What impact does inflation have on the value of the dollar today?

The impact of inflation on the time value of money is that it decreases the value of a dollar over time. Time value of money is a concept that describes how the money you have available today is worth more than the same amount of money at a future date.

It also assumes that you are not investing the money you have today in an interest-bearing equity, debt or bank account. Essentially, if you have a dollar in your pocket today, that dollar’s value, or the value, will be less a year from today if you keep it in your pocket.

Inflation raises the price of goods and services over time, effectively decreasing the number of goods and services you can buy with a dollar in the future, as opposed to a dollar today. If wages stay the same but inflation pushes the prices of goods and services up over time, it will take a higher percentage of your income to buy the same good or service in the future.

Here is a graph of the inflation rate from the late 1600s to today. Note that since the 1950s the inflation rate has been positive almost every year.

Source: OfficialData.org.
Image by Sabrina Jiang © Investopedia 2020

So, for example, if an apple costs $ 1 today, it is possible that it costs $ 2 for the same apple in a year. This effectively decreases the purchasing power of silver over this period because it will cost twice as much to purchase the same product in the future. To mitigate this decrease in the time value of money, you can invest the money you have available today at a rate equal to or greater than the rate of inflation. Consider the table below, which shows the purchasing power of $ 100 from 1799 to today. So in the example above, if we had $ 100 worth of apples in 1799, those same apples would cost over $ 2,000 today.

Source: OfficialData.org.
Image by Sabrina Jiang © Investopedia 2020

What has an impact on inflation?

Basically, inflation is caused by an increase in the price of goods or services. Now it’s determined by supply and demand. Everything else constant, an increase in demand can push up prices (if the supply of goods and services is stable), while a decrease in supply can push up prices as well.

Demand may increase because consumers have more money to spend. More spending increases inflation, in particular, greater consumer confidence. When wages are stable or rising and unemployment is relatively low, inflation is likely to rise. Additionally, manufacturers are likely to increase their prices if consumers are willing or able to spend more.

Then there is the offer. Lower supply can lead to lower demand, leading to higher prices. A drop in supply can occur for a number of reasons, such as disasters that disrupt the supply chain or the capabilities of manufacturers. Or assuming an item proves to be very popular, it can sell out quickly, as is the case with iPhones.

The Federal Reserve and inflation

One of the main responsibilities of the Federal Reserve is to monitor and control inflation. The Fed aims to keep the inflation rate around 2%. The Fed manages inflation in one of three ways: fed funds rate, reserve requirements, and money supply reduction.

The federal funds rate is the rate at which banks can borrow money from the government. To help curb rising inflation, the Fed will raise rates, which inherently increases the interest rates charged by banks. This slows down spending and lowers prices, thus helping to control inflation.

Then there are the minimum reserves, that is, the amount of capital that banks must keep. To curb spending and inflation, the Fed can increase reserve requirements, which decreases the amount of money banks can lend. Finally, there is the money supply, which involves the Fed directly influencing the amount of money in circulation by issuing or calling bonds, which helps reduce the amount of money in circulation.

The Fed measures inflation by monitoring and tracking various indexes, particularly price indexes that track changes in the prices of particular goods and services. The main index used by the Fed includes the personal consumption expenditure index published by the Commerce Department. The PCE index includes a variety of goods and services that are part of household expenditure, but it consults other indices, such as the consumer price and producer price indices of the Ministry of Labor.

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