Download MAKING SENSE OF INFLATION AND DEFLATION

MAKING SENSE OF INFLATION AND DEFLATION
When we look at the money in our pocket, we can almost automatically figure out what it is worth in terms of something
else. If you have a five-dollar bill, you can buy a value meal at a fast food restaurant or any number of things. What is a little more
difficult to understand is how the REAL value of money changes over time. Ten years from now, the same five-dollar bill will not be
able to buy the same amount of REAL stuff. When the value of money changes over time, it creates certain problems in the economy,
and can hurt some people much more than others. Money can change value in TWO ways:
INFLATION: This is when prices are rising, and a given sum of money will buy less in the future. Cars used to cost
$10,000, now they cost around $20,00. Inflation is generally always rising today, usually about 3% each year.
DEFLATION: This is when prices actually drop in the economy, and a given sum of money can buy more goods than they
could at an earlier period. Deflation is rare today, but in the past, it was a regular occurrence.
The value of money in the economy changes primarily because of the amount of money in circulation. If the amount of
money rises, prices rise. If the amount of money falls, prices usually fall. Just think of what would happen if we would all DOUBLE
the amount of money that we have. This would SEEM to be a good thing. But if this happened prices would also double in a short
amount of time, and you would not end up with any more REAL stuff than you had before. Thus, more money is not always a good
thing.
The most interesting thing about inflation or deflation is that it does not normally hurt the average worker in society. They
will either get a pay raise or a pay cut, but prices will adjust so that their standard of living remains unchanged. While this is true,
there are people who can gain or lose a lot if there is inflation. Inflation gets tricky when we either borrow money from a bank or loan
it to the bank in a savings account. The examples below should show you why this is true:
DURING INFLATION: People who borrow from the bank “win” and banks or lenders “lose” during inflation. The reason
is simple. When inflation occurs (wages, salaries, and prices of general goods increase) you are still paying the same loan
amount back to the bank. Banks are getting “cheaper dollars” from you that can not buy the same REAL stuff that it could
before.
DURING DEFLATION: In this case, the effects are just the opposite. If you borrow money today and pay it back later, the
dollars that you pay back will be worth more than the ones that you borrowed. The banks do well because they get the
dollars that buy MORE than those that they loaned out. In this case, lenders are “winners” and borrowers are “losers”.
Now that you have a better understanding of how inflation and deflation either help or hurt certain people in the economy,
you are ready to put your newfound knowledge to the test. On the other side of the sheet you will find a scenario and some questions
that follow. When you are done, you should see exactly why farmers were so upset and formed the Populist movement to help their
lot in life.
READ THE FOLLOWING AND USE THIS DATA TO ANSWER THE QUESTIONS BELOW:
Imagine that you are a farmer in Nebraska in 1885, and that you make a living raising and selling wheat on the open market.
You are happy now because your wheat sells for $7 a bushel, and you can use this money to pay off the loan from the bank that you
needed to start the farm. Skip ahead to 1887, and your wheat is now worth $5 a bushel. By 1889 your wheat is selling for $3 a bushel.
Your loan from the bank requires you to pay $100 per month for the next 10 years. This loan is a FIXED AMOUNT for the entire
period and it will not get cheaper over the life of the loan. If you do not pay off your loan, you will be forced to give up the farm to
the bank!
1.) How many bushels of wheat do you have to produce each month to pay off your loan in 1885? In 1887? In 1889?
2.) Is your labor worth as much in 1889 as it was in 1885? Why/Why not? Overall, as a farmer, are you hurt or helped by deflation?
3.) What solution would you propose that the government come up with to help you out in this situation?
(HINT: The government controls the money supply in the economy.)
4.) If the government does what you say, who might begin to lose from this situation?