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Inflation

WHAT IS INFLATION?

Inflation has been defined as a process of continuously rising prices, or equivalently, of a continuously falling value of money. In other words, inflation causes the buying power of a dollar to decrease over time. A 15 cent hamburger in 1966 seems to us a lot cheaper than the 79-cent hamburger of today. But when the price of that 1966 burger is adjusted for inflation, the price is comparable. To experiment with the change in buying power of a dollar over time, try out the on-line inflation calculator maintained by the U.S. Bureau of Labor Statistics (BLS). The CPI inflation calculator uses the average Consumer Price Index for a given calendar year. This data represents changes in prices of all goods and services purchased for consumption by urban households. This index value has been calculated every year since 1913. For the current year, the latest monthly index value is used.

HOW IS INFLATION MEASURED?

Various indexes have been devised to measure different aspects of inflation. Two commonly used indexes are the Consumer Price Index (CPI) and the US Implicit Price Deflator for Personal Consumption (IPD). The CPI measures inflation as experienced by consumers in their day-to-day living expenses. The method used to construct the CPI compares the current and base year cost of a basket of goods and services of fixed composition. For the CPI the base is a fixed "market basket" or bundle of goods and services representative of the purchases of urban consumers. The index is the ratio of today's cost of the fixed bundle to the base year cost of the same bundle. This kind of index implicitly assumes that the consumer's consumption pattern does not change in response to any price changes.The alternative index to the CPI is the implicit price deflator for personal consumption (IPD). This price index uses current period quantities as the weights rather than some fixed bundle. Current personal consumption is measured in today's prices and then compared to current personal consumption at prices from a base year. This price index method assumes that the consumer has made allowances for changes in relative prices. There are a number of other indexes of price changes other than the CPI and IPD: the Producer Price Index (PPI) measures inflation at earlier stages of the production and marketing process; the Employment Cost Index (ECI) measures it in the labor market; the Bureau of Labor Statistics' International Price Program measures it for imports and exports; and the Gross Domestic Product Deflator (GDP-Deflator) measures combine the experience with inflation of governments (Federal, State and local), businesses, and consumers. Finally, there are specialized measures, such as measures of interest rates and measures of consumers' and business executives' inflation expectations.

What is the Difference between Inflation and the Consumer Price Index?

Many people are confused by the difference between Inflation and the Consumer Price Index. The Consumer Price Index is as its name implies an index, or “a number used to measure change”.The Consumer Price Index (CPI-U) The government chose an arbitrary date to be the base year and set that equal to 100. Currently that date is 1984. (Or more accurately the average of the years 1982-1984) previously the base year was 1967. Every month the Bureau of Labor Statistics (BLS) surveys prices around the country for a basket of products and publishes the results as a number. Let us assume for the sake of simplicity that the basket consists of one item and that one item cost $1.00 in 1984. Then the BLS published the index in 1984 at 100. If today that same item costs $1.85 the index would stand at 185.0 of course a group of items would work the same way. If you have 100 items each would account for 1% of the total index. By itself that does not tell us what the current Inflation rate is. We must do some calculations using that index to tell us the Percentage of increase or decrease in the level of prices.

How to use CPI to measure inflation?

CPI measures prices of consumer goods and services. CPI, as other indexes, measures price changes by comparing the price to a price in a base year. In many cases, the Bureau of Labor Statistics uses 1982-84 as their base index period. This means that all prices at this time are considered to be "100". When comparing prices in of a future period, you must compare the prices to that base period and calculate the index. For example, if prices double from the base year, the index would be 200. This is calculated by: index = current price / base price * 100.

for example
index = $6.00 / $3.00 * 100 = 200
In order to make use of the CPI study, you will need to understand how to use an index to determine the percentage change of a particular item, when using CPI, a good or service. Below is an example of how to calculate the change in two index figures:

CPI for current period136.0
Less: CPI for previous period129.9
Equals index point change6.1
Divided by previous period CPI129.9
Equals0.047
Result multiplied by 1000.047 x 100
Equals percent change4.7%

Inflation" & how it eats your money silently & affects your investments!

Inflation, is an economic concept. What the cause of inflation is, is not important to us from the point of view of this article. What is important to us is the effect of inflation! The effect of inflation is the prices of everything going up over the years. A movie ticket was for a few paise in my dad’s time. Now it is worth Rs.50. My dads first salary for the month was Rs.400 and over he years it has now become Rs.75,000. This is what inflation is, the price of everything goes up. Because the price goes up, the salaries go up.

