inflation

Examples of inflation in the following topics:

• Differences Between Real and Nominal Rates

  • Nominal rate refers to the rate before adjustment for inflation; the real rate is the nominal rate minus inflation: r = R - i or, 1+r = (1+r)(1+E(r)).
  • The real rate is the nominal rate minus inflation.
  • If the lender is receiving 8% from a loan and inflation is 8%, then the real rate of interest is zero, because nominal interest and inflation are equal.
  • Where r is the real rate, i is the inflation rate, and R is the nominal rate.
  • Since the future inflation rate can only be estimated, the ex ante and ex post (before and after the fact) real rates may be different; the premium paid to actual inflation may be higher or lower.

• Inflation Premium

  • An inflation premium is the part of prevailing interest rates that results from lenders compensating for expected inflation.
  • An inflation premium is the part of prevailing interest rates that results from lenders compensating for expected inflation by pushing nominal interest rates to higher levels.
  • Actual interest rates (without factoring in inflation) are viewed by economists and investors as being the nominal (stated) interest rate minus the inflation premium.
  • In the Fisher equation, π is the inflation premium.
  • Since the inflation rate over the course of a loan is not known initially, volatility in inflation represents a risk to both the lender and the borrower.

• Impact of Inflation on Inventory Management

  • High inflation encourages companies to keep a high level of inventories.
  • Consequently, inflation also reflects an erosion in the purchasing power of money–a loss of real value in the internal medium of exchange and unit of account in the economy.
  • Negative effects of inflation include an increase in the opportunity cost of holding money; uncertainty over future inflation which may discourage investment and savings; and if inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future.
  • Therefore, high inflation encourages companies to keep a high level of inventories.
  • The Nobel laureate Robert Mundell noted that moderate inflation would induce savers to substitute lending for some money holding as a means to finance future spending.

• The Fisher Effect

  • We did not adjust the nominal interest rates for inflation.
  • Unfortunately, inflation can have a significant influence on the financial markets.
  • It equals a geometric average of the expected inflation rate and real interest rate.
  • For low inflation and low interest rates, we can use the approximation that we had derived in Equation 2.
  • Investors know the inflation would erode the value from their investment while businesses could repay the bonds with inflated dollars.

• Macroeconomic Factors Influencing the Interest Rate

  • Taylor explained the rule of determining interest rates using three variables: inflation rate, GDP growth, and the real interest rate.
  • According to Taylor's original version of the rule, the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP:
  • In other words, (πt - π*t)is inflation expectations that influence interest rates.
  • Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now.
  • Describe how the nominal interest rate is influenced by inflation, output, and other economic conditions

• Comparing Interest Rates

  • Variables, such as compounding, inflation, and the cost of capital must be considered before comparing interest rates.
  • To find the real interest rate, simply subtract the expected inflation rate from the nominal interest rate.
  • Company 1 will pay you 5% per year, but is in a country with an expected inflation rate of 4% per year.
  • Company 2 will only pay 3% per year, but is in a country with an expected inflation of 1% per year.
  • The nominal interest rate is approximately the sum of the real interest rate and inflation.

• Impact of Inflation on Financial Statement Analysis

  • Inflation accounting is used in countries with high inflation.
  • Accountants in the United Kingdom and the United States have discussed the effect of inflation on financial statements since the early 1900s .
  • Inflation accounting, a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation, is a solution to these problems.
  • This type of accounting is used in countries experiencing high inflation or hyperinflation.

• Disinflation

  • Disinflation is a decrease in the inflation rate; a slowdown in the rate of increase of the general price level of goods, services.
  • Disinflation is a decrease in the rate of inflation–a slowdown in the rate of increase of the general price level of goods and services in a nation's gross domestic product over time.
  • If the inflation rate is not very high to start with, disinflation can lead to deflation–decreases in the general price level of goods and services.
  • When the growth rate of unemployment is below the natural rate of growth, this leads to an increase in the rate of inflation; whereas, when the growth rate of unemployment is above the natural rate of growth it leads to a decrease in the rate of inflation also known as disinflation.
  • Disinflation is a decrease in the rate of inflation as illustrated in the yellow region of this graph.

• Time Lags and Targets

  • Since the 1990s, the Fed has emphasized a low inflation goal, and this policy has been successful.
  • Europe and Japan also emphasize price stability and low inflation rates.
  • However, commodity prices do not accurately predict inflation well.
  • U.S. dollar exchange rate: Exchange rates can predict inflation and real GDP growth rate.
  • Thus, a central bank should not focus on the economy but maintain low inflation.

• Central Banks

  • When a central bank increases the money supply, it can create inflation.
  • Although inflation erodes the value of money, a low inflation rate is not necessarily bad because it might indicate economic growth.
  • However, if the money supply grows too quickly, then inflation can strike an economy with rapidly rising prices.
  • Nominal GDP includes the impact of inflation.
  • On the other hand, economists can remove the effects of inflation by calculating real GDP.