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

Question 1

Inflation

Answer 1

• 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.

Question 2

What are the 2 most common measures of inflation?

Answer 2

• Consumer Price Index (CPI) and

* Producer Price Index (PPI)

Question 3

What does the CPI program produce?

Answer 3

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

Question 4

What does the PPI program measure?

Answer 4

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

Question 5

Does inflation mean that all prices are rising?

Answer 5

• 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.

Question 6

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

Answer 6

• 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.

Question 7

Deflation

Answer 7

• When prices are falling in absolute terms.

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

Question 8

Disinflation

Answer 8

When prices are still rising but at a declining rate.

Question 9

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

Answer 9

• High quality debt instruments

* Preservation of capital should be primary concern

Question 10

Why avoid low-quality bonds during deflationary periods?

Answer 10

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

Question 11

What happens to bond prices and purchasing power during deflation?

Answer 11

• 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.

Question 12

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

Answer 12

• 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.

Question 13

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

Answer 13

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

Question 14

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

Answer 14

• Likely to fall in value.

Question 15

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

Answer 15

• 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.

Question 16

Stagflation

Answer 16

• 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.