If you really thing about it, inflation makes the worth of money reduce. What you could buy in my dad’s time for Rs.10, now a days you will not be able to buy for Rs.400 also. The worth of money has reduced! If this is still not clear consider this, when my father was a kid, he used to get 50paise pocket money. He used to use this money to go and watch a movie (At that time you could watch a movie for 50paise!)

Now, just for the sake of understanding assume that my dad decided in his childhood to save 50paise thinking, that one day when he becomes big, he will go for a movie. Many years pass. The year now is 2006. My dad goes to the theater and asks for a ticket. He offers the ticket-booth-guy at the theater 50paise and asks for a ticket. The ticket booth guy says, “I am sorry sir, the ticket is worth Rs.50. You will not be able to even buy a “paan” with the 50paise!!”

The moral of the story is that, the worth of the 50paise reduced dramatically. 50paise could buy a whole lot when my dad was a kid. Now, 50paise can buy nothing. This is inflation. This tells us two important things.

Firstly: Do not keep your money stagnant. If you just save money by putting it your safe it will loose value over time. If you have Rs.1000 in your safe today and you keep it there for 10years or so, it will be worth a lot less after 10 years. If you can buy something for Rs.1000 today, you will probably require Rs.1500 to buy it 10 years from now. So do not keep money locked up in your safe.

Always invest money.
If you can’t think where to invest your money, then put it in a bank. Let it grow by gaining interest. But whatever you do, do not just lock your money up in your safe and keep it stagnant. If you do this, you will be loosing money without even knowing it. The more money you keep stagnant the more money you will be loosing.

Secondly: When investing, you have to make sure that the rate of return on your investment is higher than the rate of inflation.

What is the rate of inflation?

As we said earlier, the prices of everything goes up over time and this phenomenon is called inflation. The question is: By how much do the prices go up?

At what rate do the prices do up?

The rate at which the prices of everything go up is called the "rate of inflation". For example, if the price of something is Rs.100 this year and next year the price becomes approximately Rs.104 then the rate of inflation is 4%. If the price of something is Rs.80 then after a year with a rate of inflation of 4% the price go up to (80 x 1.04) = 83.2 So, when you make an investment, make sure that your rate of return on the investment is higher than the rate of inflation in your country. In our county India, for the year 2005-2006 the rate of inflation was 4% (Which is really low and amazing!). This rate keeps changing every year. The finance minister generally gives the official statement on the inflation rate of the country for a particular year.

What is the rate of return?

The rate of return is how much you make on an investment. Suppose you invest Rs.100 in the market and over a year, you make Rs.120, then you rate of return is 20%. If you invest Rs.100 in the market today and you make money at a 3% "rate of return" in one year you will have Rs.103. But now, since the rate of inflation is at 4%, an item costing Rs.100 today will cost Rs.104 a year from now. So what you can buy with today’s Rs.100, you will only be able to buy with Rs.104 a year from now. But the Rs.100 that you invested has grown only at a 3% rate of return and so it is worth Rs.103. In effect, you are loosing money! So in conclusion, the rate of return on your investments, have to be higher than the rate of inflation. From the above paragraphs you can note how silently, inflation eats into your money. You would not even know about it an your money would sit loosing value for no fault of yours. But inflation is not the only thing you should be considering, there are other things too that eat into you money. The first thing is “brokerage” and the second thing is “taxation”.

Is moderate inflation good for an economy?

Many economists are of the view that once the unemployment rate falls to below a certain percentage, the Non-Accelerating Inflation Rate of Unemployment (NAIRU), it sets off an inflationary spiral. This acceleration in the rate of inflation takes place through increases in the demand for goods and services. It also lifts the demand for workers and puts pressure on wages, reinforcing the growth in inflation. A Brookings Institution study three scholars, William Dickens, George Perry and George Akerlof, concluded that a rate of unemployment of 4.5 per cent is where the rate of inflation stabilizes. This finding is below the generally accepted view that the rate of inflation tends to accelerate when the unemployment rate falls to below 5 per cent. The writers of the report also argue that eradicating inflation altogether may do more harm than good.

If inflation were to fall to zero, worker productivity would decline, unemployment would rise and the overall economy would sink. According to the research-paper an inflation rate of 3.4 per cent, which is consistent with the unemployment rate of 4.5 per cent, is the ideal situation for the economy. It seems that while too much inflation can destroy your health, a little bit of it could actually be good for you. But does this make sense?

