Economics and The Time Value of Money - Inflation, Deflation and Stagflation

Inflation
Inflation refers to a general increase in the price of goods and services. This occurs when demand for these items grows faster than the supply. The result is more money chasing fewer goods, and therefore prices increase. Ensuring that your client's investments outpace the rate of inflation over the long haul is one of the major challenges for an IA.

The most important measure of inflation is the Consumer Price Index (CPI). The stock and bond markets are very sensitive to changes in the CPI because when inflation rises, purchasing power is eroded. The ensuing drop in consumer spending has a negative effect on stock and bond prices.

For more on the CPI, such as how it is constructed, its uses, and how it can be used to protect against inflation, refer to Why the CPI Is a Friend to Investors.

The rate of inflation tends to increase during economic expansions and decrease during recessions. Inflation tends to be moderate during expansions, and high inflation rates tend to hasten the transition from peak to recession. Deflation is rare and occurs only during recessions.

What causes inflation? How does it affect your investments and standard of living? The tutorial All About Inflation has the answers.


Deflation
Deflation is a general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can also be caused by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.

Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, the Federal Reserve (the Fed) can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and take some of the depressive pressures off wages and debtors of every kind.

This is the opposite of inflation, which is characterized by rising prices (do not confuse deflation with disinflation, which is simply a slowing of inflation). To many economists, deflation is more serious than inflation because deflation is more difficult to control.

Equity prices begin to decline as people sell off their investments, which are no longer offering good returns, and bonds temporarily become more attractive.

Stagflation
This is a condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, or inflation.

Stagflation occurs when the economy isn't growing but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. For these countries, including the U.S., stagnation increased the inflationary effects.

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