There’s a lot of talk these days about inflation, what might be the road ahead for the US dollar, and what it might mean for the average working person.
The first thing is to understand is how much a dollar is worth. Economists explain that it’s possible to calculate how much a dollar is worth by looking at the “Price Index”. The price index is a basket of commodities such as cheese, bread, gas, etc…. Keeping an eye on the price of a group of items helps us track the buying power of the dollar and hence what a dollar is worth or how much it can be traded for in the open market in today’s economy.
When the Federal Reserve prints money without any form of return in exchange (it just creates money) then this causes an inflation of the Dollar (because the Dollar has just lost buying power because it was diluted) and is trackable in the price index.
The obvious question is why the Federal Reserve would just print money. One answer may be to pay off debt. This is because the debt is held in a contract in the form of a dollar number and not a dollar value. Another way of looking at it is; the government doesn’t owe a value amount rather they owe a specific dollar amount and to pay this off they can print dollars. Another way for the government to pay off its debt is through raising taxes.
In the case of raised taxes, it can be seen as a more surgical approach and wouldn’t affect everyone equally. This is because certain entities can seek tax asylum, be granted tax deductions, or be entirely tax pardoned. So, raising taxes would affect a more limited amount of people while in the case of inflation everyone (as in every dollar) gets hit (devalued) equally.
The resulting economic reaction differs with each approach. We already mentioned that printing money has an inflationary effect; however, raising taxes can actually have a deflationary effect. Sometimes a high tax rate can be used as a deflationary device. As people have less of their income to spend this forces prices of consumer goods down as far as margins can go. However, when raising taxes there is an important thing to remember. Namely, that there are those that hold US dollars but don’t pay US taxes. Such as other countries that hold the US dollar as a reserve currency. These entities, or governments, will become extremely powerful in the US. Since our market prices have gone down and our citizens have fewer dollars, while they have the same dollar amount.
Safe asylum from inflation does exist. For example by holding assets (rather than currency). The bigger problem is if the world economy gets spooked from holding the dollar as its reserve currency or using it for trade.
Currently, many countries use the US dollar to make purchases between each other because the dollar has been an extremely stable currency. This gives the US a very powerful tool when it makes a trade embargo on a particular country. For example, if the US were to say no one can trade with Iran, then other countries would comply for fear of the US no longer accepting their currency which would effectively make it worthless on the open market. However, if countries start using China’s Yuan, for example, as a reserve and trade currency this will make China the “go to” country for goods and services and other countries may no longer care for the US trade opinions.
Is this a simplification? Yes. However, it does capture the general thoughts and logic found in the actions taken by governments within the world of finance and money.