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What is Inflation?

What is Inflation?

What is inflation and what does it measure? Inflation measures the rate at which prices increase for consumer goods and services. Inflation also measures the rate at which a currency’s purchasing power declines. If consumer goods and services are getting more expensive, then inflation is rising. As inflation rises, the relevant currency’s purchasing power declines. As prices increase, the amount a consumer can purchase with one unit of currency decreases.

Inflation Information

Inflation is a consistent increase in the general level of prices in an economy. The inflation rate is a measure of this phenomenon.

What causes inflation? Many economists point to an increase in the rate of growth of the money supply in an economy as the primary culprit. In comparison, others point to sudden changes in aggregate demand and aggregate supply, following a Keynesian approach to macroeconomic analysis.

Inflation Rate Example

For example, let’s take the price of a can of soda. Let’s say last year a can of soda cost $1.00. And let’s say the inflation rate for the past 12 months is 5%. We could then assume the cost of a can of soda today is $1.05. The price has gone up by 5%. The dollar’s purchasing power has gone down – one dollar is no longer enough money to buy a can of soda.

Inflation Measures

There are two important inflation measures in the U.S. They are the headline inflation rate and the core inflation rate. In addition, these inflation rates are published monthly by the U.S. Bureau of Labor Statistics.

The headline inflation rate, also called the consumer price index (CPI), measures the rate at which prices are rising for a wide selection of consumer goods. Headline inflation is designed to measure the rate at which cost of living expenses increase over time.

The core inflation rate is the headline inflation rate but without food and energy prices. Food and energy prices are considered more volatile than other consumer prices. Therefore, some consider it important to view the inflation rate excluding these two components.

There are a variety of other approaches to estimating the inflation rate, such as calculations based off of the US Producer Price Index (PPI) and the US Gross Domestic Product (GDP Deflator).

Inflation and Monetary Policy

Most central bank’s have a target inflation rate. For example, the U.S. central bank, the U.K. central bank, and the European Central Bank prefer to keep inflation at around 2%. A nation’s central bank can use certain monetary policy tools to influence inflation. These includes the following:

  • Foreign exchange market intervention
  • Open-market operations
  • Adjusting the reserve requirement ratio
  • Adjusting key interest rates.

Central banks often implement monetary policy tools to influence the inflation rate towards the target inflation rate.

Market Intervention

Foreign exchange market intervention refers to a central bank buying or selling currency in the open market in order to influence the nation’s money supply. Increasing the money supply devalues the currency and increases inflation. Whereas, decreasing the money supply appreciates the currency and decreases inflation. Ergo, a nation’s central bank can purchase currency in the open market to fight inflation.

Open Market Operations Definition

Open-market operations refer to a central bank buying or selling government securities. Buying government securities increases the money supply and spurs inflation. But selling government securities decreases the money supply and curbs inflation. Therefore, a nation’s central bank can sell government securities to fight inflation.

Reserve Requirement Ratio

The reserve requirement ratio is the amount of cash a commercial bank must hold relative to the value of its customer deposits. For example, if a bank receives customer deposits totaling $100, and the reserve requirement is 10%, then that bank must always have at least $10 cash on hand. A central bank can either increase or decrease the reserve requirement ratio for the nation’s commercial banks, thereby decreasing or increasing the domestic money supply. Furthermore, increasing the reserve requirement curbs inflation, decreasing the reserve requirement spurs inflation.

Key Interest Rates

Central banks can also raise or lower key interest rates in an effort to influence inflation. In the U.S., the central bank’s key interest rate, the fed funds rate, is the rate at which banks lend to each other overnight. Raising the interest rate can reduce the money supply, damp economic activity, and curb inflation. But lowering the key interest rate can increase the money supply, stimulate the economy, and increase inflation. A central bank can raise interest rates to fight inflation.

Inflation Protection

When faced with the threat of rising inflation, which can erode the value of investment returns, investors may seek investments that are protected from inflation. One option is to invest in U.S. Treasury Inflation Protected Securities (TIPS).

TIPS are U.S. Treasury securities that are protected against inflation. The coupon payments and the principal value automatically adjust according to the headline inflation rate. This protects investors from the negative effects inflation can have on investment returns. The downside is that TIPS offer a comparatively low interest rate.

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See Also:

Economic Indicators
Consumer Price Index
Supply and Demand Elasticity
The Feds Beige Book
Z-Score Model

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Treasury Inflation Protected Securities

Treasury Inflation Protected Securities

Treasury Inflation Protected Securities or TIPS for short are debt instruments that are issued by the U.S. government. TIPS are indexed with the Consumer Price Index (CPI), and adjust accordingly to the inflation rate presented in the CPI.

