensive. It’s money losing value.
Why does money lose value? Well, above all because of the Law of Market Equilibrium. Governments are constantly printing more of it, banks grant loans (if you don’t know what that has to do with the amount of money, find out how loans work), and the amount of money in circulation grows. And since people have more money (while the amount of goods hasn’t increased), their prices will rise, because people will be willing to pay more. If money becomes cheaper, you have to pay more money for the same good. We call this phenomenon inflation, that is, a rise in prices.
Money printing and the monetary base
When we talk about printing money, we often picture printing presses running at full speed. In reality, central banks “print” money by increasing the monetary base through market operations and interest-rate adjustments. It’s a more complicated process than physically printing banknotes, although of course that happens too.
More money in circulation
When more money appears in the economy, this naturally leads to an increase in the amount of funds available to spend. More money leads to rising prices, that is, inflation. When listing the causes of inflation, you can’t stop at the fact that central banks print more money. There is one more factor that makes money appear out of nowhere in the economy. It is money creation by commercial banks, which consists of creating new money through lending.
When a customer deposits 1 złoty in a bank, the bank keeps only part of that amount as a reserve (e.g. 10%, that is 10 grosz) and lends the rest (90 grosz) to another customer. This process repeats many times: the customer deposits those 90 grosz from the loan into a bank as a deposit, from which a loan is granted again. Thanks to this system, banks can turn a single deposited złoty into as many as 10 new złoty in the economy. This is possible because banks don’t have to hold the entire deposited amount, only part of it, and can lend the rest on. Interesting, isn’t it? You deposit 1,000 PLN in the bank, and the bank turns those 1,000 PLN into 10,000 PLN – that is, it creates an extra 9,000 PLN out of nothing.
And that’s still assuming a required reserve ratio of 10%. In Poland it currently stands at 3.5%! This means that from a single złoty of deposit, a bank in Poland can create around 28.57 złoty through repeated lending and depositing. So thanks to your 1,000 PLN deposit, the bank can “conjure up” 27,570 PLN! And these are precisely the causes of inflation.
Inflation – what it is and how it works
Inflation is a rise in the average level of prices in the economy. It can be measured using various indices, such as the CPI (Consumer Price Index) or the PPI (Producer Price Index). Inflation is a natural phenomenon, but a high level of it can significantly affect your life. That’s why, even though the state itself generates the causes of inflation, it also tries to prevent them. But how the state fights inflation – that’s coming up shortly.
Knowing the Law of Market Equilibrium, you can assess how the (market) price will change in a specific situation. In an economics degree programme, the lecturer teaching Microeconomics would ask: how will the price of coffee on the world market change if a drought in Brazil reduces yields by 25%? And the student then has to say that the drought in Brazil will cause producers to grow less coffee, so the supply curve will shift upward, and therefore the equilibrium price will rise.
Prices can rise for various reasons. Demand-pull inflation occurs when demand for products exceeds supply, which leads to rising prices. Cost-push inflation, on the other hand, appears when production costs rise and are passed on to consumers in the form of higher prices.
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In short, the question “why do prices rise” can be answered by saying that it’s for two main reasons (setting aside the state-driven causes of inflation, which we’ve already discussed):
- Because people want to buy more (e.g. because they earn more, because they received the 500+ child benefit).
- Because producers can produce less (e.g. because they had to raise the minimum wage, so their costs went up).
Examples of hyperinflation
While stable (low) inflation is a normal phenomenon, sometimes it gets out of control and turns into hyperinflation.
History provides many examples of drastic inflation. The best example of how printing affects inflation was the hyperinflation in the Weimar Republic after World War I, when papering your walls with 1-mark banknotes became cheaper than using actual wallpaper. Money lay scattered in the streets because no one wanted to bend down to pick it up.
At its worst point, inflation reached 29,525.71%. That means that bread which costs 3 PLN today would cost 6 PLN in 10 days, 12 PLN 10 days after that, and 24 PLN another 10 days later. So within a month its price would rise from 3 PLN to 24 PLN. So if you earn 3,000 PLN, this month you’ll buy 1,000 loaves, and a month from now only 125.
The most recent high-profile hyperinflation was the one in Venezuela, where it reaches 100% year after year. That means everything gets 100% more expensive over the course of a year. These aren’t values as extreme as in Germany, but they still effectively make normal life impossible. Seeing how inflation affects an economy when it isn’t controlled, we should be glad when in our own economy it doesn’t exceed a few percent.
How to protect your money against inflation?
Inflation can have a significant impact on your savings and purchasing power. Fortunately, there are several strategies that can help protect your wealth from the falling value of money. Here are a few of them:
Inflation-protected investments
One of the most effective ways to protect yourself against inflation is investing. Below you’ll find a few inflation-protected investment options worth considering:
- Shares: Investing in shares can be beneficial, because many companies raise the prices of their products and services in response to inflation, which can lead to higher revenues and higher share values. Since the causes of money losing value come down to rising prices, investing in those who decide on those price increases is a logical solution. Companies in sectors such as technology, healthcare or consumer goods often do well during inflation.
