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CHAPTER SIX

CHAPTER SIX. INFLATION. INFLATION IN THE U.S. INFLATION DEFINITION: the percentage change in a specific cost-of-living index at various points in time. INFLATION IN THE U.S. INFLATION cost-of-living index the “overall” price level computed for a “basket of goods”. INFLATION IN THE U.S.

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CHAPTER SIX

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  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 C0 = CPI at the beginning of period C1 = 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 SHORT PERIODS OF TIME • stock returns are positively related to both actual and expected rates of inflation

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