After reading this tutorial, you should have some insight into inflation and its effects. For starters, you now know that inflation isn't intrinsically good or bad. Like so many things in life, the impact of inflation depends on your personal situation.
Some points to remember:
- Inflation is a sustained increase in the general level of prices for goods and services.
- When inflation goes up, there is a decline in the value, or purchasing power of money.
- Variations on inflation include disinflation, deflation, hyperinflation and stagflation.
- Theories as to the cause of inflation are up for debate. Some common theories include demand-pull inflation, cost-push inflation, and monetary inflation.
- When there is unanticipated inflation, creditors lose, people on a fixed-income lose, menu costs go up, uncertainty reduces spending and exporters aren't as competitive.
- Lack of inflation (or deflation) is not necessarily a good thing and can lead to destabilizing deflationary spirals.
- Inflation is measured with a price index.
- The two main groups of price indexes that measure inflation are the Consumer Price Index and the Producer Price Indexes. The GDP- and Price-deflator are also used.
- Interest rates are decided in the U.S. by the Federal Reserve. Inflation plays a large role in the Fed's decisions regarding interest rates since it uses inflation-targeting as a policy.
- In the long term, stocks and precious metals are good protection against inflation.
- Inflation is a serious problem for fixed income investors. It's important to understand the difference between nominal interest rates and real interest rates.
- Inflation-indexed securities offer protection against inflation but offer low returns.
Essay on MONEY AND INFLATION
Inflation and deflation, in fact, are two sides of the same coin: inflation shows how prices of goods and services have risen, and deflation how they fell. Both these conditions may adversely affect the return on investment, and therefore these are the economic factors that must be taken into account when planning and managing investments. While in the apparent predominance of one trend (rising or falling of prices) the actions of an investor to protect one’s portfolio are quite obvious, if both deflation and inflation threaten the portfolio at the same time, it is necessary to undertake more complex steps to protect the investment. Below, we will consider in detail how the prediction of inflation or deflation will affect our personal investment decisions.
Over time, the prices of almost all commodities are growing. However, when this growth is too rapid, consumers as well as investors face difficulties: their purchasing power is falling, therefore they cannot purchase the desired amount of goods. In addition, inflation negates return on investment: the amount received as profit is no longer sufficient to acquire the necessary goods and services (Hellerstein, 1997).
In our view, there are several effective strategies to protect investments from inflation. In particular, investors who seek to receive a fixed income from investments often choose the inflation-protected state treasury securities: these bonds guarantee the increase in payments along with the increase of inflation. You can also invest in foreign bonds and currency, thus diversifying the portfolio and gaining access to the markets of those countries that are experiencing the negative effects of inflation to a lesser extent, or do not have them at all (Amadeo, 2010).
Another popular way to hedge is gold. This metal has always served as the most reliable tool for conservation of savings, and today the price of gold increases with increasing instability, inflation and negative sentiment in the market. One more beneficial way of investment during inflation includes other tools of commodity market. Investing in shares of companies from developing countries who are engaged in the export of raw materials, investors may receive income from rising prices for oil, gas, gold, metals and others (Correa, 2012). In general, in anticipation of the depreciation of money, investors seek to find more cost-effective use of money, in particular, investing in business expansion, commodity assets, and real estate.
Deflation occurs when the low level of demand leads to a significant drop in prices. Anticipation of the coming fall in prices leads to postponement of current consumption of goods and services by the population. People delay shopping expecting the prices to go down, thereby the total consumption falls with all the consequences (Hellerstein, 1997). For example, the increase of the money purchasing power leads to lower commitment of companies to invest with all other conditions being equal, employers begin to reduce their workforce, lenders begin to wind down their lending programs, and central banks will cut interest rates to encourage consumers to take credits and spend more.
Under these conditions, investors can take advantage of the bonds as tools to protect their investments, as well as invest in shares of companies producing essential goods (Hellerstein, 1997). Indeed people will buy basic food, medicine, hygiene products, etc., no matter what, which means that the shares of such companies will be able to go through difficult times with minimal loss. Such securities are often called protective.
Conditions of uncertainty
Sometimes it is difficult to determine whether inflation or deflation will bring more threats to investments. Such a situation could be seen during the global crisis of 2008-2009, when the real estate market and raw materials experienced deflation, while prices of consumer goods grew very rapidly (Hellerstein, 1997). The best solution in this situation is to prepare an investment portfolio for both situations – to draw the portfolio including both, securities giving good results in periods of deflation, and the tools to protect against inflation. If the investor does not have a desire or sufficient skills to rapidly and accurately determine the cycle of inflation/deflation, diversification can provide income and preservation of funds regardless of the trends that will develop in the economy (Correa, 2012). In particular, we can recommend to invest in the securities of “blue chips”: they are more persistent to deflation and pay dividends more often than other companies during inflation. Another way is investing in foreign emerging markets: companies from these countries are often exporting commodity, which are in high demand (protection against inflation) and are not too much attached to their national economy (which will protect investments in the case of deflation).
At the same time, time factor plays an important role in the choice of ways to protect the investments. When making a long-term investment in the future, perhaps, one should not react to the slightest changes in the economy (Hellerstein, 1997). However, if the return on investment is a serious budget item, there is no time to wait for economic recovery. In order to continue to earn income and feel stable it is necessary to promptly take measures to protect one’s investments and diversify the portfolio in line with the current market situation.
When the prices of goods and services are rising and the purchasing power of money falls, we call this phenomenon inflation. When prices are falling and the purchasing power of money grows, it is deflation. General assumptions of investors about future changes in the price level affect their assessment of rate of return, and thus get reflected in the market value of assets. Thus, financial investments that bring fixed incomes could be seriously damaged by a sudden rise in inflation, and conversely, could provide additional benefit in unexpected deflation. Unanticipated inflation reduces the value of the coupon payments on bonds as well as other fixed payments received by pension plans, annuities and insurance policies. Sudden deflation affects these payments in the opposite direction: the value of fixed payments such as interest on bonds rises, and therefore, the price of fixed income securities grows (Correa, 2012). In turn, during periods of sudden burst of inflation the most profitable are the investments in real estate, long-lived commodities, gold, and shares of commodity companies. To the extent in which prices in other countries change independently from the prices in the country of the investor, the possession of foreign currency or foreign securities can also protect from the effects of inflation and deflation.