The NAIRU however, is an arbitrary measure, it is derived from a statistical correlation between changes in the consumer price index and the unemployment rate. What matters here is whether the theory “works”, i.e., whether it can predict the future rate of increases in the consumer price index. This way of thinking doesn’t consider whether a theory corresponds to reality. Here we have a framework, which implies that “anything goes” as long as one can make accurate predictions. The purpose of a theory, is to present the facts of reality in a simplified form. The theory has to originate from the reality and not from some arbitrary idea that is based on a statistical correlation. If “anything goes” then we could find by means of statistical methods all sorts of formulas that could serve as forecasting devices. For example, let us assume that high correlation has been established between the income of Mr Jones and the rate of growth in the consumer price index. The higher the rate of increase of Mr Jones’ income, the higher the rate of increase in the consumer price index. Therefore we could easily conclude that in order to exercise control over the rate of inflation the central bank must carefully watch and control the rate of increases in Mr Jones’ income. The absurdity of this example matches that of the NAIRU framework. Contrary to mainstream thinking, strong economic activity doesn’t cause a general rise in the prices of goods and services and an economic overheating known as inflation. Regardless of the rate of unemployment, as long as every increase in expenditure is supported by production no overheating can occur.

The overheating emerges once expenditure is rising without the backup of production. This can only occur when the money stock is increasing. Once money increases it generates an exchange of nothing for something, or consumption without preceding production, which leads to the erosion of real wealth. As a rule, rises in the money stock are followed by rises in the prices of goods and services. Here is why. Prices are another name for the amount of money that people spend on goods they buy. If the amount of money in an economy increases while the amount of goods remains unchanged more money will be spent on the given amount of goods i.e., prices will increase.

Conversely, if the stock of money remains unchanged it is not possible to spend more on all the goods and services, hence no general rise in prices is possible. By the same logic, in a growing economy with a growing amount of goods and an unchanged money stock, prices will fall. If the general rise in prices is the outcome of the rising money stock, how could it then benefit the economy if it stabilizes at 3.4 per cent? People’s real income will be eroded year after year by 3.4 per cent, so how could this promote economic growth and stability as the Brookings report suggests?

On the contrary, people’s capacity to save out of their eroding incomes will diminish. With fewer savings less funding will be generated, which in turn will hamper the future of economic growth. Curiously, writers of the Brookings report in suggesting that the rate of inflation of 3.4 per cent is good for the economy imply that a higher figure is bad. However, regardless of how fast it rises, inflation is always bad news, for it sets an exchange of nothing for something, implying an erosion of the real wealth. The only difference between the 3.4 per cent rate of inflation versus 10 per cent is that the larger number will cause greater damage. Yet both figures undermine people’s well being. Contrary to the Brookings report then, the ideal setup is the complete eradication of inflation. This however, means that the central bank must stop its monetary pumping and the abolition of fractional reserve banking. Ignoring the facts of reality by means of an arbitrary theory is an attempt on behalf of the Brookings report to justify the central bank’s tampering with the economy. This however, can only further undermine people's living standard.

A detailed analysis of the cause of inflation is beyond the scope of this short article, but we can mention some things that tend to cause inflation.

Increases in government taxes and fees can lead to inflation (especially when businesses are taxed). When the cost of business goes up, product prices go up. When prices go up your income effectively goes down. Then you have to work harder or find a better job. Or hope that your employer will give you a raise. Which then makes the business costs go up and so prices go up and so on.

Also when your personal income taxes, property taxes, sales taxes, auto registration fees, etc. increase you are forced to live on less or hit the boss up for a raise.

If you get your raise (and several of your co-workers also are given raises) the cost of doing business has gone up. The business will then pass the extra costs on to their customers - inflation.

Inflation can also be caused by scarcity. If there are only a 10,000 Beanie-Babies, "Tickle-Me-Elmos", "Chicken-Dance-Elmos", or what ever the current toy-craze is, and there are 100,000 people that want one, the price is going to go up.

If mad-cow disease causes cattle ranchers to destroy large portions of their herds and there is less beef on the market, the price of beef will go up.

If interest rates go up, inflation can also result. If it costs more to borrow money, the cost of doing business has gone up and so will product and service prices.

For the last 10 years inflation has been relatively low. It is my uneducated opinion that inflation has been minimal because people have relied on the stock market boom of the 90s to supply extra cash. Also many people have taken on additional debt rather than curtail their spending.

