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UNDERSTANDING MONETARY INFLATION - page 2 / 6

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estimates inflation from a "basket" of several key commodities. Price changes are tracked for the entire basket and a consumer price index (CPI) calculated from the aggregate of all price changes, assuming that temporary non-inflationary price adjustments for individual items cancel each other out.

Rate of Inflation

Inflation is normally expressed as an annual rate calculated from the CPI from year to year. The comparison points can be any month of the year, the December “end-of-year” value, the annual average value, or even a semi-annual average value. The example below calculates the end-of-year annual inflation rate for 2005:

2 CPI Dec 2005:

196.8

1 CPI Dec 2004:

190.3

Difference:

6.5

Rate of inflation: ρ = (CPI2 – CPI1) / CPI1

ρ = (6.5) / 190.3 = 3.4%

Some experts, including Alan Greenspan, the recently retired Chief of the Federal Reserve Bank, advise that the CPI slightly overstates the rate of inflation, and other formulas using other financial data are also used to estimate inflation.

Real Rate of Interest

Once a businessman has a handle on the rate of inflation is, He can calculate the real rate of interest or set an appropriate contract rate of interest to protect himself. The relationship between the rate of inflation, ρ, the real rate of interest, r, and the contract rate of interest, i, was defined by Irving Fisher in his 1933 publication Inflation, as follows:

(1 + i) = (1 + r)·(1 + ρ)

where i = the contract rate of interest r = the real rate of interest, and ρ = the rate of inflation

The Fischer equation can also be written in more familiar form as i = r + ρ + r ·ρ

The cross-product r ·ρ can be discarded for values of r and ρ below 10%, which reduces the relation to:

ir+ρ which is what we might have intuitively concluded.

Money as a Commodity

Money is more than just the medium of exchange for labor, goods and services. In and of itself, it is also a commodity. Large projects typically need much more money than available on- hand to fund a project. The additional cash is used to obtain labor, materials, equipment, supplies, and services to turn into facilities and enterprises to earn profits. Since there is a finite quantity of money available at any one time, demand for use of the money affects the “price” of money. The price for the use of money is the premium we pay for the use of it – commonly called “interest.”

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