LO 7.1.4: Differentiate the characteristics of inflation, deflation, disinflation, and stagnation. Flashcards

1
Q

Inflation

A
  • Defined as a rise in the average level of prices of goods and services.
  • In effect, erodes/reduces the purchasing power of money—each dollar of income will buy fewer goods and services.
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2
Q

What are the 2 most common measures of inflation?

A
  • Consumer Price Index (CPI) and

* Producer Price Index (PPI)

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3
Q

What does the CPI program produce?

A

Monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.

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4
Q

What does the PPI program measure?

A

The PPI program measures the average change over time in the selling prices received by domestic producers for their output.

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5
Q

Does inflation mean that all prices are rising?

A
  • No.
  • Even during periods of rapid inflation, some prices remain constant while others may be falling.
  • Also geographical differences in inflation rates, not all goods and services will be priced the same around the country.
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6
Q

How should financial planners approach using inflation as a reflection of a basket of goods and services in any given client scenario?

A
  • Use with caution, an individual person’s basket of goods may have a different inflation rate than overall.
  • Example: medical costs and cost of higher education have had sustained inflationary periods much faster than the overall inflation rate.
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7
Q

Deflation

A
  • When prices are falling in absolute terms.

* U.S. hasn’t experienced a pronounced deflationary period since depression of 1930s.

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8
Q

Disinflation

A

When prices are still rising but at a declining rate.

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9
Q

What would be the appropriate asset to own in a deflationary environment?

A
  • High quality debt instruments

* Preservation of capital should be primary concern

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10
Q

Why avoid low-quality bonds during deflationary periods?

A
  • Issuers of debt have trouble meeting their principal and interest payments
  • So, lower-quality bonds should be avoided because likelihood of default increases.
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11
Q

What happens to bond prices and purchasing power during deflation?

A
  • Bond prices rise and purchasing power increases.
  • Then, in a deflationary period, market interest rates are falling. Recall:
    • Market interest rates are inversely rated to bond prices
    • Bond yields are also inversely related to bond prices
    • TF, if bond prices rise, then interest rates and bond yields are fall.
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12
Q

What industries/asset class would be good to purchase if the deflation is relatively mild?

A
  • Selective purchases of defensive common stocks could be profitable
  • Food and beverage stocks might do well if the prices of their raw materials (commodities) fall.
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13
Q

What industries of stocks would be good to purchase if deflation is severe?

A

An investor would not hold stocks; example of severe deflation was in the 1930s.

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14
Q

How do real assets (e.g., real estate, collectibles, gold, and other precious metals) perform in a deflationary period?

A
  • Likely to fall in value.
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15
Q

How has the credit crisis influenced the Fed’s concern about the possibility about deflation?

A
  • Problems in credit markets and ongoing decline in home prices cause uncertainty about possibility of deflation.
  • The Fed is committed to avoiding a deflationary spiral at all costs, perhaps even at the expense of rising inflation. An uncontrolled downward spiral can hurt the economy as much as, if not more than, runaway inflation.
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16
Q

Stagflation

A
  • Comes from a combination of “stagnation” and “inflation”
  • Last example was mid-1970s: rising prices and increasing unemployment and declining spending, reduced productive output (245)
  • There are few monetary or fiscal policies that can be implemented to quickly counter a stagflation economy.