Inflation is a state in the economy of a country, when there is a price rise of goods as well as

INFLATION

 It is defined as the rise in the general price level and fall in the money value

 It occurs when the amount of buying power is more than the output of goods and services.

 It also occurs when the amount of money exceeds the amount of goods and services available

TYPES OF INFLATION

1) Creeping inflation

2) Trotting inflation

3) Galloping inflation

4) Hyper inflation

CREEPING INFLATION- when there is general rise in prices at very low rates, which is 2- 4%
annually

TROTTING INFLATION- when there is rise in price to almost 5%

GALLOPING INFLATION- when rate is increased with a noticeable speed and at a remarkable
rate usually from 10-20% HYPER INFLATION-when the inflation rate rise to over 20%

CAUSES OF INFLATION

DEMAND-PULL INFLATION:-

 Occurs when the consumers, businesses and the governments’ demand for goods and services
more than the supply; therefore the cost of item rises unless the supply is perfectly elastic

 The increase in demand is created from in increase in other areas, such as the supply of money,
the increase of wage which would then give rise in disposable income, and once the consumer
have more disposal income this would lead to aggregate spending
 As a result in aggregate spending there would also be an increase in demand for exports and
possible hoarding and profiteering from producers. The excessive demand, the price of final goods
and services would be forced to increase and this increase give rise to inflation

COST-PUSH INFLATION

 Cost push inflation is caused by an increase in production costs. It is generally caused by an

increase in wages or an increase in the profit margin of the entrepreneurs

MONETARY INFLATION

Monetary inflation occur when there is an excessive supply of money. It is understood that the
government increase the money supply faster than the quantity of goods increase, which result in
inflation. Interestingly as the supply of good increase the money supply has to increase or else
price actually go down.

STRUCTURAL INFLATION

Planned inflation that is caused by government’s monetary policy is called structural inflation.
This type of inflation is not caused by the excess of demand or supply but is built into an economy
due to governments’ monetary policy.

In developed countries they are characterized by a lack of adequate resources like capital, foreign
exchange, land and infrastructure. Furthermore, over-population with the majority depending on
agriculture for livelihood means that there is a fragmentation of landholdings. There are other
institutional factors like land-ownership, technological backwardness and low rate of investment
in agriculture.

IMPORTED INFLATION Another type of inflation is imported inflation. This occur when the
inflation of goods and services from foreign countries that are experiencing inflation are imported
and the increase in prices for that imported goods or services will directly affect the cost of living

COSTS OF INFLATION Almost everyone thinks inflation is evil, but it isn't necessarily so.
Inflation affects different people in different ways. It also depends on whether inflation is
anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are
expecting (anticipated inflation), then we can compensate and the cost isn't high. For example,
banks can vary their interest rates and workers can negotiate contracts that include automatic wage
hikes as the price level goes up.

Problems arise when there is unanticipated inflation:

 Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those who
borrow, this is similar to getting an interest-free loan.

 Uncertainty about what will happen next makes corporations and consumers less likely to spend.
This hurts economic output in the long run.

 People living off a fixed-income, such as retirees, see a decline in their purchasing power and,
consequently, their standard of living.

 The entire economy must absorb reprising costs ("menu costs") as price lists, labels, menus and
more have to be updated.

 If the inflation rate is greater than that of other countries, domestic products become less
competitive.

People like to complain about prices going up, but they often ignore the fact that wages should be
rising as well. The question shouldn't be whether inflation is rising, but whether it's rising at a
quicker pace than your wages.

Finally, inflation is a sign that an economy is growing. In some situations, little inflation (or even
deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the
economy is weakening.

HOW IN FLATION IS MEASURED?

Measuring inflation is a difficult problem for government statisticians. To do this, a number of

goods that are representative of the economy are put together into what is referred to as a "market
basket." The cost of this basket is then compared over time. This results in a price index, which is
the cost of the market basket today as a percentage of the cost of that identical basket in the starting
year.

In North America, there are two main price indexes that measure inflation:
Consumer Price Index (CPI) - A measure of price changes in consumer goods and services such
as gasoline, food, clothing and automobiles. The CPI measures price change from the perspective
of the purchaser. CPI data can be found at the Bureau of Labor Statistics.

 Wholesale price index (WPI)- The Wholesale Price Index (WPI) is the price of a representative
basket of wholesale goods. Some countries ( like the Philippines) use WPI changes as a central
measure of inflation.But now India has adopted new CPI to measure inflation. However, United
States now report a producer price index instead.

 Producer Price Indexes (PPI) - A family of indexes that measure the average change over time
in selling prices by domestic producers of goods and services. PPIs measure price change from the
perspective of the seller. U.S. PPI data can be found at the Bureau of Labor Statistics.

You can think of price indexes as large surveys. Each month, the U.S. Bureau of Labor Statistics
contacts thousands of retail stores, service establishments, rental units and doctors' offices to obtain
price information on thousands of items used to track and measure price changes in the CPI. They
record the prices of about 80,000 items each month, which represent a scientifically selected
sample of the prices paid by consumers for the goods and services purchased.

In the long run, the various PPIs and the CPI show a similar rate of inflation. This is not the case
in the short run, as PPIs often increase before the CPI. In general, investors follow the CPI more
than the PPIs.

Inflation Rate and Stock Returns

Inflation is conventionally defined as a persistent rise in the general level of prices of goods and
services in an economy over a period of time. When the general price level rises, each unit of
currency buys fewer goods and services, thus eroding the purchasing power of money. Inflation is
measured by inflation rate, the annualized percentage change in the general price index (usually
the Consumer Price Index) over time. The effects of inflation on an economy are numerous and
can be positive or negative, but mainly negative. Negative effects of inflation includes a decrease
in the real value of money and other monetary items over time, uncertainty over future inflation
which may discourage investment and savings, and if inflation is very rapid, shortages of goods as
consumers begin hoarding out of concern that prices will increase even more in the future. Positive
effects includes ensuring that central banks can adjust nominal interest rates (intended to mitigate
recessions), and encouraging investment in non-monetary capital projects. Economists generally
agree that high rates of inflation are caused by an excessive growth in money supply. The essence
of investment is to attain a reasonable return while minimizing risk. Minimizing risk and earning
reasonable returns on investment calls for proper attention on the current rate of inflation otherwise
the value of the investment will be eroded overtime

The relationship between inflation rate and stock returns has been examined by several financial
economists around the world. However, the relationship has not been widely investigated in the
Nigerian Stock Market, hence; the study would significantly contribute to the existing literature
on the subject matter. The stock market is an integral component of the financial sector; its
performance is very critical to growth process of the economy at large. In the last ten years, there
has been rapid increase in the activities of the stock market, which has also fostered rapid
competitiveness in stock trading in securities (stocks).

In an increasing world of finance, the overall performance of the stock market is critical to viability
of investment and in turn economic growth, thus, the inflation-stock market nexus is a critical issue
in the stock market returns literature.