Treasury Inflation-Protected Securities (TIPS) Explained

Treasury TIPS means that the security will adjust for inflation or deflation on whether the CPI increases or decreases. Because of this extra protection from inflation rates, TIPS owners are forced to pay more in taxes, a major disadvantage, when the security matures or it is sold. Treasury tips are normally sold with 5, 10, or 30 year maturities in denominations of $1,000 or more.

Treasury Inflation Protected Securities (TIPS) Example

Timmy has just invested in a TIPS note which has a 4% rate of return and a 10 year maturity. The following results are how an inflation protected security react to inflation and the market.

If interest rates rise by 1% in the first year then the principal would change to $1,010 (1,000 * 1.01). Thus the coupon rate would be calculated by taking 4% * $1,010 which equals a coupon payment of $40.40.

If the interest rates were to rise again by 2% then the new principal would change to $1,020 ($1,000 * 1.02), and the coupon payment would be 4% * $1,020 which equals $40.8.

Note: The new coupon payment and interest will change in the same manner no matter if deflation or inflation occurs.

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treasury inflation protected securities
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treasury inflation protected securities

See Also:
Treasury Securities
Treasury Notes (t notes)

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Stagflation

See Also:
Economic Indicators
Balance of Payments
Supply and Demand Elasticity
The Feds Beige Book
What are the Twin Deficits?

Stagflation Definition

In economics, stagflation refers to the combination of stagnation and inflation. Stagnation refers to slowing economic growth or recession. It is a period of low gross domestic product and high unemployment. Inflation refers to rising consumer prices. The combination of these two conditions makes for a troubled economy.

The term stagflation was first used by economists in the 1970s when both the U.S. and the U.K. were experiencing simultaneous stagnation and inflation. At that time much of the economic trouble was due to rising oil prices which can contribute to both inflation and stagnation.

Central Banks and Stagflation

Central banks have certain tools for counteracting unfavorable economic conditions. They can implement monetary policy tools to try to influence the conditions of the economy. Central banks can raise or lower interest rates, raise or lower reserve requirements, and buy or sell currency to influence money supply.

For example, if inflation is rising, a central bank can raise interest rates, raise reserve requirements, or purchase currency to reduce the money supply in an attempt to curb inflation.

And during a period of stagnation, if the economy is slowing down, the central bank can lower interest rates in an attempt to increase the money supply and stimulate business and economic activity.

Stagflation Dilemma

However, when inflation and stagnation occur simultaneously, the tools of the central bank are not so simple to implement. For example, during a period of stagflation, a central bank could raise interest rates to fight inflation. But this would hurt the struggling economy. And the central bank could lower interest rates to stimulate the economy, but this would exacerbate inflation.

So one of the main reasons stagflation is such a problem is that central bank monetary policy is essentially unable to ameliorate the unfavorable economic conditions. Trying to fix one half of the problem only makes the other half of the problem worse. Additionally, it doesn’t matter which side of the problem they attempt to correct or influence.

stagflation

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Present Value (PV)

See Also:
Future Value
Adjusted Present Value (APV)
Net Present Value Method
Investment Analysis
Discount Rate

Present Value (PV) Definition

The present value is simply the value of future dollars or currency in present day terms. The present value is simply answering the question how much a dollar in the future is worth today.

Present Value (PV) Explanation

The present value is often used in valuation to discount projections that companies make about themselves so they can figure out how much the company stock price is or maybe its equity value. The present value becomes useful because of inflation. If inflation were to increase at an increasing rate then the company would see the present day dollar as less valuable to them.

Present Value (PV) Formula

The present value formula is as follows:
PV = FV/((1 + i)n)

Where:
PV = Present Value
FV = Future Value
i = rate
n = number of years or periods

Present Value (PV) Example

Jim Bob has just won the lottery. He has the choice of accepting the $2 million now, or he can accept $1 million now and another $2 million 5 years from now. Which of the choices should Jim Bob take? Assume a rate of 8%.

Option #1 PV = $2 million

Option #2 PV = $500,000 + $1,361,166 = 1,861,166

PV calculation:
PV = 2 million/((1+.08)5) = $1,361,166

Option #1 is better because it is worth more to you today than the present payment plus the payment at the end.

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Present Value (PV)

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Present Value (PV)

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Nominal Interest Rate Definition

See Also:
What is Compound Interest
Effective Rate of Interest Calculation
Interest Expense
When is Interest Rate Not as Important in Selecting a Loan?
Interest Rate Swaps

Nominal Interest Rate Definition

A nominal interest rate is the interest rate rate quoted on lending and borrowing transactions. Nominal rates represent the rate of exchange between current and future dollars, unadjusted for the effects of inflation. Since nominal rates are not adjusted for inflation, they do not convey the prices of lending and borrowing transactions as accurately as real interest rates.

