The Conceptual Foundations of Investing

3BONDS AND INFLATION

Inflation is generally described as an increase in the prices of goods and services generally, but that is a misleading way of thinking about it. Inflation is more appropriately thought of as a decline in one price – the purchasing power of the unit of account, the dollar.

To see how it works, let's do a thought experiment. In the case of distance measurement, the most widely used unit of account is the meter. Until the twentieth century, the meter was defined to be the length of a platinum bar kept in an air-tight, temperature-controlled vault in Paris. If a dispute arose regarding whether some object was a meter long, in principle the vault could be opened and the bar could be used to confirm whether the object in question was the same length.

Now assume that some alien force is able to start shrinking the platinum bar as part of an effort to confuse humanity. How would we experience the shrinkage? By definition, the bar in the vault would always be a “meter.” But when the official meter is used to measure the length of other objects they would all appear to be getting longer. Suppose, for instance, that the bar was shrinking at 2% per year. In that case, every object would be measured as being 2% longer each year. This could get confusing because true lengths could also be changing for other reasons. For example, a growing child would be measured as taller both because the child was growing and because the meter was shrinking.

One way to confront the ...