According to Boucher(2006), the inflation-stock returns correlation has been subjected to

extensive study at the end of 1970s and the beginning of the 80s,Lintner(1975), Bodie (1976),
Fama and Schwert (1977), Jaffe and Mandelker(1976), Nelson(1976), Fama (1981), Pyndick
(1984) and confirmed by (Graham, 1996 Siklos and Kwok, 1999;Barnes et al., 1999).Other early
studies such as Modigliani and Cohn, 1979; Feldstein, 1980 focused on the negative relationship
between inflation and the level of real stock prices, as reflected in dividend price ratios and price-
earnings ratios. Ritter and Warr (2002), and Sharpe (2002) confirmed this negative relationship. A
number of alternative hypotheses have been advanced in literature explaining the negative
relationship between inflation and stock prices. These alternatives include; (i) a correlation
between expected inflation and expected real economic growth (the “proxy hypothesis” suggested
by Fama (1981); (ii) the hypothesis that investors may irrationally discount real cash flows using
nominal interestrates (Modigliani and Cohn, 1979); (iii) changes in the expected returns and risk
aversion. Experts believe that the rate of inflation will influence the stock market volatility and
risk. Most emerging equity markets in Africa, particularly in Nigeria, have been bedeviled with
selldown in recent times with foreign portfolio investors shifting their money to a more matured
market where their returns on investment will not be eroded by inflation. Since the issue of
inflation in the region becomes more of concern, funds will begin to flow out from the region
largely on the theme of inflation, the worst of which is not over especially with the increase in the
price of oil (Geetha, Mohidin, Chanran and Chong, 2000).

In a comprehensive study of relationship between inflation rates and stock markets in US, Malaysia
and China, Geetha, et al. (2011) stated that inflation rate can be divided into expected inflation and
unexpected. Expected inflation rate is as a result that economist and consumers plan on year to
year, if inflation is expected, people are less likely to hold cash, overtime money losses value due
to inflation. While, the unexpected inflation is beyond what was expected by economists and
consumers. In general, the effect of unexpected inflation is much more harmful than the effects of
expected inflation. The major effect of unexpected inflation is a redistribution of wealth from
lenders to borrowers. Several studies have been carried out on the relationship between inflation
rates and stock markets or returns across emerging markets and developed economies. While some
of these studies showed significant positive relationship between inflation rates and stock market,
some found a significant negative relationship between stock market and inflation rate, and others
found no significant relationship between the two variables. For instance, the studies of Fraser and
Oyefeso (2002), Jang andSul (2002), Moon (2001).Tessaromatis (1990), Peel, Pope and Paudyal
(1990) all found significant positive relationship between inflation rates and stock market; Fama
and Schwert (1977), Schwert (1981), Fama (1981), Geske and Roll (1983) and Kaul (1987) and
others found a significant negative relationship between stock market and inflation. However,
some other studies such as Pearce and Roley (1985), and Hardouvelis (1988) found no significant
relationship between the two variables (inflation and stock market)

How does inflation affect the stock market

When there is threat of escalating inflation, the central bank tries to control this by raising interest
rates. By increasing interest rate, they hope to attract investors to park their cash in fixed income
instruments, thereby siphoning off excess liquidity from the system. Theoretically, when there is
less liquidity, there is less speculative demand for goods in the economy, hence slowing down the
increase in general prices.
The prospect of higher interest rates is bearish for the stock market because it encourages investors
to lock in their cash from equities to more attractive, less risky securities, like money market funds.
The lower the funds flow into the market, the lower the demand for stocks, hence lower share
prices.
The other way to look at it is by valuation. The expectation of higher inflation is what is driving
the market crazy at the moment. When there is uncertainty, the risk premium tends to increase,
which leads to higher expected returns from the stock market.
Let’s say you put risk premium of 1 percent on top of the current inflation rate of 4.9 percent, so
your minimum expected return must be 5.9 percent. For you to make this kind of return from
stocks, you need to buy the market at its equivalent price-earnings (P/E) ratio or lower.
How do you compute this? Assume that the expected return of 5.9 percent is the earnings yield,
which is represented as E/P. To get the equivalent P/E, you simply divide the number one by 5.9
percent to derive 17x ratio. If you compare this valuation to current market P/E of 21x, you should
expect the market to correct further before you start buying again.
Imagine if inflation continues to increase, the minimum return on stock investment will also be
higher which will push market valuation lower. Share prices will fall until the estimated earnings
yield increase to a point enough to offset the expected inflation.
The expectation of rising inflation, albeit benign, can adversely affect the stock market in the short-
term. However, this should not discourage from participating in the market. In fact, this is the best
time to invest at good price if the market falls further.
Investing in stocks can be a good hedge against inflation over the long term. Stocks are one of the
few assets that you can rely on when it comes to beating inflation. The other asset that you can
consider is real estate which tracks inflation through value appreciation. However, this is not as
liquid as stocks. You may find it difficult to sell at the price you want when you need money.
Rising inflation can cause the most damage in fixed income securities. If you have put your money
in bonds and long-term commercial papers, you are most likely going to lose in real terms if the
interest rate per annum that you agreed to receive is less than the current inflation of 4.9 percent.
If inflation goes up further, the higher the increase, the larger your losses will be in real terms.

Stocks can beat inflation over time because companies can raise prices to account for rising costs
brought about by inflation. For example, when cost of sales and wages increases due to inflation,
companies can simply pass on the higher cost to consumers by raising prices over time. When
companies increase their prices, their revenues and earnings also increase. The higher the earnings,
the higher the valuation, which leads to higher share prices.
Why does inflation make stock prices fall?
Stock markets have been on a wild ride recently, plunging one day and then soaring the next.

Pundits have offered many reasons for the biggest stock market swoon in two years. One of the
most frequently blamed culprits was the threat of inflation, which loosely means an increase in
consumer prices over time.

That threat became a little more real after the latest data, released on Feb. 18, showed inflation in
January rising more than expected, sending stocks and bonds lower.

Inflation is defined as the rate of change in the prices of everything from a bar of Ivory soap to the
costs of an eye exam.

The CPI increased 0.5 percent in January from the previous month on a seasonally adjusted basis,
more than economists had forecast and the most since September.

Over the previous 12 months, the index gained about 2.1 percent on a nonseasonally adjusted basis,
meaning the price of most goods and services rose by about that amount on average during the
period. Some, such as hospital services, climbed at a faster pace than the average (6 percent), while
other categories rose more slowly or even declined, such as airline fares, which fell 5.1 percent.

The present value of money

So what spooks stock investors about inflation? To answer that, let’s examine the two ways
inflation directly affects stock prices. The first concerns how we value future income.

When you purchase a stock, for example in Walmart or IBM, you are actually buying a long stream
of future cash flows based on the profits of the company. The value of the company (and its stock
price) is based on how much these future cash flows are worth today, a finance concept called
“present value.” The present value of any sum of money expected to be collected in the future is
computed by factoring in the impact of interest rates and inflation.
For example, let’s say you win the lottery and you’re offered either US$10,000 in a year’s time or
$9,600 right now. What should you do? Well, if you’re acting rationally and you don’t have any
urgent debts that need paying off, you would try to determine what that $10,000 is currently worth.
To do so, you would divide it by 1 plus the interest rate you could readily get at a bank, let’s say
3 percent (we’re assuming that there is no inflation). So the present value of $10,000 a year from
now would be $9,709 – which means it’s best to be patient and wait, rather than take the money
now.

Now let’s imagine the same scenario but with inflation, which is expected to be 2 percent during
the period. Inflation causes the bank rate to be 5 percent, and as a result that 10 grand is actually
worth only $9,524 today. In which case, take the $9,600.

Because inflation made the “discount rate” higher, the value today of the future $10,000 was
reduced. The same thing happens to stocks. Since a stock’s price is just the risk-adjusted present
value of the company’s future cash flows, a rise in inflation will cause it to drop as well.
When investors buy Walmart stock, they’re really buying the expectation that all these customers
will keep coming back and generating cash flows in the future for the company.

Inflation’s flip side

A second way inflation directly affects stocks has the opposite effect. That is, it should cause them
to increase in value.

Rising prices means companies are able to make more money from every computer game, sofa or
pastry they sell. A baker, for example, who sold bread for $5 a loaf increases the price to $5.50
because of strong demand. While the cost of the flour and yeast may have also climbed at the same
pace, the baker still makes more money because profit goes up too.
That leads to higher future cash flows and thus a higher present value today.
These two effects of inflation should in theory cancel each other out. And yet stock prices are
usually hammered when inflation rises. So what’s going on?

There’s lots of evidence, including my own research, that many investors suffer from something
called “inflation illusion.” They worry about the present value effect of inflation of stocks but they
ignore the growth in cash flows and profits that result from higher inflation. This results in stock
prices falling when they shouldn’t.

Stock markets have been a sea of red lately. AP Photo/Sadiq Asyraf

Slowdown on the horizon
However, there’s a third, indirect way inflation affects stocks. And this might be what is causing
the concerns in the markets today. This effect has inflation playing the role of a canary in a coal
mine, warning that bad times are coming.

To understand this, we have to consider how inflation varies through the business cycle, which is
a way of measuring the growth of the economy from the beginning of an expansion to the end of
a recession.

At the beginning of a cycle, inflation is often low. (It was practically nonexistent or even
negative following the financial crisis of 2008.) But as the economy heats up and people have more
money to spend (as is the case now), companies begin to sell more goods and services at steadily
increasing prices, earning higher profits, while most people are able to find work.

As more stuff is being created and sold in the economy, the demand for raw materials and workers
increases. Besides pushing up prices, this can also result in higher wages. The fastest increase in
take-home pay in nine years was another “warning sign” that spooked investors recently.

This is where we are now. If left unchecked, inflation could spike, which would likely cause the
economy to slow down quickly and unemployment to increase. The combination of rising inflation
and unemployment is called “stagflation,” and is feared by economists, central bankers and pretty
much everyone else. It’s what can cause an economic boom to suddenly turn to bust, as we saw in
the late 1970s.

This is where the Federal Reserve steps in. The U.S. central bank has the ability, through various
tools, to manipulate short-term interest rates. So before the economic party gets out of hand and
stagflation takes hold, the Fed steps in to calm things down by increasing the cost of borrowing in
an effort to gradually slow the economy rather than let it crash and burn.

Think of the Fed as the sensible person telling everyone to go home at midnight instead of partying
until the early hours. It’ll spoil the fun at midnight, but we’ll all be happier the next day.

Back to the current turmoil. The latest CPI figures suggest inflation may be accelerating, but it
won’t be clear until we get a couple more readings.
For now, it’s mostly just the threat of inflation that’s causing trouble as investors begin to realize
that the party is getting a little too crazy and that the Fed is going to step in and slow things down
a bit. In other words, inflation is warning sign that an economic slowdown is coming – whether
gradually executed by the Fed or abruptly by a spike in inflation.

So if all of this is understood, why did the market crash? Investors, naturally, want to stay at the
party as long as they can. It is only when they see others heading for the exits that they realize
maybe it’s time they left too, prompting a rush to the door. Thus the market tanks.

This is why a market can appear to be doing great and then suddenly fall at the first hint of inflation.

Note that not all listed stocks have this kind of returns. Some just have returns of above 10 percent
by beating average inflation rate such as PLDT, Meralco, BPI, SM Prime and Filinvest Land, to
name a few. Some stocks have returns below average inflation rate and some have even negative
returns since their IPO listing.
Take advantage of inflation fears. Never mind if the market falls. Buy blue chips at attractive prices
and hedge your savings against inflation for the long term.
Effect of Inflation on Stock Prices
A direct correlation exists between inflation and stock prices. Theoretically, inflation should not
affect stock prices because companies can simply raise their prices to make up for the increased
cost to produce goods and services. In reality, companies competing globally cannot raise their
prices for fear of losing business to competitors. These companies are negatively affected by
inflation. Investors must understand the importance of inflation to stock prices to know the impact
inflation will have on their investments.

Corporate Profits

Inflation negatively affects corporate profits. Stock prices are a direct reflection of corporate net
earnings. Many businesses are not able to change their prices to reflect increased cost. Companies
typically pass the rising cost of production to customers in several stages instead of all at once.
While this process is taking place, companies must bear the increased cost to deliver products and
services to consumers. Businesses are also hesitant to increase the price of goods and services out
of fear of consumers’ reactions. If a competitor is offering similar prices at a lower cost, consumers
will buy goods and services from the competitor. A loss of consumers will reduce corporate profits
and negatively affect the value of the company’s stock.
The Economy

Inflation often causes the government to restrict monetary policy. The Federal Reserve typically
increases interest rates in an effort to control inflation. Increased interest rates make borrowing
money more expensive, which decreases the amount of money circulating through the economy.
When consumers have less money, they spend less money. A decrease in consumer spending
negatively affects companies’ earnings, and consequently stock prices. Increased interest rates also
affect business investments, which are critical to the long-term growth of a company.

Investor Confidence

Inflation can last for a short or long period of time. The uncertainty about inflation affects investor
confidence. Some investors may choose to sell their shares if they believe inflation will stick
around for the long-term. If too many investors sell their shares, it can cause stock prices to decline
because supply is greater than demand. Investors who continue to invest in stocks require a higher
rate of return because of the associated risk. To achieve higher returns, stock prices must decrease.

Measuring Inflation

The effect of inflation on stock prices depends on the severity of inflation in the economy. The
measurement of inflation can show the severity of inflation. Several methods exist to measure
inflation, with the Consumer Price Index (CPI) serving as the most popular method. CPI calculates
sample prices of goods commonly used in the economy. Others methods include the Producer
Price Index, the Employment Cost Index, the Gross Domestic Product Deflator and the Bureau of
Labor Statistics' International Price Program.

services. To meet the required price rise, individuals have to shell out more than is presumed. With
increase in inflation, every sector of the economy is affected. Ranging from unemployment,
interest rates, exchange rates, investment, stock markets, there is an aftermath of inflation in every
sector. Inflation is bound to impact all sectors, either directly or indirectly. Inflation and stock
market have a very close association. If there is inflation, stock markets are the worst affected.

Inflation and stock market- the logistics:

Prices of stocks are determined by the net earnings of a company. It depends on how much profit,
the company is likely to make in the long run or the near future. If it is reckoned that a company
is likely to do well in the years to come, the stock prices of the company will escalate. On the other
hand, if it is observed from trends that the company may not do well in the long run, the stock
prices will not be high. In other words, the price of stocks are directly proportional to the
performance of the company.In the event when inflation increases, the company earnings (worth)
will also subside. This will adversely affect the stock prices and eventually the returns.

Effect of inflation on stock market is also evident from the fact that it increases the rates if interest.
If the inflation rate is high, the interest rate is also high. In the wake of both (inflation and interest
rates) being high, the creditor will have a tendency to compensate for the rise in interest rates.
Therefore, the debtor has to avail of a loan at a higher rate. This plays a significant role in
prohibiting funds from being invested in stock markets.

