- What is inflation and why does it occur?
- What are the types of inflation?
- How is inflation calculated?
- What effect does inflation have on the stock market?
What is inflation?
Inflation is a situation in which the general level of prices of goods and services increases continuously over a certain period of time (usually one year). The important point is that any kind of price increase cannot be considered inflation; Because the element of time and continuity of the increase in the general level of prices is very important in defining inflation.
Therefore, if the general level of prices increases only in a certain period and only once and then this upward trend is interrupted, this process is not called inflation. Therefore, the general level of prices must increase continuously over time to be considered inflation. In order to fully learn these topics, we suggest you to participate in the fundamental analysis course of Rahevard Academy.
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Definition of inflation in terms of economics
From an economic point of view, inflation is an increase in the general level of prices in a certain period of time. Inflation can be seen as an unreasonable increase in the price of goods and services without support and without planning, which reduces the purchasing power and upsets the balance between the demand for products and the liquidity available to buy products.
Causes of inflation
Inflation is the disproportion between the amount of money in circulation and the supply of goods and services. All economists believe that stable and long-term inflation has no root other than money supply and increased liquidity. The higher the inflation rate, the lower the purchasing power of a currency.
One of the roots of inflation is the lack of balance between government revenues and expenditures. In this way, when the expenses of the government are more than its revenues in the annual budget, the government faces a budget deficit. If the government borrows from the central bank or sells foreign exchange earnings to the central bank to solve the budget deficit problem, the monetary base and then the total liquidity in the economy will increase, and this increase in liquidity will have inflationary effects.
Another reason for the increase in the inflation rate is inflationary expectations. This means that if people predict based on their past experiences or based on market observations that prices will increase in the near future, they will increase their spending. On the other hand, producers and sellers refuse to sell and supply their goods in the hope of a price increase in the future. It is obvious that in this case, supply and demand will directly affect prices and increase inflation.
Types of swelling
Inflation is divided into different categories according to its speed:
Creeping inflation or mild inflation occurs when the annual price increase is 3% or less. According to the US Federal Reserve, an increase of 2 percent or less in the price level is beneficial for economic growth.
Because consumers think that prices will rise in the future, they will increase their demand to avoid higher prices in the future. In this way, creeping inflation will cause economic prosperity.
Swelling is going on
Walking Inflation is stronger or more destructive and takes numbers between 3 and 10 percent annually. This inflation is harmful for countries. Because people buy more than necessary necessities so that they don’t have to pay more money to buy them in the future.
This increase in purchases will increase the demand even more and the suppliers will not be able to meet the excess demand. In such a situation, due to insufficient wages, a large part of the people lose their access to essential goods and services due to the high cost of them.
Galloping inflation occurs when the inflation rate is 10% or more. At this time, the economy is weakened and the value of money also decreases to some extent. Also, the human forces of businesses also face problems in meeting their needs.
Despite the high inflation, investors refuse to invest in the country and withdraw their capital from the country. The economy will become unstable and government officials will lose their credibility. Therefore, it is recommended to avoid saddle inflation at any cost.
Hyperinflation is a rapid, widespread and out-of-control price increase in the economy. While inflation refers to the increase in prices in the economy, hyperinflation refers to a rapid increase in inflation of more than 50% per month.
Hyperinflation is a rare phenomenon in the economy of developed countries. The possibility of hyperinflation is high during war and economic chaos of countries and at the same time as the central bank of that country prints a lot of money.
How is inflation calculated?
What are inflation measurement indicators?
In general, there are four types of common price indices as follows to measure inflation:
Price index of consumer goods and services
This index measures the price of a certain basket of goods and services purchased by consumers. Since the retail prices paid by consumers are used to calculate this index, the said index reflects the state of living expenses and its changes. Changes in the consumer price index in a certain period of time are used to calculate consumer inflation.
