It would be of some interest to the investor to have an understanding of inflation and what effect it would have on the various financial instruments being held in his portfolio. A simplistic definition of the word itself would be an increase in prices in general and an increase in the supply of money is regarded to cause this.
Further, the inflation rate would be decided on the basis of the increase in the prices of a basket of goods and services; which are in turn expected to be representative of the economy in general. Now the opposite of this would be deflation; where the prices of these select goods and services would move down.
Relationship between inflation and money: The relationship between inflation and money is intrinsic in nature and would be based on the economic principals of supply and demand of both goods (and services) and money.
As an example to understand this; let's say that the supply of a good (machine tools) is constant, but the demand for it increases due to buoyancy in the economy. This would result in an increase in demand for it, causing its price to move up over a period of time. This would be an inflationary condition or inflation at play. Further there would be an increase in the money supply; which would have the effect of further reducing the per unit value of the money under study. On occasion to counter this inflationary condition, the government may decide to decrease the money supply by increasing the short term interest rates; thereby making money more expensive.
On the other hand, if there is a condition of excess supply of a good and the demand for it were to be constant or reduced due to a slow down in economic activity. Then the manufacturer would be required to reduce its price to be able to sell the excess inventory being held at the factory end. This would be deflation. Further, this condition may also come to exist due to a reduced money supply relative to the goods and services available in the economy. On occasion the government may decide to increase the money supply by reducing the short term interest rates to counter this deflationary condition in the economy.
Thus, inflation may be said to be caused by a combination of the following:
- The supply of money increasing in the economy.
- The supply of goods and service reducing (or decreasing) in an economy relative to the demand for it.
- A decrease in the demand for money when the money supply is constant or maintained at earlier levels.
- The demand for goods and services increases while the supply of the same is constant or at an earlier level.
Relationship between inflation and the stock markets: Inflation is a matter of concern not only to the central banks of the countries under study, but also to investors who invest their money in various financial instruments including stocks traded at and through the stock markets. A high interest rate regime and increased stock prices of underlying corporate entities is not a healthy state of affairs for the investor community.
However, most investors still consider investing in stocks as a reasonable hedge against inflation; as it is expected that the revenues and earnings of the underlying corporate entities would increase at a rate which would be in step with inflation. To substantiate this, some corporate entities are in a position to increase the prices of their goods and services to counter inflationary effects on their revenue and earnings. However, other corporate entities may not be in a position to do so due to the international nature of their marketplace; where producers from other geographies may be in a position to prices the same goods and services more competitively.
The investor of course, is faced with a situation of an increase in the price of the stocks of underlying corporate entities he may have under study, without any corresponding real increase in the assets, revenues or earnings of these corporate entities. This would by extension imply an over-statement of the revenues and earnings to the extent of the inflation rate; in spite of any asset value the corporate entities may have created during the period of time under study. So, in a manner of speaking the investor would be paying more for less.