The economics you hear and read about in the financial press usually goes beyond the simple

concept of supply and demand. It is important to get a grasp of at least some of the economic
concepts that affect the markets. Doing so can have a significant positive impact on your
financial future.

What is Inflation?
One of the most important economic concepts is inflation. At its most basic level, inflation is
simply a rise in prices. Over time, as the cost of goods and services increase, the value of a
dollar is going to go down because you won't be able to purchase as much with that dollar as
you could have last month or last year Of course, it seems like the cost of goods are always
going up, at least to an extent, even when inflation is thought to be in check.
It is important to note that some amount of inflation is considered normal (actually, as we
explain below, because of its relationship with unemployment, some inflation is actually
desirable). While the annual rate of inflation has fluctuated greatly over the last half century,
ranging from nearly zero inflation to 23% inflation, the Fed actively tries to maintain a
specific rate of inflation, which is usually 2-3% but can vary depending on circumstances.
Deflation (for example, -1%) occurs when prices actually decrease over a period of time.
Please note that deflation is not the same as disinflation, which is when the rate of inflation
decreases but stays positive (for example, a change from a 3% rate to a 2% rate).

How Inflation is Measured

There are two main indices used to measure inflation. The first is the Consumer Price Index,
or the CPI . The CPI is a measure of the price of a set group of goods and services. The
"bundle," as the group is known, contains items such as food, clothing, gasoline, and even
computers. The amount of inflation is measured by the change in the cost of the bundle: if it
costs 5% more to purchase the bundle than it did one year before, there has been a 5% annual
rate of inflation over that period based on the CPI.
You will also often hear about the "Core CPI" or the "Core Rate." There are certain items in
the bundle used to measure the CPI that are extremely volatile, such as gasoline prices. By
eliminating the items that can significantly affect the cost of the bundle (in either direction)
on a month-to-month basis, the Core rate is thought to be a better indicator of real inflation,
the slow, but steady increase in the price of goods and services.
The second measure of inflation is the Producer Price Index, or the PPI . While the CPI
indicates the change in the purchasing power of a consumer, the PPI measures the change in
the purchasing power of the producers of those goods. The PPI measures how much
producers of products are getting on the wholesale level, i.e. the price at which a good is sold
to other businesses before the good is sold to a consumer. The PPI actually combines a series
of smaller indices that cross many industries and measure the prices for three types of goods:
crude, intermediate and finished. Generally, the markets are most concerned with the finished
goods because these are a strong indicator of what will happen with future CPI reports. The
CPI is a more popular measure of inflation than the PPI, but investors watch both closely .

Impact of Inflation
Inflation and Your Investments
Inflation is greatly feared by investors because it grinds away at the value of your
investments. Put simply, $100 today is not the same as $100 in 1 or 10 years. It is crucial to
include measures of expected inflation when calculating your expected return on investment.
As the most basic example, if you invest $1000 in a 1-year CD that will return 5% over that
year, you will be giving up $1000 right now for $1050 in 1 year. If over the course of that
year there is an inflation rate of 6%, the purchasing power of $1000 has decreased by $60,
and you have actually lost ground! (Of course, the capital gains taxes you pay on your "gain"
will increase this loss.) If you had spent that $1000 instead of investing it, you would have
been able to purchase a larger bundle of goods than was possible with the $1050 you earned a
year later.
However, this is not a suggestion that you spend your money instead of saving it. First, the
reasons to save are too numerous to list, but a home and retirement should be enough to
inspire you. Given that savings are important, inflation eats away at your purchasing power
more if you just put your savings under your mattress than if you had invested it.
Now that this issue has been clarified, it is important to be aware of the effects of inflation on
your investments. Whenever you can, try to determine your "real rate of return", which is the
return you can expect after factoring in the effects of inflation. If you are working with a
financial professional, ask him or her for an estimate of the real rate of return of a given
investment or portfolio.
As explained, inflation can erode the value of cash investments, such as stocks, bonds, and
CDs. However, some people believe that investments in real goods, such as a home, are
protected from inflation. This is because the value of a real good is determined to a large
extent by its intrinsic nature, as opposed to money, which is valued only for what you can
trade it for. If inflation is high, the price of a home or a car may simply increase at a similar
rate, insulating it from price erosion. The same cannot be said for a 10-year bond. As a result,
some investors seek protection from inflation, and investment options which do just that are
becoming available. The most popular example is Treasury Inflation Protected Securities (or
TIPS). These investments are just like bonds except that they are insulated from the effects of
inflation .
The description above explains why investors follow CPI and PPI reports so closely. In
addition to being aware of the current rate of inflation, it is crucial to be aware of what
inflation rate the experts are anticipating. Both the value of current investments and the
attractiveness of future investments will change depending on the outlook for inflation.

Inflation and Unemployment

Many modern economists believe that inflation is inversely related to unemployment. This
relationship is shown through something called the Phillips Curve. The Phillips Curve shows
the relationship between a given level of inflation and the expected level of unemployment
that would go along with it. As inflation decreases, unemployment is expected to rise. This

relationship is why you hear about the Fed's dual tasks of keeping inflation in check and
maintaining full employment. Economists agree that there is a minimum level of
unemployment that an economy can handle without causing inflation to accelerate .
(iv) Demand-pull 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. It
has been described by Coulborn as a situation of too much money chasing too few goods.

Keynesians hold a different argument. They argue that there can be an autonomous increase
in aggregate demand or spending, such as a rise in consumption demand or investment or
government spending or a tax cut or a net increase in exports (i.e., C + I + G + X M) with
no increase in money supply. This would prompt upward adjustment in price. Thus, DPI is
caused by monetary factors (classical adjustment) and non-monetary factors (Keynesian
argument).
DPI can be explained in terms of Fig. 4.2, where we measure output on the horizontal axis
and price level on the vertical axis. In Range 1, total spending is too short of full employment
output, YF. There is little or no rise in the price level. As demand now rises, output will rise.
The economy enters Range 2, where output approaches towards full employment situation.
Note that in this region price level begins to rise. Ultimately, the economy reaches full employment situation, i.e., Range 3, where output does not rise but price level is pulled upward.
This is demand-pull inflation. The essence of this type of inflation is that too much spending
chasing too few goods.

(v) Cost-push 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 an increase in the prices of raw materials, wages, etc. Often trade unions are
blamed for wage rise since wage rate is not completely market-determinded. Higher wage
means high 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 wage-push inflation and profit-push inflation.
Anyway, CPI stems from the leftward shift of the aggregate supply curve: