Monday, June 16

Macro economics - the inflation cycle

Inflation is a rise in general level of prices of goods and services over time. Although "inflation" is sometimes used to refer to a rise in the prices of a specific set of goods or services, a rise in prices of one set (such as food) without a rise in others (such as wages) is not included in the original meaning of the word. Inflation can be thought of as a decrease in the value of the unit of currency. It is measured as the percentage rate of change of a price index.
Annual Inflation Rate = (Current Price Level - Year ago Price level) / Year Ago Price level.
It isn't that easy to calculate it though as the inputs to the "Price Level" is huge and is generally calculated using piles of data by government and specialised agencies.
Types and Causes of Inflation:
Demand Pull Inflation is caused by an increase in aggregate demand. This results from an increase in money supply and increased government spending i.e. Government purchases.
Cost Push Inflation is caused by a decrease in aggregate supply (now this may seem equal to an increase in aggregate demand, but consider the demand being constant; cet per; remember?). This results from an increase in the real price of an important factor of production like wage rate, price of key raw material etc

Without explaining more about what is Inflation, lets come to the point; the effects of inflation on the Investment industry or the economy and lets learn what does the government and central agencies do to manage inflation.
Lets consider an Overheating Economy
  • Government fears inflation
  • The Central bank decides to Decrease Aggregate Demand and Consumer Spending
  • It raises interest rates in order to discourage borrowing and expenditure on goods and services
  • It sells securities in the open market, mops up bank reserves and induces banks to cut their lending
  • Bank Reserves and Quantity of Money supply decreases,
  • Banks thus make smaller quantity of new loans
  • The quantity of money in the economy decreases
  • Interest rates rise (if not raised by the central bank, as mentioned above)
  • The Home currency appreciates in the Foreign Exchange market
  • Exports Decreases
  • Consumption and Investment Decreases
  • People want to hold more money
  • People sell their (financial) assets
  • Supply of (financial) assets increases
  • Aggregate Demand Decreases
  • Price level Falls
  • Real GDP Growth rate decreases
  • Inflation decreases.

Reverse may be situation when the economy is falling.

So now u know why the central bank keeps selling or buying the financial securities in the market and why the financial market makes a fuss each time the central bank buys/sells the securities.

More question? post comment or email me !!

Hope u found the information useful!!

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