When a dollar is not worth a dollar – Your money and inflation
Article by R. Joseph Ritter, Jr. CFP® EA
Two topics will be dealt with in this article: What is money and what is inflation?
What is a dollar worth if it does not go as far as it did 20 years ago? The price of a gallon of gasoline in January 1994 was $0.99 according to the U.S. Energy Information Administration. In the week of January 13, 2014, 20 years later, the average price of gasoline is $3.31 according to AAA’s fuel gauge report. This shows that the price of gasoline has increased at a rate of 6.22% per year over the last 20 years. If the gas station would accept a dollar for a gallon of gasoline in 1994, why will they not accept a dollar for a gallon in 2014? Is my money worth less just because 20 years passed?
There are two factors involved in answering this question. One is inflation and the other is the foreign exchange rate. Inflation is the increasing relative cost of goods and services over time. Inflation is a vicious cycle. As the cost of goods and services increases, salaries must also increase to provide people the money to buy those goods and services. When salaries increase, this adds to the cost to produce and provide the goods and services, which means the prices must again rise. Inflation is what we hear about the most in the news, although there are other economic forces at work as well. Another way of looking at inflation is that it is the erosion of the value of a dollar over time. If the level of inflation rises or falls (deflation) too quickly all at once, then there are all sorts of economic problems. Inflation is what we often complain about when considering the cost of goods and services in comparison to our salaries, so let’s unpack it a little.
First, inflation over the last 20 years has not affected everything the same way. Milk and bread, for example, have not risen in price as much as gasoline, and perhaps other products or services have increased in cost more than gasoline. One reason for prices rising, falling or remaining steady is competition, which usually helps to keep prices lower. There is competition in gasoline in terms of different brands and oil refineries, and this competition has helped to keep prices from skyrocketing. However, that is not the only factor involved in price fluctuations.
Foreign exchange rates affect the costs associated with importing goods and do not affect all products equally. Ingredients for bread and bakeries which make bread are largely contained within the United States. Oil for refining into gasoline is partly imported. The cost of goods made within the United States is largely dependent on the costs of the underlying ingredients and the cost of human capital, construction, real estate, equipment and so forth. The costs to import goods depends more on the value the foreign countries with whom we trade perceive our dollar to be worth.
Let’s look at an example. Let’s assume that 20 years ago a barrel of oil could be bought from a foreign country for $50. Today, let’s assume that the same barrel of oil can be bought for $100. Has the price of oil risen or has the value of the dollar fallen? While it may be true that the cost of extracting and refining oil has risen, one issue that exacerbates prices when importing goods is the exchange rate, or the amount of foreign currency one U.S. Dollar can buy. While some countries may accept U.S. Dollars for the goods they have for sale without having to first exchange the money into the foreign currency, there is still something like an exchange rate factor which affects how much oil one U.S. Dollar can buy.
Then, why do foreign countries believe our dollar does not go as far today as it did 20 years ago?
Inflation really means for you and me that the gas station or store is only willing to sell you so much for one U.S. Dollar as they believe the Dollar is worth to them. In simple terms, one U.S. Dollar is a measure of worth represented by a piece of paper. The paper is inherently worthless, so the person to whom you are giving the Dollar is concerned primarily with what they believe the Dollar is worth to them. In other words, one U.S. Dollar is worth only what someone else perceives its value to be, and the value can fluctuate based on policies and acts of our government and the Federal Reserve.
Our currency today is based solely on paper. If a person believes he or she is wealthy with $1 million in the bank, what they really have to show for it is 1 million pieces of paper that is said to be worth one dollar each. The paper is worthless unless someone else believes it is worth something to them. As we have seen, a dollar today may not be worth as much tomorrow. Currency is meaningless until you go to spend it, and then its value depends on what the other person believes its worth to be.
Although our economy is built around currency, what we work for and hope to accumulate in savings is nothing more than a stack of pieces of paper which only have worth as long as someone will accept them as currency.
These pieces of paper are cause for a great deal of stress in our lives and can bring us joy as well.
This is not an article encouraging you to accumulate hard assets instead, such as land, collectibles, commodities, gold or other property. Instead, I trust that this article will challenge your thinking on what it is you are dealing with and what it is that can be the cause of so much anxiety in your life – a piece of paper that stores accept in selling you goods and services, the value of which fluctuates from day to day.
The pieces of paper you receive as a paycheck and have in your bank account are much more controllable if you put them in their proper context and perspective. We can help you take control over your finances, create a plan that gets the most out of the pieces of paper that flow through your household, and work with you to achieve the most happiness despite the number of pieces of paper you have to handle your current financial situation.