Producer price index
Instead of measuring the status of prices paid by consumers, the producer price index measures the status and change of prices imposed by producers at different stages of the production process. In addition to final goods and services, this index also includes semi-finished goods and raw materials and is considered a good tool for checking cost changes in various industries. Changes in the producer price index in a certain period of time are used to calculate producer inflation.
In the economic literature, the producer price index is referred to as a predictive index; This means that by examining this index, one can get information about the level of price changes in the market of consumer goods and services or inflation. In other words, any price increase or decrease in the producer price index is also observed in the consumer price index with a time interval.
Wholesale price index
This index is a measure of changes in the general level of prices in the wholesale sector and measures the changes in the prices of goods and services at the level of major manufacturers and sellers. In other words, this index shows the changes in the price paid for goods in different stages of distribution up to the retail stage and includes the price of raw materials for final and intermediate use, the price of unfinished or intermediate goods, and the price of finished goods.
Price index of imported goods
The trend of price changes of products supplied to the country during a certain period of time is shown using the price index of imported goods. In fact, the number of this index represents the average price changes of various goods in a certain basket of imports based on the base year.
Changes in the price index of imported goods are influenced by exchange rate variables, global inflation and economic policies of governments. Considering that the price of imported goods is one of the most important factors affecting the amount of foreign exchange of countries, therefore, its changes are of great importance.
The consequences of inflation on society
- Uncertainty in society and decrease in economic growth
- Unequal distribution of income and reduction of social welfare
- Decrease in exports and balance of payments imbalance
- Creating a government budget deficit
- Improper allocation of resources and expansion of unproductive activities
- Reducing the level of public trust of the people
- Undesirable social consequences such as embezzlement and bribery
- Decrease in the purchasing power of a currency
Inflation situation in the world
According to the International Monetary Fund report published in 2018, Venezuela has the highest inflation rate in the world with an inflation rate of more than 80,000 percent. According to the same report, Japan has the lowest inflation rate in the world with negative inflation of 0.2%.
This report also indicates that globally, 26 countries have a double-digit inflation rate, one country has a three-digit inflation rate, 152 countries have a single-digit inflation rate, and two countries (Japan and Great Britain) have a negative inflation rate.
The inflation situation in Iran
According to the report of the International Monetary Fund, Iran has the highest inflation rate in the Middle East with an inflation record of more than 26%. While the average inflation rate in the Middle East countries is 3.3%. Also, Iran has the second highest inflation rate in the world.
When we look at the characteristics of inflation in Iran, we see that inflation in Iran has not been accompanied by employment growth and market prosperity. On the other hand, wages do not grow in line with inflation. It seems that inflation in Iran is more rooted in the cost pressure of raw materials and the inappropriate structure of the monetary, financial, supply and demand system.
Ways to control inflation
As liquidity is injected into a country’s economy in different ways, there are also different ways to control it. Some of these solutions are short-term and some are long-term, which we mention:
- Sale of shares
- Competitive interest of investment deposits
- Providing liquidity to economic enterprises through people’s capital
- Expansion and creation of home production infrastructure
- Joint and public investment with foreign investors
- Vertical development of eligible properties
- Collection of bank claims
- Reducing the growth rate of wages and stabilizing the price of government services
- minting new coins and injection in the currency and coin market
- Printing large banknotes
- Allocating land to housing cooperatives and building low-cost housing
- Activation of stock exchange and money and capital markets
- Completion of semi-finished construction plans and the development plan of large industrial units
- Reduction of withdrawals from the foreign exchange reserve fund
- Budget contraction policies
- Shrinking the government
- Strengthening the central bank’s authority to control monetary and financial institutions
- Pre-sale of capital goods
- Import policy and reducing inflation
- Implementation of the general policies of Article 44 of the Constitution
- Selling currency to money markets
- Spending oil revenue in production and development projects
Frequently asked questions about inflation
What effect does inflation have on the stock market?
