Understanding Inflation: When Money Loses Its Power

I'm Andy Temte and welcome to the Saturday Morning Muse! Start your weekend with musings that are designed to improve financial literacy around the world. Today is August 16, 2025.

Last month, we explored how the Bank of England revolutionized finance in 1694 with the world's first government-backed banknotes. These standardized promissory notes, solved many problems that had plagued earlier banking systems. But as we'll see today, even the most sophisticated monetary systems face a persistent challenge that has haunted economies for millennia: inflation.

Connecting the Dots: From Debasement to Modern Inflation

Back in our June 21st episode, we discovered how Roman emperors would reduce the precious metal content in their coins to fund military campaigns. When a Denarius contained less silver, traders quickly realized each coin was worth less, requiring more coins to buy the same goods. This currency debasement led directly to higher prices—what we call inflation.

While we no longer face the literal debasement of metal coins, the underlying economic forces that drive inflation remain remarkably similar. Whether it's a Roman emperor diluting silver content or a modern central bank increasing the money supply, the fundamental dynamic is the same—more money chasing the same amount of goods and services drives prices higher.

What Inflation Really Means

Let's start with a precise definition:

Inflation is a sustained increase in the general price level of goods and services in an economy over time.

Notice the word "sustained"—a one-time price increase for gasoline due to a pipeline disruption isn't inflation. Inflation occurs when prices across the economy rise persistently over months or years.

Inflation is intimately connected to purchasing power—your money's ability to buy goods and services. When inflation occurs, each dollar in your wallet loses purchasing power. If inflation runs at 3% annually, something that costs $100 today will cost $103 next year. Your dollar will purchase fewer goods and services.

This purchasing power erosion affects everyone differently. If your salary increases by 5% while inflation runs at 3%, you're ahead—your purchasing power improved. But if you're on a fixed pension that doesn't adjust for inflation, you're falling behind every year.

The Primary Drivers of Inflation

Economists have identified several key causes of inflationary cycles:

Demand-Pull Inflation occurs when demand for goods and services exceeds supply. Think of concert tickets for a popular band—if everyone wants tickets but there are only so many seats, prices rise. This can happen economy-wide when consumers have more money to spend than there are goods available.

Cost-Push Inflation happens when the costs of production increase, forcing businesses to raise prices. If oil prices spike, transportation costs rise, making everything more expensive to produce and deliver. Tariffs on imported materials create similar effects—when governments impose taxes on steel imports, for example, domestic manufacturers face higher costs for raw materials. We saw this dynamic during the 1970s oil crises, when OPEC's oil embargoes quadrupled petroleum prices, driving up costs for everything from gasoline to plastics to heating bills. Companies pass these increased costs on to consumers through higher prices.

Monetary Inflation results from increases in the money supply that outpace economic growth. This is the modern equivalent of currency debasement—when central banks create too much new money relative to the goods and services being produced, each unit of money becomes worth less.

Built-in or Expectational Inflation creates a self-reinforcing cycle. When people expect prices to rise, they demand higher wages. Businesses then raise prices to cover higher labor costs, validating the original expectation and perpetuating the cycle. This spiral played out dramatically in the United States during the late 1970s, when inflation expectations became so entrenched that union contracts routinely included automatic cost-of-living adjustments, essentially guaranteeing that wages would rise with prices and ensuring inflation continued.

The Great Recoinage Crisis of 1696: A Cautionary Tale

To understand how monetary policy decisions can disrupt economies, let's examine a fascinating crisis that struck England just two years after the Bank of England's founding. While we've been discussing inflation, the Great Recoinage of 1696 provides an equally important lesson about deflation—inflation's opposite, where prices fall and money becomes more valuable. This episode shows how government monetary policy can trigger severe economic disruption in either direction.

By the 1690s, England faced a monetary crisis. The silver coins circulating throughout the realm had been "clipped"—people would shave small amounts of silver from the edges of coins before spending them. Over decades, this practice had reduced many coins by nearly half their original weight. Additionally, counterfeit coins constituted approximately 10% of the nation's currency. This chaotic currency situation contributed to rising prices, particularly for food and necessities, as merchants struggled with coins of uncertain value. Merchants began refusing lightweight coins or accepting them only at reduced value, creating chaos in daily commerce.

King William III's government, advised by philosopher John Locke and scientist Isaac Newton, decided on a radical solution: they would recall all old silver coins and mint new ones with milled edges to prevent clipping. The policy seemed logical, but its execution proved disastrous.

The government announced that after a certain date, old coins would no longer be accepted at face value. This created immediate panic as people rushed to exchange their clipped coins before the deadline. Many people engaged in a final round of clipping to extract as much silver as possible before turning in their coins. Meanwhile, the mints couldn't produce new coins fast enough to replace the old ones being withdrawn.

The result was a severe shortage of circulating currency just as England was fighting an expensive war against France (the Nine Years' War). The estimated value of money in circulation fell from around £26 million in December 1695 to under £17 million six months later. To address the liquidity crisis, people increasingly relied on credit transactions and the few gold coins still in circulation.

Rather than causing inflation, the recoinage initially created deflation and economic contraction. In the second half of 1696, England's economy essentially stopped, and the ensuing monetary contraction led to massive unemployment, poverty, and civil unrest. The crisis caused a run on the Bank of England and one of history's first stock market crashes.

The government's attempt to solve a monetary problem through well-intentioned policy created severe economic disruption. The episode demonstrates how even sound economic reasoning can lead to disastrous outcomes when implementation is poorly managed, and how monetary policy changes can have far-reaching unintended consequences.

Modern Implications: Why This Matters Today

The Great Recoinage teaches us several crucial lessons about monetary policy that remain relevant today. First, monetary policy decisions have far-reaching consequences that policymakers don't always anticipate. When central banks adjust interest rates or money supply, they're essentially conducting economic experiments on a massive scale.

Second, whether dealing with inflation or deflation, monetary disruptions directly affect your daily life. Every trip to the grocery store, every rent payment, every tank of gas reflects the cumulative impact of monetary forces. Understanding these dynamics helps you make better financial decisions.

In today's economy, we face similar challenges to those 18th-century policymakers. Supply chain disruptions create cost-push inflation. Government spending programs can fuel demand-pull inflation. Central bank policies influence monetary inflation. And once inflationary expectations take hold, they become self-fulfilling prophecies.

The key insight is that monetary crises rarely have simple solutions—they typically require multiple approaches working together. The Great Recoinage crisis ultimately ended not through any single policy success, but through the conclusion of the Nine Years' War in 1697, the expansion of credit systems to substitute for scarce coins, and England's gradual transition toward a gold standard.

Understanding inflation empowers you to protect your purchasing power through smart saving, investing, and career decisions. When you see inflation rising, you can adjust your financial strategy accordingly—perhaps by choosing inflation-protected investments or negotiating salary increases that keep pace with rising prices.

Most importantly, remember that monetary stability depends on both sound policy and public confidence. The Great Recoinage showed how even well-intentioned monetary reforms can create severe disruptions when poorly executed, reminding us that the complexity of monetary systems typically requires careful, gradual changes rather than dramatic overhauls.

Until next week...

Grace. Dignity. Compassion.