Chapter six inflation in the u. S

CHAPTER SIX

• INFLATION

INFLATION IN THE U.S.

• INFLATION
• DEFINITION: the percentage change in a specific cost-of-living index at various points in time.

INFLATION IN THE U.S.

• INFLATION
• cost-of-living index
• the “overall” price level computed for a “basket of goods”

INFLATION IN THE U.S.

• PRICE INDICES
• measure changes in prices relative to a fixed period in time usually called the base period

INFLATION IN THE U.S.

• PRICE INDICES
• the Consumer Price Index (CPI) is calculated by the U.S. Bureau of Labor Statistics in the Department of Labor
• the Bureau uses a “market basket” of over 2000 U.S. consumer goods and services

INFLATION IN THE U.S.

• NOMINAL AND REAL RETURNS
• Fisher Model of Real Returns stated that real returns are important to investors
• they represented how much purchasing power has changed

INFLATION IN THE U.S.

• NOMINAL AND REAL RETURNS
• price change may impact an asset’s nominal return

INFLATION IN THE U.S.

• NOMINAL AND REAL RETURNS
• adjustments to the nominal return are needed to remove the effects on purchasing power of inflation or deflation

INFLATION IN THE U.S.

• FORMULA FOR CALCULATING REAL RETURNS
• where C0 = CPI at the beginning of period
• C1 = CPI at the end of the period
• NR = the time period’s nominal return
• RR =the real return for the period

INFLATION IN THE U.S.

• NOMINAL AND REAL RETURNS
• a quick calculation of the real return
• NR - IR = RR
• where IR = the rate of inflation for the period
• NR= the nominal return
• RR= the real return

INFLATION IN THE U.S.

• THE EFFECT OF INVESTOR EXPECTATIONS
• investors’ attitudes toward inflation show they are concerned with real returns

INFLATION IN THE U.S.

• THE EFFECT OF INVESTOR EXPECTATIONS
• Looking to the future
• E(RR) = E(NR) - E(CCL)
• where
• E(RR) = the expected real return
• E(NR) = the expected nominal return
• E(CCL)= the expected inflation rate

STOCK RETURNS AND INFLATION

• OVER LONG PERIODS OF TIME
• common stocks generated large, positive real returns

STOCK RETURNS AND INFLATION

• OVER LONG PERIODS OF TIME
• T-bills produced much lower, positive real returns

STOCK RETURNS AND INFLATION

• OVER SHORT PERIODS OF TIME
• stock returns are not positively related to either actual or expected rates of inflation

STOCK RETURNS AND INFLATION

• OVER LONG PERIODS OF TIME
• stock returns are positively related to both actual and expected rates of inflation