Econ Grapher

Inflation

What is Inflation?
Inflation refers to rising prices, or a reduction in purchasing power (i.e. falling value of the currency). It is generally measured using a Consumer Price Index, and is calculated as a percent change in the relevant price index. For example the annual rate of inflation is Price Index in period 1 divided by Price Index in period 0, minus 1. For example if the price index in March 2004 is 101, and it was 100 in March 2003 then the annual inflation rate would be 1%. Inflation is closely related to economic growth, and plays a major part in the setting of monetary policy, indeed many central banks have explicit inflation targets.

How does it relate to Markets?
Inflation is generally bad for stock prices, a high rate of inflation implies a lower expected future value of earnings, and thus a lower valuation. But because inflation also impacts on monetary policy settings, an increase in the level of inflation may prompt the central bank to raise interest rates in order to try and reduce inflationary pressures and slow down the economy. The result of higher interest rates is generally lower stock prices as the discount rate applied to valuations rises, and behaviorally a higher interest rate will encourage investors out of risky assets. [So a low inflation rate will generally mean higher stock prices, however a low inflation rate can also be a product of a recession or economic slowdown, which is not so good; so it is a complex system]. Likewise inflation plays a critical role in currency markets as a high rate of inflation implies a decline in the value of that currency - so relative inflation rates will play into exchange rate movements (as will the implications on interest rates and interest rate differentials!).

Good or bad?
Is inflation good or bad? Generally speaking a high inflation rate is bad, and a negative inflation rate (i.e. deflation) is also bad,  but a stable low rate of inflation is widely seen as a good thing. Some of the bad effects of high inflation include rising inflation expectations (high inflation expectations lead to factoring in of future price rises into price negotiations e.g. wages), hyperinflation (which can be very disruptive to the functioning of an economy), disruption of price signaling and a reduction of locative efficiency. Some of the positives include: labour market adjustments (e.g. since wages tend not to fall much, a constant nominal wage will in effect be a lower wage in an inflationary environment, so the labour market may adjust faster), lower effective interest rate on debt (i.e. the "real" interest rate you pay is the nominal interest rate minus the inflation rate), greater investment in physical assets.

Causes
Inflation can be driven by a multitude of factors such as "demand pull" inflation (caused by increases in aggregate demand due to increased private and government spending i.e. growth driven), "cost push" inflation (caused by a drop in aggregate supply, or a supply shock - where supply is for whatever reason severely restricted e.g. due to war, natural disaster, etc), and inflation expectations driving a self-reinforcing cycle of price increases. It can also be caused by exceedingly loose monetary policy e.g. low interest rates and quantitative easing (i.e. growth in the money supply).

Hyperinflation and Deflation
Two destructive forms of inflation are Hyperinflation (an excessively high level of inflation - think wheelbarrows of 1 million notes in Zimbabwe for buying a loaf of bread etc), and Deflation (think Japan and its "lost decade"). Hyperinflation throws everything off and basically disrupts the normal function of the economic system, it will often eventuate in the scrapping of the currency and replacement with a new one and tight monetary policy. Deflation can be very hard to escape and encourages hoarding of financial assets and under-investment in physical assets (because if prices are going down then obviously you want to hold cash and wait until prices drop to start buying).

Sources and further reading:
Milton Friedman: Nobel Lecture - Inflation and Unemployment
What You Should Know About Inflation
Understanding Inflation and the Implications for Monetary Policy: A Phillips Curve Retrospective
Inflation, PE Ratios, and Stock Prices
Inflation vs Unemployment
Wikipedia - Inflation

Graph Library:
Metric - Inflation

Original Source: http://www.econgrapher.com/encyclopedia-inflation.html

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