What Is Inflation?

Inflation! If you’re like us, then just reading the word might have just sent a chill down your spine. But just what is inflation?

Why? It’s arguably one of the biggest drains on our wallets and makes everything much more expensive over time. It’s certainly not ideal! But did you know inflation wasn’t always a thing? 

Before Inflation

That’s right, there was a time when you didn’t have to worry about the effects of inflation on your finances. We’re talking about the late 19th and early 20th century—back when most national currencies were pegged to a specific quantity of gold.

These days, the governments of most countries actually set a fixed exchange rate between their currencies and gold. This meant you could walk into a bank with a bunch of cash and walk out with a fixed allocation of gold. In fact, you could do it again the next day, and the next, and get the exact same amount of gold each time. Yes—the exchange rate would not even change from day to day.

This system was effective for a couple of main reasons. Firstly, gold is difficult to come by. The supply is limited to the number of known gold deposits and it’s also difficult to extract, refine, and transport. Secondly, gold is incredibly hard to counterfeit. That’s because manufacturing is impossible while checking its authenticity is very easy.

This system was known as the gold standard, but it’s no longer in place. Where currencies used to be backed by a fixed allocation of gold, they’re not anymore! Instead, they’re simply backed by the goodwill of the government that prints/mints it. 

That might seem all well and good, but changes in economic circumstances over the last century have forced governments to print more currency than ever before. And as a result, we’re feeling the strain. We all face it, but many of us aren’t aware of just how damaging it is to our finances.

Know what we’re talking about? Yep, it’s our good old friend, inflation again.

How Fiat Currency Introduced Inflation

Before we get into the nitty-gritty of inflation and why it straight-up sucks, we first need to take a look at how fiat currency came about—that is the kind of money we have today, that isn’t backed by gold or anything else. 

Back when countries needed to adhere to the gold standard, they had to maintain a significant gold reserve to match the amount of currency in circulation.

In other words, they couldn’t print money unless they had enough gold in reserves to back it up. Unless they changed the exchange rates (which, of course, they did, plenty of times). 

However as countries needed to ramp up their spending due to World War I, they found that they were limited by the availability of gold. So they simply suspended the interconvertibility of gold or changed its exchange rate to increase cash flow. 

But the gold standard didn’t completely die until the 1970s. This was finalised when the United States dissolved something known as the Bretton Woods Agreement.

With this, the US dollar became what is now known as a ‘fiat currency’—that is, a currency that has its value enforced by the government that issues it. Instead of relying on the value of gold, USD became reliant on the continued faith of its users.

This is the kind of money that we generally use today—it doesn’t have any intrinsic value like commodity money. Plus, governments can print as much of it as they like, since it’s not reliant on the availability of real-world resources.

And boy have they been busy printing—with around one-fifth of all US dollars printed in 2020 alone. 

The rapidly increasing money supply, in combination with other factors like rising wages and production costs, has caused the purchasing power of currencies to collapse over time. This means it costs more and more over time to buy the same things. 

In other words, inflation is the reason everything seems to be getting more expensive over time!

How Inflation Affects You

Like most things, the value of a fiat currency is largely dependent on changes in supply and demand. 

When supply goes up and demand decreases or stays the same, the value of that currency tends to drop—while the opposite is true if demand increases while supply drops or stays the same. That’s supply and demand in a nutshell. 

But with fiat currencies, this balance is almost always skewed toward oversupply. This oversupply is where the problems start—there’s just too much currency in circulation. 

You know where this is going.

With too much money in circulation, its value tends to diminish over time, making it less and less valuable. 

This isn’t too noticeable when measured from day to day or even month to month, but when you compare it by the decade, the damage becomes clear. 

If you’ve been around for several decades, you may have already noticed how money just doesn’t go as far as it used to. Put simply, that’s due to inflation. Overall, the purchasing power of the US dollar (USD) has fallen by more than 90 percent in the last 100 years. In fact, it’s dropped more than 30 percent in just the last twenty years.

To put this into perspective, $100 in 2021 will get you less than a tenth of what it would have 100 years ago, or just two-thirds of what it would in 2001. 

This is part of the reason why the price of a McDonald’s Big Mac rose from $0.45 in the 1960s up to $5.66 in 2021. Talk about a tough number to chew!

Yep, things haven’t just been getting more expensive, your money is also losing value. Double whammy!

As you might imagine, keeping money in the bank for long periods of time can result in a dramatic loss in purchasing power. This is certainly the case if the interest rate you receive (the money you earn for parking your money at the bank) doesn’t cover inflation. 

And that’s if your bank is generous enough to even pay interest—many don’t. Some even enforce negative interest rates, meaning you actually lose money for holding your funds at a bank! Ouch. 

This isn’t just a problem that affects the US dollar (USD). Practically every modern currency suffers from inflation. Some even suffer from ‘hyperinflation’—due to extremely rapid increases in the cost of goods.

All in all, it’s not a pretty picture.

Why Crypto Hedges Against Inflation

Cryptocurrencies are now one of the most popular hedges against inflation. That’s because some of their properties can make them resistant to the purchasing power decline that fiat currencies typically experience over time. 

To explain, Fiat currencies tend not to have a maximum supply limit. That means the value of a specific currency is at the whim of its government. For example, the US government can print as many dollars as they’d like.

On the other hand, many cryptocurrencies (including Bitcoin and Cardano) have a fixed maximum supply that cannot be easily exceeded. This means you can always be sure exactly how many units of a cryptocurrency will ever exist.

These coins with limited supply have a predictable rate of inflation. In short, their value isn’t dependent on the surrounding economic environment but instead baked in at the protocol level. In many cases, this rate of inflation (new coins entering circulation each year) decreases over time, making the coin deflationary. These sorts of assets are less susceptible to ‘supply shock’, meaning a sudden increase in the supply is never looming. 

Some would also argue that unlike fiat currencies which have no supply limit and are not backed by a commodity, the scarcity of many cryptocurrencies is what gives them at least part of their value. 

They’re a bit like gold in that respect, which is why some people call Bitcoin ‘digital gold’. 

How Inflation May Affect Your Future

Inflation is a problem that we all face, but often don’t recognize how problematic it can be. It creeps up on you over years and decades. Use an inflation simulator to better understand the impact of leaving your savings in the bank.

As such, cryptocurrencies are often hailed as the potential ‘future of money’. They empower the individual and protect against economic decline. Put simply, cryptocurrencies let us retake control of our finances. After all, who wants to see the value of your money erode over time?

Knowledge is power – so keep on learning! If you enjoy getting to grips with crypto and blockchain, check out our School of Block video Get Rich Quickly In Crypto.