When the government has enough fund to circulate in the market, the cost of goods, services
usually go up. This leads to the decrease in the purchasing power of individuals. The value of
money also decreases. In a nut shell, for the economy to flourish, inflation and stock market ought
to be more conforming and predictable.

INFLATION IN INDIA

The annualized inflation rate in India is 5.37% as of February 2018, as per the Indian ministry of
statistics and programme implementation. This represents a modest reduction from the previous
annual figure of 9.6% for June 2014. Inflation rates in India are usually quoted as changes in the
Wholesale Price Index, for all commodities.

Many developing countries use changes in the Consumer Price Index (CPI) as their central
measure of inflation. India used WPI as the measure for inflation but new CPI(combined) is
declared as the new standard for measuring inflation CPI numbers are typically measured monthly,
and with a significant lag, making them unsuitable for policy use. Instead, India uses changes in
the Wholesale Price Index (WPI) to measure its rate of inflation.

Provisional annual inflation rate based on all India general CPI (Combined) for November 2016
on point to point basis (November 2016 over November 2017) is 11.24% as compared to 10.17%
(final) for the previous month of October 2016. The corresponding provisional inflation rates for
rural and urban areas for November 2016 are 11.74% and 10.53% respectively. Inflation rates
(final) for rural and urban areas for October 2016 are 10.19% and 10.20% respectively.

The WPI measures the price of a representative basket of wholesale goods. In India, this basket is
composed of three groups: Primary Articles (20.1% of total weight), Fuel and Power (14.9%) and
Manufactured Products (65%). Food Articles from the Primary Articles Group account for 14.3%
of the total weight. The most important components of the Manufactured Products Group are
Chemicals and Chemical products (12%); Basic Metals, Alloys and Metal Products (10.8%);
Machinery and Machine Tools (8.9%); Textiles (7.3%) and Transport, Equipment and Parts
(5.2%).

ISSUE

The challenges in developing economy are many, especially when in context of the monetary
policy with the Central Bank, the inflation and price stability phenomenon. There has been a
universal argument these days when monetary policy is determined to be a key element in
depicting and controlling inflation. The Central Bank works on the objective to control and have
a stable price for commodities. A good environment of price stability happens to create saving
mobilization and a sustained economic growth. The former Governor of RBI C. Rangarajan points
out that there is a long-term trade-off between outputand inflation. He adds on that short-term
trade-off happens to only introduce uncertainty about the price level in future. There is an
agreement that the central banks have aimed to introduce the target of price stability while an
argument supports it for what that means in practice.

THE OPTIMAL INFLATION RATE It arises as the basis theme in deciding an adequate monetary
policy. There are two debatable proportions for an effective inflation, whether it should be in the
range of 1-3 per-cent as the inflation rate that persists in the industrialized economy or should it
be in the range of 6-7 per-cents. While deciding on the elaborate inflation rate certain problems
occur regarding its measurement. The measurement bias has often calculated an inflation rate that
is comparatively more than in nature. Secondly, there often arises a problem when the quality
improvements in the product are in need to be captured out, hence it affects the price index. The
consumer preference for a cheaper goods affects the consumption basket at costs, for the increased
expenditure on the cheaper goods takes time for the increased weight and measuring inflation. The
Boskin Commission has measured 1.1 per cent of the increased inflation in USA every-annum.
The commission points out for the developed countries comprehensive study on inflation to be
fairly low.

MONEY SUPPLY AND INFLATION

The Quantitative Easing by the central banks with the effect of an increased money supply in an
economy often helps to increase or moderate inflationary targets. There is a puzzle formation
between low-rate of inflation and a high growth of money supply. When the current rate of
inflation is low, a high worth of money supply warrants the tightening of liquidity and an increased
interest rate for a moderate aggregate demand and the avoidance of any potential problems.
Further, in case of a low output a tightened monetary policy would affect the production in a much
more severe manner. The supply shocks have known to play a dominant role in the regard of
monetary policy. The bumper harvest in 1998-99 with a buffer yield in wheat, sugarcane, and
pulses had led to an early supply condition further driving their prices from what were they in the
last year. The increased import competition since 1991 with the trade liberalization in place have
widely contributed to the reduced manufacturing competition with a cheaper agricultural raw
materials and the fabric industry. These cost-saving driven technologies have often helped to drive
a low-inflation rate. The normal growth cycles accompanied with the international price pressures
has several times being characterized by domestic uncertainties.

GLOBAL TRADE Inflation in India generally occurs as a consequence of global traded

commodities and the several efforts made by The Reserve Bank of India to weaken rupee against
dollar. This was done after the Pokhran Blasts in 1998. This has been regarded as the root cause
of inflationcrisis rather than the domestic inflation. According to some experts the policy of RBI
to absorb all dollars coming into the Indian Economy contributes to the appreciation of the rupee.
When the US dollar has shrieked by a margin of 30%, RBI had made a massive injection of dollar
in the economy make it highly liquid and this further triggered offinflation in non-traded goods.
The RBI picture clearly portrays forsubsidizing exports with a weak dollar-exchange rate.All these
account for a dangerous inflationary policies being followed by the central bankof the country.
Further, on account of cheap products being importedin the country which are made on a high
technological and capital intensive techniques happen to either increase the price of domestic raw
materials in the global market or they are forced to sell at a cheaper price, hence fetching heavy
losses.

FACTORS

There are several factors which help to determine the inflationary impact in the country and further
help in making a comparative analysis of the policies for the same.The major determinant of the
inflation in regard to the employment generation and growth is depicted by the Phillips curve.

DEMAND FACTORS

It basically occurs in a situation when the aggregate demand in the economy has exceeded the
aggregate supply. It could further be described as a situation where too much money chases just
few goods. A country has a capacity of producing just 550 units of a commodity but the actual
demand in the country is 700 units. Hence, as a result of which due to scarcity in supply the prices
of the commodity rises. This has generally been seen in India in context with the agrarian society
where due to droughts and floods or inadequate methods for the storage of grains leads to lesser
or deteriorated output hence increasing the prices for the commodities as the demand remains the
same.

SUPPLY FACTORS

The supply side inflation is a key ingredient for the rising inflation in India. The agricultural
scarcity or the damage in transit creates a scarcity causing high inflationary pressures. Similarly,
the high cost of labor eventually increases the production cost and leads to a high price for the
commodity.

The energies issues regarding the cost of production often increases the value of the final output
produced. These supply driven factors have basically have a fiscal tool for regulation and
moderation. Further, the global level impacts of price rise often impacts inflation from the supply
side of the economy.

Consensus on the prime reason for the sticky and stubbornly high Consumer Price Index, that is
retail inflation of India, is due to supply side constraints; and still where interest rate remains the
only tool with The Reserve Bank of India. Higher inflation rate also constraints India's
manufacturing environment.
DOMESTIC FACTORS

Developing economies like India have generally a lesser developed financial market which creates
a weak bonding between the interest rates and the aggregate demand. This accounts for the real
money gap that could be determined as the potential determinant for the price rise and inflation in
India. There is a gap in India for both the output and the real money gap. The supply of money
grows rapidly while the supply of goods takes due time which causes increased inflation. Similarly
Hoarding has been a problem of major concern in India where onions prices have shot high in the
sky. There are several other stances for the gold and silver commodities and their price hike.

