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What is Inflation
Inflation refers to a general rise in prices for goods and services measured against a standard level of purchasing power. As inflation rises, every dollar you own buys a smaller percentage of a good or service. For example, if the inflation rate is 5% annually, a good or service costing $100 will cost $105 in a year. (Note: The goal for most developed countries has been to sustain an inflation rate of 2-3%)

There are few variations of inflation you need to know.

What causes Inflation ?
There is no one cause that’s universally agreed upon, but at least two theories are generally accepted.

• Demand Pull Inflation: If demand for goods/services is growing faster than supply, the prices will increase. This usually occurs in emerging markets/growing economies.
• Cost-Push Inflation: If there is a sudden decrease in supply, the prices go up. This in turn increases the cost of doing business for most companies. To maintain their profit levels they in turn increase the price of their goods/services which would ultimately be passed on to the consumers in the form of increased prices.

How is inflation measured ?
Inflation is measured with a price index which can be thought of as a large survey. One way of measuring inflation is by comparing two sets of goods at two different times, and calculating the increase in cost. There are many measures of inflation depending on the specific circumstances. I have listed few of the widely used ones.

• Consumer Price Index (CPI): Measures consumer prices from the perspective of the buyer. (For eg. prices of gas, car, food)
• Producer Price Index (PPI): Measures prices received by a producer/seller. PPI will give a clear indication of the pressure being put on producers/sellers. Normally this is passed on to the consumers, or producers/sellers reduce profits or they increase productivity. A subset of PPI is the Wholesale Price Index (WPI) which measures prices of goods at wholesale prior to retail prices.
• GDP Deflators: Measures an entire economy as the basket of goods and services, rather than some particular subset.
  

Other note worthy measures are commodity price index & purchasing power parity.

So who actually measures Inflation ?
Each month, the U.S. Bureau of Labor Statistics contacts thousands of retail stores, service establishments, rental units and doctors to obtain price information on thousands of items used to track and measure price changes in the CPI.

How about interest rates ?
In US, interest rates are decided by the Federal Reserve. They meet 8 times/year to set short-term interest rates. CPI and PPI plays a big role in the decision making process. Generally when the interest rate drops, consumer spending increases which in turn is good for the economy.

How does Inflation affect investments ?
Inflation can affect/not affect certain type of investments. Let us find out which ones.

• Affects people living on a fixed income, such as students & retirees. (Reason: Purchasing power drops)
  
• Does not affect people investing in stocks, provided the company’s profits increase at the same pace as inflation. (Caution: In times of high inflation, a company may look like it’s prospering, when really inflation is the reason behind the growth)

To protect yourself from inflation, you can buy inflation indexed securities. However these securities are so safe, they offer an extremely low rate of return which disinterests most investors.

So Is Inflation Evil ?
Yes and No. People like to complain about prices going up, but they often ignore the fact that wages are also rising. The question shouldn’t be whether inflation is rising, but whether it’s rising at a quicker pace than your wages.

It is evil or not depends on whether inflation is predictable or unpredictable.

1. If inflation is predictable, the affect can be compensated. (For example, banks can increase their interest rates, workers can negotiate wage hikes to combat inflation.)
2. If inflation is unpredictable, there will be imbalance. (For example, lenders tend to lose if they do not anticipate inflation correctly, companies spend less when there is uncertainty and indirectly hurt the economy, fixed income investors see a decline in their purchasing power, domestic products become less competitive hurting exports.)

So to sum up if inflation is evil or not actually depends on the overall economy as well as your personal situation.

Conclusion: Inflation is a sign that an economy is growing. Little inflation can be just as bad as high inflation. High inflation can break the monetary system where as lack of inflation may be an indication that the economy is weakening. I believe moderate rise of inflation is good for the economy and that is what every country tries to achieve.

The goal of this post was to educate the readers about inflation in general. I hope it has achieved that goal. I also wanted to cover the relation between inflation and interest rates. I will leave it for a future date….

Related Posts:

1. When US economy goes down
2. Can Weak Dollar Make Money
3. Economic Indicators: Few interesting numbers

(Source: Investopedia, Wikipedia, Maps of World)

Everyone knows that the market goes through a correction every once a while. The problem is not everyone knows when. Stocks slumped Tuesday 27th Feb on worries about economic growth at home and abroad especially China.

What Happened
The Dow dropped 416.02 points equivalent to 3.29%, its biggest one-day point loss in nearly 5 & 1/2 years. The S&P 500 tumbled about 3.5 % and the Nasdaq skidded 3.9 %.

What Caused It

There used to be a time when trading on the currency exchange (foreign exchange market or forex) was not for everyone. It used to be a domain for government central banks, commercial banks, investment banks, hedge funds and huge international corporation. However with the advent of the electronic trading networks, trading in forex is now more accessible than ever. The forex offers trading 24-hours a day, 5 days a week, and the daily dollar volume of currencies traded in the currency market exceeds $1.4 trillion, making it the largest and most liquid market in the world.

Forex is generally a low volatile market. Currency fluctuations are usually very small. Most high risk investors & speculators use leverage (which is possible due to high liquidity) to increase the profit margins. For example, it is possible for an investor to control a position of $100,000 by putting down as little as $1,000 up front and borrowing the remainder from his or her broker.

The movement of currency prices are based upon the demand and supply model. This cannot be manipulated easily because the size of the market does not allow even the largest players, such as central banks, to move prices at will.

What is Forex all about ?
Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros. This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars into euros. The same goes for traveling. A French tourist in Egypt can’t pay in euros to see the pyramids because it’s not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. One unique aspect of this international market is that there is no central marketplace. All transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The forex market can be extremely active any time of the day, with price quotes changing constantly.

Spot Market and the Forwards and Futures Markets
The 3 ways to trade forex are the spot market, the forwards market and the futures market. The spot market is the largest market because it is the underlying real asset that the forwards and futures markets are based on. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

Spot Market
The spot market is where currencies are bought and sold according to the current price. Few factors that determine the price is demand & supply, interest rates, economic indicators, political stability and future performance of one currency against another.

Forwards Market
The forward market does not trade in actual currency. Instead they deal in contracts of a certain currency type at a specific price/unit and a future date. Forward contracts are traded over the counter.

Futures Market
The futures market also does not trade in actual currency. Like forwards market they deal in contracts of a certain currency type at a specific price/unit and a future date. Futures contracts are traded upon a standard size and settled over public commodities markets such as the Chicago Mercantile Exchange.

Trading Instruments
The majority of forex traders focus their efforts on seven different currency pairs: the four majors, which include (EUR/USD, USD/JPY, GBP/USD, USD/CHF); and the three commodity pairs (USD/CAD, AUD/USD, NZD/USD). All other pairs are just different combinations of the same currencies, otherwise known as cross currencies. This makes currency trading easier to follow.

Conclusion: The forex market provides plenty of opportunity for investors. The currency market is also the only market that is truly open 24 hours a day. The amount of leverage available in the forex market also makes it attractive for many speculators. However, in order to be successful, a currency trader has to understand the basics behind currency movements otherwise the benefits of leverage can work against the trader.

Forex trading is a vast topic and will be covered in depth..
To be continued….

(Source: Investopedia)