nflation and Deflation

n the world of economIcs, there are two fundamental terms used to descrIbe the prIces of goods and servIces over tIme: InfIatIon and defIatIon As Investors, It's Important to understand the Impact InflatIonary or deflatIonary
tImes can have on our Investments
n thIs publIcatIon, we're goIng to start by defInIng the two macroeconomIc terms InflatIon and deflatIon Next, we'll talk about how these condItIons are measured by the U.S. ureau of Labor StatIstIcs FInally, we'll brIefly
descrIbe some of the best Investment optIons for beatIng eIther InflatIon or deflatIon
InfIatIon and 0efIatIon 0efInedIn economIcs, we Iearned there are two ways to descrIbe the changes In the prIces of goods and servIces over tIme:
InfIatIon a consIstent Increase In the prIces of goods and servIces over tIme Is known as InflatIon 0urIng InflatIonary tImes, money loses Its buyIng or purchasIng power, and It takes more unIts of currency to purchase the
same unIts of goods or servIces Dver tIme, InflatIon lowers the value of each unIt of currency
0efIatIon a consIstent decrease In the prIces of goods and servIces over tIme Is known as deflatIon 0urIng deflatIonary tImes, money Increases In Its buyIng or purchasIng power, and It takes less unIts of currency to purchase
the same unIts of goods or servIces Dver tIme, deflatIon Increases the value of each unIt of currency
ControIIIng InfIatIon
EconomIsts generally favor a low and steady rate of InflatIon The job of keepIng InflatIon low Is assIgned to the monetary authorItIes at the FederaI Peserve nflatIon can be controlled by IncreasIng or decreasIng the money
supply The levers used to control the money supply Include Interest rates, buyIng and sellIng of government securItIes (Dpen |arket DperatIons), and bank reserve requIrements
Interest Pates and InfIatIon
The relatIonshIp between Interest rates and InflatIon Is relatIvely straIghtforward f InflatIon Is too hIgh, the Feserve can lower the money supply by raIsIng Interest rates HIgher Interest rates dIscourage borrowIng, and that
lowers the money supply Conversely, to fIght deflatIon, the Feserve can lower Interest rates, thereby encouragIng borrowIng The Federal Feserve controls Interest rates through the 0Iscount Fate, whIch Is the Interest rate that
banks are charged when they borrow money from the Federal Feserve
Dpen harket DperatIons and InfIatIon
The Federal Feserve, along wIth the Central 8ank, can control the money supply through the buyIng and sellIng of government securItIes (bonds) When the Central 8ank buys securItIes, It Is exchangIng money for the securIty
Therefore, when the Central 8ank wants to lower InflatIon, It can sell government securItIes and decrease the supply of money Conversely, when the Central 8ank wants to fIght deflatIon, It can buy government securItIes
ank Peserve PequIrements and InfIatIon
WhIle arguably the most effectIve tool the Federal Feserve can use to control InflatIon, changIng the reserve requIrement Is rarely used by those In charge of establIshIng monetary polIcy The reserve requIrement Is the money a
bank needs to keep In Federal Feserve vaults The requIrement Is a fIxed percentage of the customer deposIts held at each deposItory InstItutIon or bank
When the Federal Feserve wants to lower InflatIon, they can Increase the reserve requIrement, thereby decreasIng the supply of money Conversely, when the Central 8ank wants to fIght deflatIon, It can decrease the reserve
requIrement
HyperInfIatIon
When InflatIon Is out of control, It's possIble for prIces to Increase by several hundred percent per month Cenerally, the term hyperInflatIon Is used when prIces Increase In excess of 50 per month f hyperInflatIon contInues, a
country's monetary system can collapse That Is to say, the country's money becomes nearly worthless
heasurIng InfIatIon
n the UnIted States, the most famous measure of InflatIon Is the Consumer PrIce ndex At a slIghtly more granular level, the 8ureau of Labor StatIstIcs publIshes several other measures aImed at IdentIfyIng domestIc InflatIonary
trends IncludIng:
Consumer PrIce Index (CPI) thIs program monItors monthly changes In the prIces paId by urban consumers for a basket of goods and servIces ThIs basket Includes food, clothIng, shelter, fuels, transportatIon fares, doctor and
dental servIces, and prescrIptIon medIcatIons The CP Is used by a wIde varIety of organIzatIons to adjust wages, rents, and other Items affected by a change In the cost of lIvIng