- Real estate: Investing in real estate is another inflation-protected investment. Property values tend to rise during inflation, and on top of that you can generate rental income. Commercial and residential real estate can be a solid inflation-protected investment.
- Gold and precious metals: Gold is traditionally seen as a safe haven during inflation. Precious metals such as gold, silver or platinum often gain in value when inflation rises, so they are without doubt inflation-protected investments. You can invest directly in physical gold or through investment funds and ETFs that track the prices of precious metals.
- Inflation-indexed bonds: Inflation-indexed bonds are designed to protect investors against inflation. The face value of these bonds rises along with inflation, which provides protection of capital.
Budget planning
A carefully planned household budget can help protect your finances against inflation. So when creating a budget or a financial plan, always assume a certain margin for cost increases tied to inflation, or build it on real values – that is, ones that take into account the impact of inflation and the falling value of money. Knowing why money loses value, you can assess how you think inflation will behave in the future. Being aware of how inflation affects the economy will help you when preparing your financial plan.
Review your finances regularly to adjust your budget to changing economic conditions. Monitor your spending and income so you can react quickly to rising prices. Be prepared, too, for the fact that the instalments on variable-rate loans may rise if inflation suddenly goes up.
Saving in different currencies
Saving in stable currencies can be an effective strategy for protecting yourself against inflation. So you might also consider keeping part of your savings in the currencies of countries with low inflation. Check how a given state fights inflation and whether it does so more effectively than others. This can help minimise the risk associated with a weakening of the local currency. You can do this by investing in assets denominated in foreign currencies, such as shares in foreign companies or ETF funds.
The impact of inflation on loans
Surprisingly, inflation isn’t harmful to everyone. You could say that inflation is the debtor’s friend, especially when it comes to mortgages. One of the main effects of inflation is to lower the real value of the principal portion of the instalment.
Under inflation, even with a constant inflation rate of 3% per year, the real value of every instalment falls over time. That means you pay the same nominal instalment (e.g. 1,000 PLN), but the real value of that money falls. So in reality you pay less and less. Inflation causes the purchasing power of money to decline. That means that with each year 1,000 PLN is worth less. At an inflation rate of 3%, after a year the real value of that 1,000 PLN is only 970 PLN. After two years it’s already 941 PLN. That means that if two years ago you bought a dishwasher for 941 PLN, today that same dishwasher costs 1,000 PLN.
“All right – I have a loan, but why do I benefit when money loses value?” For you, as a borrower, it means that the actual cost of repaying the loan gets smaller as time goes by. Even though you pay the same nominal amount of 1,000 PLN, its real value – that is, what that money can buy – keeps getting smaller. Inflation “eats away” at the value of the instalments, which makes the loan more cost-effective, especially over the long term.
Under constant inflation, borrowers can benefit from the declining real value of their liabilities, which makes the debt easier to repay as time goes on. From an economic point of view, then, it doesn’t pay to repay loans early (except perhaps to free up your borrowing capacity), but I’ll devote a separate chapter to that topic.
Summary
The falling value of money is a complex phenomenon, and the causes of money losing value are very varied: they include money printing, monetary policy and market changes. It’s important that you understand why prices rise, how these processes affect your life, and what steps you can take to protect your savings.
Don’t worry about how the state fights inflation, because you don’t have much influence over it. But you do need to know how inflation affects the economy in order to build your own strategy for protecting yourself against it. Investing, budget planning and diversifying your savings are key strategies that can help you preserve the value of your money in the face of inflation.
Protecting yourself against inflation requires conscious planning and diversification of your investments and savings. Investing in shares, real estate, gold or inflation-indexed bonds can help preserve the value of your wealth. In addition, careful budget planning and saving in stable currencies can be effective strategies for protecting yourself against the falling value of money.
In brief
Money loses value, which means that for the same amount of money we buy less than we did a few years ago, mainly because of inflation – the general rise in the prices of goods and services. The shift from the gold standard, where banknotes were backed by gold, to fiat money, based on trust in the issuer, gave governments greater flexibility in controlling the money supply, but it also contributed to rising inflation and the falling value of money.
The Law of Market Equilibrium, which sets the price and quantity of a good at the point where demand equals supply, helps you understand the impact of money printing on the economy. When a central bank increases the money supply, prices rise and the value of money falls, which lowers the real value of loan instalments, making mortgages easier to repay.
To protect your savings against inflation, it’s worth investing in shares, real estate, gold or inflation-indexed bonds, planning your budget with inflation in mind, and saving in stable currencies. These strategies will help preserve the value of your wealth despite rising prices.
Key concepts
Gold standard, fiat money, the value of money, the time value of money, the Law of Market Equilibrium, supply curve, demand curve, equilibrium price, monetary base, inflation, money creation, required reserve ratio, CPI, hyperinflation, real value,