Nominal Interest Rate, Real Interest Rate

Nominal interest rates are not adjusted for inflation. Whereas, real interest rates are adjusted for inflation. Make the adjustment with current or projected inflation rates. Furthermore, real interest rates offer a more accurate representation of the prices of lending and borrowing transactions. To calculate real interest rates, use the following formula:

Real Interest Rate = Nominal Interest Rate – Inflation Rate

For example, if a lender offers a loan with a nominal rate of 5% and the inflation rate is 3%, then the lender will earn real interest of 2%. However, if the inflation rate is 7%, then the lender will essentially be losing value on the loan.

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Nominal Interest Rate Definition

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Nominal Interest Rate Definition

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Nominal Interest Rate

Nominal Interest Rate Definition

A nominal interest rate is the interest rate rate quoted on lending and borrowing transactions. Nominal rates represent the rate of exchange between current and future dollars. It is unadjusted for the effects of inflation. Since nominal rates are not adjusted for inflation, they do not convey the prices of lending and borrowing transactions as accurately as real interest rates. In comparison, real interest rates are adjusted for inflation.

Nominal Interest Rate, Real Interest Rate

Nominal interest rates are not adjusted for inflation. Adjust real interest rates for inflation. Make the adjustment with current or projected inflation rates. Furthermore, real interest rates offer a more accurate representation of the prices of lending and borrowing transactions. Use the following formula to calculate real interest rates:

Real Interest Rate = Nominal Interest Rate – Inflation Rate

For example, if a lender offers a loan with a nominal rate of 5% and the inflation rate is 3%, then the lender will earn real interest of 2%. If, however, the inflation rate is 7%, then the lender will essentially be losing value on the loan.

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Nominal Interest Rate

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Nominal Interest Rate

See Also:
What is Compound Interest
Effective Rate of Interest Calculation
Interest Expense
When is Interest Rate Not as Important in Selecting a Loan?
Interest Rate Swaps

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Labor Costs

Labor Costs Definition

Labor costs, defined as the total cost of all labor used in a business, is one of the most substantial operating costs. These are particularly important in any business which experience heavy human resource labor costs: construction, manufacturing, and other industries which have partially or non-automated operations. These costs include 2 main subcategories. The direct labor costs definition is summarized as the cost of labor which is used directly to make products. Meanwhile, the indirect labor costs definition is simply explained as the cost of labor which is used to support or make direct labor more efficient.

Labor Costs Explanation

These costs are explained by many as the most important cost a company will face, is a key factor in almost any business. This is due to the fact that employee turnover is one of the main factors which causes a business to fail. To begin, it is in the best interest of any owner that unit labor costs and inflation are minimized to maximize profits.

The importance of labor costs does not stop here. They are a variable cost. As such, they must also occur in a predictable cycle to avoid cash flow problems. If a firm is seasonal and requires additional labor at peak times, business controllers must have the cash on hand to afford this increase in cost. If a business plans properly it will avoid many cash issues associated with the cost of labor.

Labor Costs Formula

A single formula will not serve the many different needs associated. Despite this, a common and simple formula is included below:

Labor Costs = (total sales x labor %) / average hourly rate of labor

Labor Costs Calculation

To perform a simple labor costs calculation follow the process outlined below:

If:
Total Sales = $1,000,000
Labor % = 15%
Average hourly rate of labor = $10

Labor Costs = ($1,000,000 x .15) / $10 = (150,000) / $10 = $15,000

Labor Costs Example

For example, Leann is the owner of a clothing store in the largest mall in her city. Leann, a fashion aficionado from birth, knows the popular styles better than any designer in Milan. She works diligently to make sure her store stays in pace with the trends of today as well as the future.

Leann is gearing up for her peak season. Additionally, she is concerned because her off-season sales have slumped slightly. She sees the new season as a great opportunity to move inventory and regain the ground. That is, if she has enough cash to get by.

Leann will need to increase hours for sales and backroom staff during these peak times. To balance that, she will also have to make sure she can pay for these employees. The slump in her off-peak season has made Leann plan more for the future. She now wants to calculate cost of labor for her peak period to make sure she can afford the cash needed to get by.

Example Calculation

Leann performs this simple calculation to find her cost of labor:

If:
Total Sales = $1,000,000
Labor % = 15%
Average hourly rate of labor = $10

Then:
Labor Costs = (total sales x labor%) / average hourly rate of labor
Labor Costs = ($1,000,000 x .15) / $10 = (150,000) / $10 = $15,000

For Leann’s retail business cost of labor total $15,000 for the period she is studying. This is more than she expected and can afford. Luckily, Leann has excellent credit. Leann decides to apply for a small business loan to help her company survive the first month of peak demand. From here she will make the cash necessary to continue.

Leann also decides to pay more attention to her company finances. She was not surprised by this situation, but still wants to be able to predict the problems that her business will face better. Her drive and insight will achieve this and many future goals.

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Labor Costs

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Labor Costs

See Also:
Absorption vs Variable Costing
Agency Costs
Operating Capital
Replacement Costs

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