EXTERNAL FACTORS

The exchange rate determination is an important component for the inflationary pressures that
arises in the India. The liberal economic perspective in India affects the domestic markets. As the
prices in United States Of America rises it impacts India where the commodities are now imported
at a higher price impacting the price rise. Hence, the nominal exchange rate and the import inflation
are a measures that depict the competitiveness and challenges for the economy.

STOCK MARKET

A stock market is place or public entity for buying and selling of company shares and derivatives
at an agreed price. These shares and derivatives are listed in stock exchange for trade.

TYPES OF MARKET IN INDIA

Primarily there are two types of market in India

1) Primary market

2) Secondary market

Primary market- it is the market where stock is issued for the first time. So, when the company is
listed in stock exchange first and issues its shares- this process is happened in primary market.

Secondary market- These is the market where the already issued stock has traded by the small
investor, AMC and HNI’s through the licensed share broker. After IPO in primary market the
trading has been done in secondary market.
Some stock exchanges have been granted exit by sebi. These stock exchanges and their date of
exits are:
Two main stock exchanges in are:

1) BSE: Bombay stock exchange and

2) NSE National stock exchange

BSE: THE BOMBAY STOCK EXCHANGE

 it is one of the largest stock exchange in with more than 6000 stocks listed
 it account for two third of the total trading volume in the country.
 Established in 1875 and one of the oldest stock exchange in asia.
 It was the first one to be recognized by the government of india among the 22 exchanges.
 Only stock exchange that had the advantage of getting permanent recognition.
 It possess the maximum number of listed organization in the world.
 Index of BSE is known as SENSEX which include 30 companies.
 SENSEX has been calculated since 1986 and initially it was calculated on the total market
capitalization methodology. This methodology was changed in 2003 to free float market
capitalization.
 SENSEX is calculated for every 15 second

NSE: NATIONAL STOCK EXCHANGE

 It was promoted by leading financial institution at the order of government of india.

  In November,1992 NSE was formed as a tax paying company.
 It was recognized as a stock exchange in april 1993 under the security contract(regulation)
act,1956
 Started its operation in june 1994
 It commenced its capital market segment started in November 1994, while derivative
segment started in june 2000.

What are the effects of Inflation on an economy? Inflation has both Negative and Positive points
which are as follows

Negative

• Add inefficiencies in the market, and make it difficult for companies to budget or plan long term

• Can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax
rates.

• Cost-push inflation - Rising inflation can prompt employees to demand higher wages, to keep up
with consumer prices. Rising wages in turn can help fuel inflation.

• Hoarding - People buy consumer durables as stores of wealth in the absence of viable alternatives
as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded
objects.

• Hyperinflation - If inflation gets totally out of control (in the upward direction), it can grossly
interfere with the normal workings of the economy, hurting its ability to supply.

• Price inflation has immense effect on the Time Value of Money (TVM)- The above two examples
explains the meaning of this statement.

Positive

• Labor-0market adjustments - Inflation would lower the real wage if nominal wages are kept
constant, Keynesians argue that some inflation is good for the economy, as it would allow labor
markets to reach equilibrium faster.

• Debt relief - Debtors who have debts with a fixed nominal rate of interest will see a reduction in
the "real" interest rate as the inflation rate rises.
How does rising inflation affect the stock market?

To tame inflation, the government usually hikes interest rates. This tends to make debt instruments
attractive relative to equities as the former carry a lower risk (small savings instruments are risk
free as they are guaranteed by the government). This results in some amount of investments
shifting from equity to debt. However, high inflation is not always bad and low inflation need not
always be good for equity markets, as the impact will differ for companies and sectors across
different time horizons. The first thing to consider is the items where prices are rising. For example
a rise in oil prices will impact a wide range of items from food products to those that require
transportation.

How are companies affected by rising inflation and how does an investor view the impact?

A rise in prices of several items means that the input prices for production of various goods and
services are rising. In these cases market analysts and fund managers will always consider the net
impact on the margin of the entity that they are tracking. While there might be an increase in the
input prices, it has to be considered in the backdrop of the company's ability to pass on the price
hike to the end-user. If a company is able to sustain its profit margin despite high inflation, the
stock price is likely to hold. If the high inflation sustains, at some stage it will lead to a chain
reaction across the economy, pushing up interest rates and even affecting demand. An increase in
interest rates will push up borrowing costs for corporates while lower demand will hurt growth in
revenues. This is likely to impact sentiment for the stock market as a whole

How Inflation affects Sensex

RBI (Reserve Bank of India) in its first monetary policy review of the FY19 came out with lower
projections on inflation front. The central bank projected inflation for the current fiscal to be in the
range of 4.7-5.1 percent on sharp moderation in food price rise and possibility of a normal
monsoon. Although any upside or downside in the stock markets occurs due to a variety of factors,
threat of inflation gets counted as one of the most blamed culprits. Inflation affects the Sensex and
Nifty in a variety of ways.
What is inflation?
A hike in general price level of goods and services in an economy over a period of time is defined
as inflation in economics.
Impact on Sensex, Nifty
Any unexpected rise in the inflation, CPI in India, is considered worrisome for the corporates as it
takes several months for them to pass on higher input costs to consumers. Even the customers feel
pinch when goods and services become pricier. They also tend to hold less cash in such a scenario,
as inflation eats away their savings. The investors with less cash holding tend to invest less in the
stock markets during such period. They also get confused since impact is likely to impact the
economy and stock prices, however not at a same rate.
At times any rise in inflation is also considered good as it can help in stimulating growth as seen
in developed countries like the US. But it can also impact corporate profits through higher input
costs as firms stop hiring. It’s therefore much required of an investor to take wise decisions during
periods of high inflation. Different groups of stocks seem to perform better during periods of
surging inflation.
Effect on bonds
As inflation rises, investor interest dips in bonds and so does the demand. So, the bond prices drop
and yields rise as both are inversely proportional to each other. Mostly, the central banks the world
over hike interest rates to counter the effect of surging inflation.
Inflation's Impact on Stock Returns
Investors and businesses constantly monitor and worry about the level of inflation. Inflation—the
rise in the price of goods and services—reduces the purchasing power each unit of currency can
buy. Rising inflation has an insidious effect: input prices are higher, consumers can purchase fewer
goods, revenues and profits decline, and the economy slows for a time until a steady state is
reached.
This negative impact of rising inflation keeps the Fed diligent and focused on detecting early
warning signs to anticipate any unexpected rise in inflation. The unexpected rise of inflation is
generally considered the most painful, as it takes companies several quarters to be able to pass
along higher input costs to consumers. Likewise, consumers feel the unexpected “pinch” when
goods and services cost more. However, businesses and consumers eventually become
acclimated to the new pricing environment. These consumers become less likely to hold cash
because its value over time decreases with inflation. For investors, this can cause confusion, since
inflation appears to impact the economy and stock prices, but not at the same rate.

High inflation can be good, as it can stimulate some job growth. But high inflation can also
impact corporate profits through higher input costs. This causes corporations to worry about the
future and stop hiring, reducing the standard of living of individuals, especially those on fixed
incomes. Because there is no one good answer, individual investors must sift through the confusion
to make wise decisions on how to invest in periods of inflation. Different groups of stocks seem
to perform better during periods of high inflation.