Producer PrIce Indexes (PPI) a famIly of Indexes aImed at measurIng the change In the sellIng prIces receIved by domestIc producers of goods and servIces At one tIme, these were known as the Wholesale PrIce ndexes, and the
measure Is a good IndIcatIon of the cost to produce goods and servIces
mpIoyment Cost Trends (CT) also referred to as the NatIonal CompensatIon Survey, thIs program publIshes quarterly Indexes that track labor costs, overtIme rates, wages, salarIes, as well as the cost to supply benefIts to
employees
InvestIng to eat InfIatIon
TradItIonally, InvestIng In goId was a hedge used by Investors lookIng to Insulate themselves from InflatIon 8ut In early 2011, gold was sellIng for more than S1,400 an ounce, and at that prIce gold may not be a good choIce for
Investors n addItIon to gold, the followIng Investments offer protectIon from InflatIon:
Treasury InfIatIon Protected SecurItIes (TIPS) InflatIon Index bonds Issued by the UnIted States government, the prIncIpal on these bonds are adjusted usIng the Consumer PrIce ndex The coupon rate on the bonds remaIns
constant, so as the prIncIpal Increases or decreases, the bond yIeld would decrease or Increase
I onds UnIted States SavIngs 8onds wIth a fIxed face value, but a yIeld that varIes wIth InflatIon The Interest rate on these bonds Is made up of two components: a fIxed rate that earns Interest monthly, plus an InflatIon
adjustment that occurs every sIx months
Corporate InfIatIon LInked onds a corporate securIty that adjusts each month for changes In the Consumer PrIce ndex
InfIatIon-Protected AnnuItIes (IPA) these are annuItIes that Increase theIr payout each year based on a measure of InflatIon or a percentage chosen by the Investor f the Investor chooses a relatIvely hIgh Increase each year,
then the startIng payouts for the annuIty wIll be lower
InvestIng to eat 0efIatIon
When deflatIon occurs, the prIces of goods and servIces are decreasIng, so the prImary goal for Investors durIng deflatIonary tImes Is to hoId cash sInce Its relatIve value Is IncreasIng Dne approach to holdIng cash Includes placIng
money In money market funds or short term treasury bonds
Corporate bonds payIng a fIxed rate of Interest Is another example of a good Investment when deflatIon occurs Femember, one of the ways the Federal Feserve can deal wIth deflatIon Is to lower Interest rates When Interest
rates decrease, the value of a fIxed rate bond wIll Increase
FInally, In the same way Investors tradItIonally held gold as a hedge agaInst InflatIon, It's a bad Idea to buy gold when deflatIon Is at hand
http://wwwmoneyzInecom/nvestIng/nvestIng/nflatIonand0eflatIon/
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nflation - prices go up meaning currency is worth LESS. i.e. you need more money to buy the same amount of goods. The nominal value of money is going down. This is technically a bad thing unless all prices are going up by the same
rate, then nothing changes. i.e. no change in buying power. This would usually occur when the economy is doing well. However, in theory, it occurs when output growth is high and unemployment rate is low

nominal value = real value + inflation (approximately)

deflation - prices go down meaning currency is worth MORE. i.e. you need less money to buy the same amount of goods. (increase buying power, ceteris paribus (everything else being the same)). This is good news for the consumer,
but firms see this as bad news because their profits seem less than previous periods or years. This usually occurs when the economy is in recession. Theory says it occurs when output growth is low and unemployment rate is high.

You can see the tradeoffs. Although deflation is a good thing for the consumer, firms need profits to produce and they can only sustain their profits if they hire less people. So, even though deflation is a good thing for the consumer, it
bites them back with the possibility of no job.

People have this pessimistic view and have stronger opinions on anything going down. i.e. they lean more to things going down than when the go up. So when recession hits, it would take longer to recover than otherwise necessary.
think they talk about this when they mention confidence in the economy

n other words, people prefer inflation over deflation, but as people dislike inflation, you would want to keep it as low as possible.
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