But people can only stand so much debt. Once you are maxed out on your ability to pay (you may never max out your credit limit as long as you keep paying on time), you will either have to reduce your lifestyle, beg for a raise or find a higher paying job.

I predict that once the majority of middle-class America is saturated with debt, inflation will begin to rise or the economy will stagnate for years until some of the debt is paid down or people's homes appreciate so that they can borrow more money against them. (Yes, you will be getting further into debt, but at least you can buy that new boat.)

For the most part, regular, steady inflation has little effect on our day-to-day living. Most people get a pay raise every year or every other year that either keeps pace with inflation or helps them move a bit ahead.

But when you are looking at the long run and making long term plans, inflation can have a big impact.

For example if you are 30 right now, wouldn't it be great to retire with a million dollars when you are 60. You could live on that forever. Right?

Well, let's factor in just 3% inflation for 30 years and see how much your million will buy then. After 30 years of 3% inflation, one million dollars will buy about $400,000 worth of goods and services. That's 60% of your money gone to inflation.

If you were counting on a monthly retirement amount of $2778 each month for 30 years, you now only have the equivalent of $1111 each month. Less than half! Could you live on $1111 a month?

Sure you may have your home paid for and you won't have to buy expensive work clothes or pay for lunch every day, but your medical bills will go up as you get older and your insurance costs will increase. Also you may want to golf or travel more than you do now. You will have more time for hobbies; how will you pay for them?

The biggest problem I see with a lot of long range financial planning, especially retirement planning, is that people forget to factor in the effect of inflation on their investments and savings.

You may be able to live on $2778 a month at today's prices, but could you live on $1111 at what prices could be 30 years from now.

So what can you do about inflation? Really nothing. It is out of your hands.

But when planning for the future you can include it in your calculations. If you want to live on the equivalent of $2778 a month when you retire 30 years from now, you need to plan to save/accumulate $1.8 million and have it invested at 5% after you retire and want it to last 30 years.

That means that if you are earning 11% (as the stock market has averaged for the last 30 years) and you are 30 now, you will have to invest $500 each month to achieve this goal. If you only invest $100 a month you will need an average return of 18.4%. (If you can average that, you should be managing the world's money!)

A good financial planner will understand the effects of inflation and help you plan for them. But I suspect that some less-trained "planners" (who are probably more like salespeople in a financial planner suit) tend to "forget", ignore or don't understand in the first place the effects of inflation.

Leaving it out of the plan makes the calculations easier and may even help them get more "sales" because you are not discouraged by the truth. And their "product" (investment) may not seem as inadequate as it may really be.

Another quick way to account for the effect of inflation is to subtract the inflation rate from any rate of interest you will be receiving on an investment. So if you are going to assume a 3% inflation rate and the assumed rate of return is 11%, do the projection with only a 8% rate of return or interest.

This will give you a more accurate picture of the value (not the amount) of the investment at its maturity.

Some investments such as real estate and precious metals (gold, silver, etc.) actually benefit from inflation. This may make you want to truly "diversify" your portfolio into more types of assets, not just more types of stock.

Inflation does not have to be scary as long as you understand how it works and how it affects your future money values. Accounting for it in financial equations and projections can be done simply. But overlooking it or downplaying its effects can cause you to miss your financial goals by a wide margin.

Why is inflation bad?

Inflation appears to be back, with recent reports showing it higher than in recent years. Recent turmoil in the stock market, some say, is over this inflation scare. But why should we fear higher inflation? What’s so bad about it? These are the questions N.C. State University economist Mike Walden answers in today's Economic Perspective "I think one simple reason is higher inflation means that we have to get that much more out of our job to stay even," says Dr. Walden, a professor in the Department of Agricultural and Resource Economics. "In other words, if the inflation rate is 5 percent a year that means you’ve got to get a 5 percent pay raise just to keep pace with rising costs. "From a business perspective, inflation eats into business profits. It … gives businesses a much more difficult time adjusting, for example, to international competition," he adds.

"On the investment front, inflation sort of clouds what we are getting from our investment returns. For example, let’s say you are earning 6 percent on an investment. If we had no inflation, that would be a very good return. But if inflation is 5 percent, that’s a very bad return, so you have to keep that in mind when you are looking at these investment alternatives. "And then, last, inflation often leads to higher interest rates," Walden concludes, "and so anyone who wants to borrow money it’s going to be more expensive. So I think for these many, many reasons this is why economists tend to prefer lower inflation."
 
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