Inflation and your pay



I would like to address the demand for cash balances. How much you will keep in your cash balance is a function of price levels.

If prices fall by 1/3, people will need 1/3 less money in their wallets. In the same way, if prices increase, people will need more money in their wallets.

Wallets is merely a simpler way to address liquidity. The more they need their money, the more liquid they need their savings to be.

Prices of money are determined by supply and demand of money
Purchasing power of money is merely the inverse of price levels. As prices rise, the purchasing power of money falls.

If someone uses fake money to purchase goods and services, the supply of money increases and the new price level will increase. The value of each existing dollar is diluted by the new dollar. This is similar to the inflation process. If the government releases more money into the system, the value of your money decreases.

In other words, if you did not have a pay increase this year, the value of your pay package would have decreased by the level of inflation.

Which is a more dominant force in changing prices? It is the supply of money. Government and financial institutions can collectively employ looser monetary policies to increase the supply of money. Theoretically, they could print money, drop it into your mailboxes and decrease the value of money. They could also lower interest rates to increase lending.

I hope all these are clear. But if there is one thing I would like to stress, it is that the value of your money is determined by the supply of money and the demand for money. The value of your money decreases when there is inflation. Pay increases matching inflation is not an employee benefit. It is to ensure the value of your pay remains the same as the year before.