1 CHAPTER SIX INFLATION

2 INFLATION IN THE U.S. INFLATION –DEFINITION: the percentage change in a specific cost-of-living index at various points in time.

3 INFLATION IN THE U.S. INFLATION –cost-of-living index the “overall” price level computed for a “basket of goods”

4 INFLATION IN THE U.S. PRICE INDICES –measure changes in prices relative to a fixed period in time usually called the base period

5 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

6 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

7 INFLATION IN THE U.S. NOMINAL AND REAL RETURNS –price change may impact an asset’s nominal return

8 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

9 INFLATION IN THE U.S. FORMULA FOR CALCULATING REAL RETURNS where C 0 = CPI at the beginning of period C 1 = CPI at the end of the period NR = the time period’s nominal return RR =the real return for the period

10 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

11 INFLATION IN THE U.S. THE EFFECT OF INVESTOR EXPECTATIONS –investors’ attitudes toward inflation show they are concerned with real returns

12 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

13 STOCK RETURNS AND INFLATION OVER LONG PERIODS OF TIME –common stocks generated large, positive real returns

14 STOCK RETURNS AND INFLATION OVER LONG PERIODS OF TIME –T-bills produced much lower, positive real returns

15 STOCK RETURNS AND INFLATION OVER SHORT PERIODS OF TIME –stock returns are not positively related to either actual or expected rates of inflation

16 STOCK RETURNS AND INFLATION OVER LONG PERIODS OF TIME –stock returns are positively related to both actual and expected rates of inflation