Price Stability (Inflation)

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 Price Stability
Definition
The core objective of monetary policy is price stability. If
prices are prevented from going up (inflation) or down
(deflation) too fast, this will protect the purchasing
power of the euro (any currency).

Price stability is said to exist if prices rise by just under

2 per cent per year in the medium term.

Source: - DNB (De Nederlandsche Bank)

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 Price Stability
Consumers and businesses alike must be able to trust
that prices will, on average, rise only very gradually if at all
in other words, that inflation is kept under control.

Stable prices, or price stability, means that one year from

now a euro will buy roughly the same as it buys today.

Hence price stability is a necessary precondition for a

healthy economy.

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 Price Stability
Causes of Inflation
There are two main causes of inflation:
Demand-pull
Cost-push
Demand-pull inflation
It's when demand for a good or service increases so much
that it outstrips supply. If sellers maintain the price, they
will sell out.
They soon realize they now have the luxury of raising
prices, creating inflation.

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 Price Stability
Demand-pull inflation
The following circumstances lead to demand-pull inflation.
A growing economy creates inflation as people are
confident and spend more. That further benefits economic
growth by creating an expectation of inflation. That
motivates them to buy more now to avoid further price
increases.
Discretionary fiscal policy contributes to demand-pull
inflation. The government's ability to spend more or tax
less increases demand in some areas of the economy.
Marketing and new technology create demand-pull
inflation for particular products or types of financial assets.
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 Price Stability
Demand-pull inflation
Over-expansion of the money supply. The money
supply is not just cash, but also credit, loans and
mortgages. Money supply can be increased by lowering of
interest rates. It can also be increased by the printing or
electronic creation of more money.

Cost-push inflation
The following factors contribute to this type of inflation
Wage increases. Most prices of goods and services will go
up as producers of goods and services have to compensate
for the increase in wage costs. This increase depends on
the percent of wages to their total costs.
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 Price Stability
Cost-push inflation
The existence of monopolies or cartels can also
contribute to this type of inflation. They can command
their prices and customers have no choice.
The depreciation (lowering of value)of a countrys
currency will result in the increase in prices of imported
goods and services.
Any shortage of goods and services, natural or man-made
(including government) affecting the whole country or only
certain markets

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 Price Stability
Redistributive Effects of Inflation
Inflation redistributes wealth from the lender to the
borrower
The market price of fixed-interest rate securities like
bonds, mortgages, and other debt instruments becomes
lower in value alongside the currency. The borrowers
whose wages and salaries may have increased faster than
the inflation rate thus have less of a burden to meet their
mortgages and interest payments.

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 Price Stability
Harmful Effects of Inflation
Rapidly rising prices erode our purchasing power.
People will start demanding higher wages.
Companies will, in turn, factor the higher wages into the
prices of their products.
The result is a spiral with wages and prices pushing
each other up and up while interest rates increase as
well.
In such an environment, where all goods and services keep
growing more and more expensive, consumers and
businesses are left without solid ground to base sound
economic decisions on.

Source: DNB 9
 Price Stability
Harmful Effects of Inflation
People who live on fixed incomes, like the elderly who
live on pensions or social security will find they have less
money for food, shelter and medicines.
Higher production costs in a country with an
artificially managed over-valued currency
exchange rate will make the country not
competitive globally, thus limiting exports.
Investors will hesitate from undertaking long-term
projects and concentrate only on short-term ones due to
the uncertainty of future costs

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 Price Stability

The uncertainty reaches down to the general population,

there is widespread speculation, holding cash
becomes undesirable, demand for hard goods escalates,
there is now run-away inflation.

Inflation in Zimbabwe in 2008 reached 79.6%

billion per month

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 Price Stability
The Consumer Price Index(CPI) is the benchmark
inflation guide for the U.S. economy. It uses a "basket of
goods" approach that aims to compare a consistent base of
products from year to year, focusing on products that are
bought and used by consumers on a daily basis.

The basket contains everyday products such as food,

clothing, furniture and a range of services.

As the products in the basket increase or decrease in price,

the overall value of the basket changes.

Annually, the Bureau of Labor Statistics (BLS) collects data

on the costs of the items in the basket of goods , and it
compares the price of the basket to the previous year. The
resulting ratio is the CPI.
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 Price Stability
Producer Price Index
The PPI measures the average change in the sale prices for
the entire domestic market of raw goods and services.

These goods and services are bought by consumers from

their primary producers, bought indirectly from
retail sellers and purchased by producers themselves.

The industries that compile the PPI include mining,

manufacturing, agriculture, fishing, forestry, natural gas,
electricity, construction, waste and scrap materials. As the
PPI is meant to evaluate the output of U.S. producers,
imports are excluded.
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 Price Stability
In contrast, the target set of good and services evaluated in
the CPI are expenditures of domestic and internationally
imported consumer-related services.

In Philippines, the Producer Price Index measures the

average change in price of goods and services sold by
manufacturers and producers in the wholesale market
during a given period.

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 Price Stability
Deflation
It is a decrease in the general price level of goods and
services. It occurs when the inflation rate falls below 0%
(a negative inflation rate).
Deflation can be triggered by any combination of the
following factors:
A decline in the money supply
An increase in the supply of goods or services, which
exacerbate the situation and further lower prices
A decrease in the demand for goods
An increase in the demand for money
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 Price Stability
If deflation is exacerbated, it can throw an economy into
a deflationary spiral.
This happens when price decreases lead to lower
production levels, which, in turn, leads to lower wages,
which leads to lower demand by businesses and
consumers, which lead to further decreases in prices.

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Protective Mechanisms

When it comes to protecting your portfolio from the

ravages of inflation, there are several popular strategies.
First and foremost is the stock market. Rising prices
tend to be good news for equities.
For fixed-income investors seeking an income stream that
keeps pace with rising prices, Treasury Inflation-Insured
Securities are a common choice.
These government-issued bonds come with a guarantee
that their par value will rise with inflation, as measured by
the Consumer Price Index, while their interest rate will
remain fixed. Interest on TIPS is paid semiannually.
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 Price Stability
TIPS can be purchased directly from the government
through the Treasury Direct system in $100 increments
with a minimum investment of $100 and are available with
5-, 10-, and 20-year maturities.
International bonds also provide a way to generate
income. They provide diversification too, giving investors
access to countries that may not be experiencing inflation.
Gold is another popular inflation hedge, as it tends to
retain or increase its value during inflationary periods.
Other commodities can also fit in this bucket, as can real
estate, since these investments tend to rise in value when
inflation is on an upswing.

Source: Investopedia.com
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Thank you!

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