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.
Inflation is less dramatic than a crash, but it can be more devastating to your portfolio. Understanding the risks and likely rate of inflation can help investors craft a strategically, well-diversified retirement portfolio.
Learn the underlying theories behind these concepts and what they can mean for your portfolio. When calculating your net worth, don't forget to take inflation into account. Learn to understand how to plot your portfolio's real rate of return for retirement planning to safeguard your retirement funds against inflation.
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Urinal Godwin carnivore, his brandy discloses heroically exclaim. Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise.
In other words, inflation is a state of rising price level, but not rise in the price level. It is not high prices but rising prices that constitute inflation. It is an increase in the overall price level. A small rise in prices or a sudden rise in prices is not inflation since these may reflect the short term workings of the market.
It is to be pointed out here that inflation is a state of disequilibrium when there occurs a sustained rise in price level. It is inflation if the prices of most goods go up. However, it is difficult to detect whether there is an upward trend in prices and whether this trend is sustained. That is why inflation is difficult to define in an unambiguous sense. Suppose, in December , the consumer price index was Thus the inflation rate during the last one year was As inflation is a state of rising prices, deflation may be defined as a state of falling prices but not fall in prices.
Deflation is, thus, the opposite of inflation, i. Disinflation is a slowing down of the rate of inflation. As the nature of inflation is not uniform in an economy for all the time, it is wise to distinguish between different types of inflation.
Such analysis is useful to study the distributional and other effects of inflation as well as to recommend anti-inflationary policies. Inflation may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation. Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.
The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may be called deficit-induced inflation.
An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull inflation henceforth DPI.
But why does aggregate demand rise? Classical economists attribute this rise in aggregate demand to money supply. If the supply of money in an economy exceeds the available goods and services, DPI appears. This would prompt upward adjustment in price. DPI can be explained in terms of the following figure Fig.
In Range 1, total spending is too short of full employment output, Y f. There is little or no rise in price level. As demand now rises, output will rise. The economy enters Range 2 where output approaches full employment situation. Note that, in this region, price level begins to rise. Ultimately, the economy reaches full employment situation, i. This is demand-pull inflation. Inflation in an economy may arise from the overall increase in the cost of production.
This type of inflation is known as cost-push inflation henceforth CPI. Cost of production may rise due to increase in the price of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not market-determined. Higher wage means higher cost of production. Prices of commodities are thereby increased. A wage-price spiral comes into operation. But, at the same time, firms are to be blamed also for the price rise since they simply raise prices to expand their profit margins.
Thus we have two important variants of CPI: Anyway, CPI stems from the leftward shift of the aggregate supply curve. If the speed of upward thrust in prices is very low then we have creeping inflation.
What speed of annual price rise is a creeping one has not been stated by the economists? To some, a creeping or mild inflation is one when annual price rise varies between 2 p.
If a rate of price rise is kept at this level, it is considered to be helpful for economic development. Others argue that if annual price rise goes slightly beyond 3 p.
If the rate of annual price increase lies between 3 p. When mild inflation is allowed to fan out, walking inflation appears. Walking inflation may be converted into running inflation.
Running inflation is dangerous. If it is not controlled, it may ultimately be converted to galloping or hyperinflation. It is an extreme form of inflation when an economy gets shattered. Inflationary situation may be open or suppressed.
Because of ant-inflationary policies pursued by the government, inflation may not be an embarrassing one. For instance, an increase in income leads to an increase in consumption spending which pulls the price level up.
If the consumption spending is countered by the government via price control and rationing device, the inflationary situation may be called a suppressed one.
Once the government curbs are lifted, the suppressed inflation becomes open inflation. Open inflation may then result in hyperinflation. Former leads to a rightward shift of aggregate demand curve while the latter causes aggregate supply curve to shift leftward. There are two theoretical approaches to DPI —one is the classical and the other is the Keynesian. According to classical economists or monetarists, inflation is caused by the increase in money supply which leads to a rightward shift in negative sloping aggregate demand curve.
Given a situation of full employment, classicists maintained that a change in money supply brings about an equi-proportionate change in price level. That is why monetrarists argue that inflation is always and everywhere a monetary phenomenon. Keynesians do not find any link between money supply and price level causing an upward shift in aggregate demand. According to Keynesians, aggregate demand may rise due to a rise in consumer demand or investment demand or government expenditure or net exports or the combination of these four.
Given full employment, such increase in aggregate demand leads to an upward pressure in prices. Such a situation is called DPI. This can be explained graphically. Just like the price of a commodity, the level of prices is determined by the interaction of aggregate demand and aggregate supply. AD 1 is the initial aggregate demand curve that intersects the aggregate supply curve AS at point E 1.
The price level thus determined is OP 1. As aggregate demand curve shifts to AD 2 , price level rises to OP 2. Thus, an increase in aggregate demand at the full employment stage leads to an increase in price level only, rather than the level of output. However, how much price level will rise following an increase in aggregate demand depends on the slope of the AS curve.
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