An increase in inflation leads to a decrease in people’s purchasing power and, as a result, a decrease in the sales of joint-stock companies. In this way, the profitability of companies will decrease. On the other hand, the cost of goods and products for companies increases, which again causes the company’s profit to decrease.
As the company’s EPS or actual profit decreases compared to its predicted profit, the stock price of that company falls and can affect the stock market index and reduce it. Also, people’s desire to invest in that company will also decrease because they will lose their hope of getting DPS.
On the other hand, if inflation continues, companies will be forced to increase the price of their products. An increase in the price of products can increase the nominal profit for them under the influence of inflation. In this way, the price of companies’ shares increases in the long term and causes the stock market index to increase.
What is chronic swelling?
Chronic inflation occurs when a country experiences inflation for long periods of time, for years or decades. In countries with chronic inflation, inflation expectations are institutionalized and it will be very difficult to reduce the inflation rate. This phenomenon continues until anti-inflationary expectations adapt to the new conditions. Chronic inflation can only be sustained for so long by printing unbacked paper money.
Before World War II, printing money without backing was a rare phenomenon, except in countries that were affected by the war. In these countries, the printing of unbacked banknotes caused high inflation in a few years; But this situation did not last for long. Most economists believe that chronic inflation first appeared in Latin America during World War II.
Of course, some economists believe that the French experience in 1920 was the first example of chronic inflation. Japan’s economy also had characteristics that were very similar to chronic inflation in the years close to World War II. Monetarists believe that chronic inflation is caused by excessive growth of the money supply.
What is deflation?
Stagflation or stagflation is one of the relatively emerging types of inflation that has affected some countries after the Second World War. This inflation is not only inflation in the sense of unrestrained increase in prices, but there is also stagnation in it.
Recession or recession in the economy is said to be a situation in which the national production decreases in general. In recession and economic recession, unlike economic prosperity, national income decreases and employment also decreases. Stagnation inflation is popularly called famine.
Does the stock market compensate for inflation?
In the conditions of economic inflation, due to the high risk of keeping cash, people prefer to consider different investment options and reduce their cash volume. This makes the stock market more popular. In this case, the volume of transactions in the stock market will increase and this will cause the stock market to prosper.
As we mentioned in the previous articles, entering the stock market is one of the ways to provide financial resources for joint-stock companies. Therefore, people’s acceptance of the stock market develops the financial resources of these companies and provides the basis for more production and economic development of many businesses. As a result, the boom of the stock market will be able to greatly reduce the inflation prevailing in the society.
Why is it important to pay attention to inflation in investing?
In a situation where the society suffers from inflation, most people seek to invest their money in different ways in order to prevent their money from becoming devalued. Therefore, those interested in investing should estimate the profit in different financial markets and finally choose a path whose profit rate overcomes the inflation rate prevailing in the country’s economy.
What is the relationship between liquidity and inflation?
According to the definitions provided, inflation means the disproportion of the amount of money in circulation with the supply of services and goods. All economists believe that stable and long-term inflation has no root other than money supply and increased liquidity. The higher the inflation rate, the lower the purchasing power of a currency. Therefore, with the increase in liquidity, inflation will also increase.
Does inflation affect people’s unemployment?
In the conditions of inflation, production and economic prosperity of countries will decrease and job opportunities will decrease. To the extent that sometimes people are not employed against the use of simple food and without receiving wages! In such a situation, the main problem is not the increase in prices, but widespread unemployment and stagnation of production.
Inflation is an unreasonable increase in prices without support and planning, which leads to a decrease in purchasing power and disrupts the balance between product demand and available liquidity. In order to prevent inflation or curb it, governments should use strategies with the help of economists to prevent hyperinflation and chronic inflation in societies.
Inflation affects employment, liquidity, purchasing power, stock market and many other economic and social aspects of a country. In some cases, the destructive effects of inflation are so severe that it may take years for that country to get out of the economic crisis. To learn all these concepts, we suggest you read the fundamental analysis training article.