Inflation and Stock Returns

Examining historical returns data during periods of high and low inflation can provide some clarity
for investors. Numerous studies have looked at the impact of inflation on stock returns.
Unfortunately, these studies have produced conflicting results when several factors are taken into
account, namely geography and time period.

Unexpected inflation showed more conclusive findings, most notably being a strong positive
correlation to stock returns during economic contractions, demonstrating that the timing of
the economic cycle is particularly important for investors gauging the impact on stock returns.
This correlation is also thought to stem from the fact that unexpected inflation contains new
information about future prices. Similarly, greater volatility of stock movements was correlated
with higher inflation rates.
Growth vs. Value Stock Performance and Inflation

Stocks are often broken down into subcategories of value and growth. Value stocks have strong
current cash flows that will slow over time, while growth stocks have little or no cash flow today,
but it will gradually increase over time.

Therefore, when valuing stocks using the discounted cash flow method, in times of rising interest
rates, growth stocks are negatively impacted far more than value stocks. Since interest rates are
usually increased to combat high inflation, the corollary is that in times of high inflation, growth
stocks will be more negatively impacted. This suggests a positive correlation between inflation
and the return on value stocks and a negative one for growth stocks.

Interestingly, the rate of change in inflation does not impact returns of value versus growth stocks
as much as the absolute level. The thought is that investors may overshoot their future growth
expectations and upwardly misprice growth stocks. In other words, investors fail to recognize
when growth stocks become value stocks, and the downward impact on growth stocks is harsh.
Income-Generating Stocks and Inflation

When inflation increases, purchasing power declines, and each dollar can buy fewer goods and
services. For investors interested in income-generating stocks, or stocks that pay dividends, the
impact of high inflation makes these stocks less attractive than during low inflation, since
dividends tend to not keep up with inflation levels. In addition to lowering purchasing power, the
taxation on dividends causes a double-negative effect. Despite not keeping up with inflation and
taxation levels, dividend-yielding stocks do provide a partial hedge against inflation.

The price of dividend-paying stocks is impacted by inflation similar to the way bonds are affected
by interest rates—when inflation rises, income stock prices generally decline. So owning
dividend-paying stocks in times of increasing inflation usually means the stock prices will
decrease. But investors looking to take positions in dividend-yielding stocks are given the
opportunity to buy them cheap when inflation is rising, providing attractive entry points.

Investors try to anticipate the factors that impact portfolio performance and make decisions based
on their expectations. Inflation is one of those factors that affects a portfolio. In theory, stocks
should provide some hedge against inflation, because a company’s revenues and profits should
grow at the same rate as inflation, after a period of adjustment. However, inflation’s varying
impact on stocks confuses the decision to trade positions already held or to take new positions. In
the U.S. market, the historical proof is noisy, but it does show a correlation to high inflation and
lower returns for the overall market in most periods.

When stocks are divided into growth and value categories, the evidence is clearer that value stocks
perform better in high inflation periods and growth stocks perform better during low inflation. One
way investors can predict expected inflation is to analyze the commodity markets, although the
tendency is to think that if commodity prices are rising, stocks should rise since companies
“produce” commodities. However, high commodity prices often squeeze profits, which in turn
reduces stock returns. Therefore, following the commodity market may provide insight into future
inflation rates.

Rising inflation among key risks to Indian equity market: Morgan Stanley
A likely rise in crude oil prices that could put pressure on growth, an election cycle that brings its
own set of uncertainties and an upward pressure on inflation from food price hikes that sees the
Reserve Bank of India (RBI) hike rates further are among the top risks to the Indian equities,
according to a recent Morgan Stanley India Equity Strategy Almanac: The Uphill Climb.

On Monday, the wholesale price inflation (WPI) for June rose to a four-and-a-half year high of
5.77 percent, rising from 4.43 per cent recorded in May 2018. Inflation in vegetables jumped to
8.12 per cent in June, from 2.51 per cent in the previous month.

Inflation in 'fuel and power' basket, too, rose sharply to 16.18 per cent in June from 11.22 per cent
in May as prices of domestic fuel increased during the month in line with rising global crude oil
rates, data showed.
Experts do feel that the central bank may hike rates further over the next few months. Manishi
Raychaudhuri, BNP Paribas’ Asian Equity Strategist, for instance, expects the RBI to hike rates
twice in 2018, of which, one hike already came through in June.

“We think the market’s expectation is more benign now, but given the fact that core inflation is on
a steady uptrend, consensus expectations about rates may move upwards as more data points
become available,” he says.

"While the outlook for the WPI inflation would be influenced by commodity prices, rupee
movement, effectiveness of MSPs and the dispersion of the monsoons, an easing of the base effect
should cool the WPI inflation for July 2018 to some extent. The sharper-than-expected uptick in
the WPI inflation in June 2018 reinforces our expectation of a likely repo rate hike at the next
MPC meeting in August 2018," writes Aditi Nayar, Principal economist at ICRA in a note.

Besides the above-mentioned risks, relatively rich mid-cap valuations, rising equity supply and the
fact that the markets may already be pricing in some part of the growth recovery are the other
factors that pose a risk to the India equity story, says the report authored by Ridham Desai, head
of India research and India equity strategist along with Sheela Rathi.

Their base-case June 2019 target for the S&P BSE Sensex remains unchanged at 36,000 levels,
while the bull-case scenario sees the 30-share index at 44,000.

“Indian stocks are jostling weak emerging markets, rising rates, higher oil prices, an election year
and relatively rich mid-cap valuations. The large-cap index has support from an improving growth
cycle, strong macro stability and local appetite for equities,” the report says.

On the flip side, the report highlights six factors - Strong macro stability evident in a positive
balance of payments (BoP) and backed by a Central Bank that is committed to keeping real rates
positive; a bullish steepening of yield curve; a low and falling beta, which augurs well in a weak
global equity market environment; India's growth that is likely to accelerate relative to emerging
markets (EM); strong domestic flows and a weaker foreign portfolio (FPI) positioning – that are
currently working in favour of Indian equities.
As a portfolio strategy, Morgan Stanley prefers to stick with the large-caps as compared to their
mid-cap peers.

"We like Banks (private corporate and retail), Discretionary Consumption, Industrials and
Domestic Materials, while avoiding Healthcare, Staples, Utilities, Global Materials and Energy,"
the report says.

Inflation is a state in the economy of a country, when there is a price rise of goods as well as
services. To meet the required price rise, individuals have to shell out more than is presumed. With
increase in inflation, every sector of the economy is affected. Ranging from unemployment,
interest rates, exchange rates, investment, stock markets, there is an aftermath of inflation in every
sector. Inflation is bound to impact all sectors, either directly or indirectly. Inflation and stock
market have a very close association. If there is inflation, stock markets are the worst affected.

Inflation and stock market- the logistics:

Prices of stocks are determined by the net earnings of a company. It depends on how much profit,
the company is likely to make in the long run or the near future. If it is reckoned that a company
is likely to do well in the years to come, the stock prices of the company will escalate. On the other
hand, if it is observed from trends that the company may not do well in the long run, the stock
prices will not be high. In other words, the price of stocks are directly proportional to the
performance of the company.In the event when inflation increases, the company earnings (worth)
will also subside. This will adversely affect the stock prices and eventually the returns.

