Inflation is the economic condition characterized by continuously rising prices for goods and services. As a result, the purchasing power of a country's currency deteriorates as its value decreases and interest rates rise.
What exactly causes inflation and how does it affect your investments and standard of living? See the tutorial: All About Inflation for the answers
There are two generally recognized types of inflation: demand-pull inflation and cost-push inflation.
- Demand-Pull Inflation: The money supply is seen as the cause of this type of inflation. In this situation, the money supply is too large when compared with the supply of produced goods in the economy. Interest rates rise as a result, making it more expensive to borrow money. As a result, the money supply begins to shrink with the drop in lending activity.
- Cost-Push Inflation: The rising cost of raw materials used to produce goods is seen as the cause of this type of inflation. Since manufacturers now need to pay more for these materials, they raise the prices on their products to compensate. As a result, retailers must pay more for goods, so they increase prices to pass the difference on to the consumer.
Conversely, deflation is a persistent decline in the prices of goods and services usually caused by slowing market demand with a level supply. Purchasing power increases as a result of stagnant demand, fixed-income securities become more appealing, and producers must lower their prices to compete for the limited demand.
Inflation usually has a negative effect on security prices, especially those equities that are particularly interest-rate sensitive, such as financials, smaller companies that rely on debt financing to grow, and cyclical businesses such as durable goods like heavy machinery, automobile and steel manufacturers, and other capital goods industries.
Exam Tips and Tricks
You should understand the fundamental causes and effects of both inflation and deflation. Be prepared to address the effects of each economic environment on the price of securities and on interest rates.
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