Effect of inflation on stock market is also evident from the fact that it increases the rates if interest.
If the inflation rate is high, the interest rate is also high. In the wake of both (inflation and interest
rates) being high, the creditor will have a tendency to compensate for the rise in interest rates.
Therefore, the debtor has to avail of a loan at a higher rate. This plays a significant role in
prohibiting funds from being invested in stock markets.

When the government has enough fund to circulate in the market, the cost of goods, services
usually go up. This leads to the decrease in the purchasing power of individuals. The value of
money also decreases. In a nut shell, for the economy to flourish, inflation and stock market ought
to be more conforming and predictable.

How Inflation affects Sensex

RBI (Reserve Bank of India) in its first monetary policy review of the FY19 came out with lower
projections on inflation front. The central bank projected inflation for the current fiscal to be in the
range of 4.7-5.1 percent on sharp moderation in food price rise and possibility of a normal
monsoon. Although any upside or downside in the stock markets occurs due to a variety of factors,
threat of inflation gets counted as one of the most blamed culprits. Inflation affects the Sensex and
Nifty in a variety of ways.
What is inflation?
A hike in general price level of goods and services in an economy over a period of time is defined
as inflation in economics.
Impact on Sensex, Nifty
Any unexpected rise in the inflation, CPI in India, is considered worrisome for the corporates as it
takes several months for them to pass on higher input costs to consumers. Even the customers feel
pinch when goods and services become pricier. They also tend to hold less cash in such a scenario,
as inflation eats away their savings. The investors with less cash holding tend to invest less in the
stock markets during such period. They also get confused since impact is likely to impact the
economy and stock prices, however not at a same rate.
At times any rise in inflation is also considered good as it can help in stimulating growth as seen
in developed countries like the US. But it can also impact corporate profits through higher input
costs as firms stop hiring. It’s therefore much required of an investor to take wise decisions during
periods of high inflation. Different groups of stocks seem to perform better during periods of
surging inflation.
Effect on bonds
As inflation rises, investor interest dips in bonds and so does the demand. So, the bond prices drop
and yields rise as both are inversely proportional to each other. Mostly, the central banks the world
over hike interest rates to counter the effect of surging inflation.
Inflation's Impact on Stock Returns
Investors and businesses constantly monitor and worry about the level of inflation. Inflation—the
rise in the price of goods and services—reduces the purchasing power each unit of currency can
buy. Rising inflation has an insidious effect: input prices are higher, consumers can purchase fewer
goods, revenues and profits decline, and the economy slows for a time until a steady state is
reached.
This negative impact of rising inflation keeps the Fed diligent and focused on detecting early
warning signs to anticipate any unexpected rise in inflation. The unexpected rise of inflation is
generally considered the most painful, as it takes companies several quarters to be able to pass
along higher input costs to consumers. Likewise, consumers feel the unexpected “pinch” when
goods and services cost more. However, businesses and consumers eventually become
acclimated to the new pricing environment. These consumers become less likely to hold cash
because its value over time decreases with inflation. For investors, this can cause confusion, since
inflation appears to impact the economy and stock prices, but not at the same rate.

High inflation can be good, as it can stimulate some job growth. But high inflation can also
impact corporate profits through higher input costs. This causes corporations to worry about the
future and stop hiring, reducing the standard of living of individuals, especially those on fixed
incomes. Because there is no one good answer, individual investors must sift through the confusion
to make wise decisions on how to invest in periods of inflation. Different groups of stocks seem
to perform better during periods of high inflation.

Inflation and Stock Returns

Examining historical returns data during periods of high and low inflation can provide some clarity
for investors. Numerous studies have looked at the impact of inflation on stock returns.
Unfortunately, these studies have produced conflicting results when several factors are taken into
account, namely geography and time period.
Unexpected inflation showed more conclusive findings, most notably being a strong positive
correlation to stock returns during economic contractions, demonstrating that the timing of
the economic cycle is particularly important for investors gauging the impact on stock returns.
This correlation is also thought to stem from the fact that unexpected inflation contains new
information about future prices. Similarly, greater volatility of stock movements was correlated
with higher inflation rates.
Growth vs. Value Stock Performance and Inflation

Stocks are often broken down into subcategories of value and growth. Value stocks have strong
current cash flows that will slow over time, while growth stocks have little or no cash flow today,
but it will gradually increase over time.

Therefore, when valuing stocks using the discounted cash flow method, in times of rising interest
rates, growth stocks are negatively impacted far more than value stocks. Since interest rates are
usually increased to combat high inflation, the corollary is that in times of high inflation, growth
stocks will be more negatively impacted. This suggests a positive correlation between inflation
and the return on value stocks and a negative one for growth stocks.

Interestingly, the rate of change in inflation does not impact returns of value versus growth stocks
as much as the absolute level. The thought is that investors may overshoot their future growth
expectations and upwardly misprice growth stocks. In other words, investors fail to recognize
when growth stocks become value stocks, and the downward impact on growth stocks is harsh.

Income-Generating Stocks and Inflation

When inflation increases, purchasing power declines, and each dollar can buy fewer goods and
services. For investors interested in income-generating stocks, or stocks that pay dividends, the
impact of high inflation makes these stocks less attractive than during low inflation, since
dividends tend to not keep up with inflation levels. In addition to lowering purchasing power, the
taxation on dividends causes a double-negative effect. Despite not keeping up with inflation and
taxation levels, dividend-yielding stocks do provide a partial hedge against inflation.
The price of dividend-paying stocks is impacted by inflation similar to the way bonds are affected
by interest rates—when inflation rises, income stock prices generally decline. So owning
dividend-paying stocks in times of increasing inflation usually means the stock prices will
decrease. But investors looking to take positions in dividend-yielding stocks are given the
opportunity to buy them cheap when inflation is rising, providing attractive entry points.

Investors try to anticipate the factors that impact portfolio performance and make decisions based
on their expectations. Inflation is one of those factors that affects a portfolio. In theory, stocks
should provide some hedge against inflation, because a company’s revenues and profits should
grow at the same rate as inflation, after a period of adjustment. However, inflation’s varying
impact on stocks confuses the decision to trade positions already held or to take new positions. In
the U.S. market, the historical proof is noisy, but it does show a correlation to high inflation and
lower returns for the overall market in most periods.

When stocks are divided into growth and value categories, the evidence is clearer that value stocks
perform better in high inflation periods and growth stocks perform better during low inflation. One
way investors can predict expected inflation is to analyze the commodity markets, although the
tendency is to think that if commodity prices are rising, stocks should rise since companies
“produce” commodities. However, high commodity prices often squeeze profits, which in turn
reduces stock returns. Therefore, following the commodity market may provide insight into future
inflation rates.

Impact Of Inflation And Interest Rates On Exchange Rate

While exchange rates can be subject to myriad factors in intraday trading – from market sentiment,
breaking economic news, and cross-border trade and investment flows – inflationand interest rate
policy are often important indicators for exchange rate trends – they can help traders gain an idea
of what is likely to be a profitable trade for foreign exchange positions taken over longer periods.
Inflation is commonly thought of as the pace at which prices increase in a given economy and
determines the “worth” of money in relation to goods and services offered. If more money is
perceived to be circulating at a given time, suppliers of goods and services typically react by
adjusting their prices upward, meaning less can be purchased with a given unit of currency.
Conversely, if the offer of money by consumers appears to be scarce, suppliers often react by
lowering prices to attract buyers, meaning inflation will decelerate and money in that economy
will gain relative value.
PURCHASING POWER PARITY THEORY

Under the theory of Purchasing Power Parity, the change in the exchange rate between two
countries’ currencies is determined by the change in their relative price levels locally that are
affected by inflation. It is generally agreed that this theory mostly holds true over the long run, but
economists have found that it can suffer distortions over the short term because of trade and
investment barriers, local taxation, and other factors.

As a result of this relationship, one can expect the currencies of countries with higher inflation
rates to weaken over time versus their peers, whereas currencies of countries with lower inflation
rates tend to strengthen. In economies with weak production of local goods and services, the
depreciation of the local currency can at times even be accelerated by the “pass-through effect” of
importing foreign goods with relatively higher prices.

MEASURES OF INFLATION

Inflation is normally measured by governments using groups of price levels for goods in varying
sectors known as price indices. These include measures such as a producer price index (PPI), which
measures wholesale inflation, and a consumer price index (CPI), which measures inflation for
consumers. Governments and central banks frequently use these indices to help determine their
economic measures through instruments such as inflation-targeting strategies.
Inflation in the economies of currencies being traded is an important factor to consider because it
affects the relative value of those currencies internationally and because it can determine future
policy adjustments by governments and central banks.
INTEREST RATES

Through use of monetary policy, national central banks attempt to adjust their base interest
rates and available banking money reserves to control the rate of lending by banks within their
economies. The theory is that when there is more, or cheaper, money perceived to be available in
the economy through bank loans and other types of credit, consumers and businesses will spend
more, sellers of goods and services will adjust prices upward, and inflation can accelerate.
Conversely, when there is less, or more expensive, money available, consumers and businesses
will restrict their spending, prices will fall, and inflation will decelerate. Thus, if central banks
want to curb inflation, they will raise interest rates; and if they want to induce spending and
economic activity, they will lower interest rates.
INTEREST RATE PARITY

While directly related to inflation control policy, interest rates are also considered to have their
own particular relevance for foreign exchange trading because of what is known as interest rate
parity. This theory posits that the real interest rates (interest rates less inflation) across borders tend
to move toward equilibrium, and that currencies in economies with higher interest rates tend to
weaken over time.

However, where capital is allowed to move freely across borders, investors will seek to put their
money in countries where they can get the highest returns. Thus, if one country has a higher interest
rate than another, money will tend to flow to the country with the higher interest rate, causing that
country’s weaker currency to once again appreciate over time. When the currency has risen to an
equilibrium price level where its cost is no longer offset by gains from its higher interest rate, it
reaches interest rate parity and further investment flows from abroad come to a halt.

Currency traders, then, hope to predict future exchange rate movements by paying attention to the
relative levels of inflation in the countries of their target currency pairs in addition to where each
country is in its monetary policy cycle, and the size and pace of currency flows moving into and
out of each country. While this can offer a potentially advantageous position, nothing is for certain
and traders should do their due diligence when considering following this information.

Inflation is a very good indicator of current account balance in a country. The rising and falling
prices (inflation) within a country can provide information about medium term direction in foreign
exchange and the current account balance can be used to determine the long term movements.

Higher and Lower Inflation

It is general economic theory that high inflation in a country will result in its poor economy
whereas, low inflation or deflation can result in economic progress. It can also be said as the other
way around. The idea behind this theory is that when inflation is high in a country, the costs of
consumer goods is very high. High costs attract less foreign customers and the country’s trade
balance is disturbed. Lower demand of the currency will ultimately lead to a fall in currency value.

Purchasing Power Parity (PPP)

Purchasing Power Parity model or PPP is another method of explaining the effect of inflation on
currency pairs. According to this model, one unit of currency of a country should have the same
power of purchasing some goods from another country (excluding the transportation costs and the
taxes). If there is inflation and the balance is disturbed then the PPP model distorts for the two
countries. The currency exchange rate between the countries can be adjusted to bring the
equilibrium.

Let us take an example to explain this. If a Subway meal costs $5 in the United States but the same
meal costs around $7 in Australia then the Purchasing Power Parity model is clearly out of sync.
Even though the products are same and their production cost is also equal, then how come it costs
more in one country but less in other? This is because of inflation. Inflation in Australia caused
the prices in the country to rise so a Subway meal costs a lot more in Australia as compared to in
America. It is an indication that high inflation in Australia caused its currency value to decrease
against US Dollars.

Medium Term Outlook

Inflation does not have a significant effect on short term trades because inflation acts in a diffused
pattern and its disturbance lasts for a longer time period. But for long term benefits, it is essential
to consider the effects of inflation. You can make use of inflationary data such as CPI. CPI causes
markets to move quickly when released.

Generally, inflation affects the currency exchange rates in a medium term direction. Countries with
high inflation will observe depreciation in their currencies over the medium term, whereas
countries with low inflation are likely to observe appreciation in their currencies over the medium
term. Countries with high inflation can also benefit from carry trade transactions.

Currency exchange rate is affected by inflation which directly affects your trades. A declining
exchange rate decreases your purchasing power. It also influences other income factors such as
interest rates. Even the most experienced traders can lose trades if they lack sufficient knowledge
of inflation.
If you have a better grasp of knowledge about inflation, you will be able to deal efficiently in forex
market trades. You will know what to expect when you are dealing with currency exchange rates.

Inflation and its Effects on Investments

Effect of Inflation on your investing

Inflation is a financial term.

The effect of inflation is the prices of everything going up over the years.

Example - Our grandfather is to say that in one rupee he was doing shopping for whole month and
now days you require minimum RS 10000 for your entire month. This rising prices year after year
is called effect of Inflation.

And this is reason the earning of common man has also increased from Rs 50 to 100 in older days
to Rs 5000 to 10000.
In other words inflation reduces the price of money, the movie ticket which was available for 50
paisa in olden days now have become RS 50.

Every week on Friday government declares rate of Inflation. (In current policy they have changed
it to every month)

Suppose if price of one kg sugar is Rs.100 this year and next year the price becomes approximately
Rs.106 then the rate of inflation is 6%.

What is the rate of return?

The rate of return is nothing but how much you earn on your investment.

For example - If you invest Rs.500 in stock market and after one year you make profit of RS 100
then your rate of return is 20%.
So, when you make an investment, make sure that your rate of return on the investment is higher
than the rate of inflation.

What is the Conclusion?

If you invest Rs.100 in the market today and you make money at a 5% "rate of return" in one year
then you will have Rs.105. But if the rate of inflation remains at 7%, then an item costing today
for Rs.100 will cost Rs.107 a year from now.

So what you can buy with today’s Rs.100 will be available for Rs.107 a year from now but your
earning is Rs 106. So the conclusion is you are loosing the money.
From the above explanation you may be understood that how slowly inflation eats into your
money.

So what to conclude from this Inflation

1) If you are seeking good wealthy future then it is not advisable to keep your money in safe locker
but do safe investing because if you just keep putting your money in locker then it will loose its
value as year passes.

For example if you keep Rs.5000 in your locker today and you keep it there for 15 years or 20
years then there are quit possibilities that your RS 5000 could become worth Rs. 500.

2) If it is getting difficult for you to decide where to invest then you can put in at least in bank and
let it grow by earning interest year after year.

3) When investing, you have to make sure that the rate of return on your investment is higher than
the rate of inflation though inflation control is not in your hand.