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Principles of Finance

12.2 Historical Picture of Inflation

Principles of Finance12.2 Historical Picture of Inflation

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Define inflation with concrete examples.
  • Describe the practical impact of inflation on consumption and salary.
  • Explain how expected and actual inflation are measured.
  • Detail the behavior of inflation over various historical periods.

Over time, returns in the stock market have easily outperformed returns in the bond market. However, not everyone is comfortable investing in stocks. Taking a more informed and opposing view, financial economist Jeremy Siegel queries, “You have never lost money in stocks over any 20-year period, but you have wiped out half your portfolio in bonds (after inflation). So which is the riskier asset?”14 Siegel brings up a valid point about inflation. Returns adjusted for changes in prices provide a better measure of value or wealth. Baseball pundit Sam Ewing noted, “Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”15 If what you have earned on your investments fails to keep up with changing prices, you may have a larger portfolio with less purchasing power.

Expected versus Actual Inflation

Inflation occurs when things cost more and your money buys less today than it did yesterday. It is understandable to dislike inflation and to be concerned over the prospect of rising prices. In fact, two of the primary policy objectives of the Federal Reserve are to work for price stability and moderate interest rates. However, is inflation necessarily good or bad? In practice, inflation can benefit some people and harm others at the same time. Consider the impact of differences in expected and actual realized inflation. Empirical evidence suggests that, on average, economists do a good job of developing inflation rate forecasts that match the actual rate of inflation. Estimated inflation is built into the interest rates investors require or are willing to pay for financial products, such as fixed-rate loans or bonds. When the actual rate of inflation exceeds the estimated rate on a product, such as a mortgage loan, this means borrowers are repaying the loan with less-valuable dollars and benefit from the increased inflation rate. Lenders, however, receive those inflation-impacted dollars and are harmed due to their unexpected decrease in purchasing power.

Deflation, or falling prices, is associated with economic recessions or even depressions and is thought to be an even more serious problem than inflation. Generally, policy makers tend to support moderate inflation, being careful to stay away from zero or negative price changes.

Inflation Impacts

Ultimately, inflation redistributes wealth. Lenders providing fixed-rate loans receive less-valuable dollars in return. Borrowers repay with those same less-valuable dollars. Workers receive less-valuable dollars, especially when their wage increases lag behind changes in prices. Modest inflation can benefit a consumer-driven economy like the United States if consumers are motivated to spend money before prices increase. However, too much inflation can cause frenzied buying, drive prices even higher, and outpace the rate of wage increases. Higher inflation raises the rates on new borrowing instruments and can slow the rate of business investment and economic growth. Inflation raises overall prices and may cause hardship for consumers on a fixed income.

Finally, inflation does not have an equal impact on all goods and services. As Table 12.3 shows, consumer prices did not increase at the same rate for the selected items shown. From 1980 to 2020, inflation, as measured by the consumer price index (CPI), grew at an average annual rate of 2.90%. However, the price of college tuition and fees increased at more than double that rate. Rent, another large expense for most college students, increased at an annual rate of 3.67%, also well above the average increase in the CPI. The price increases for ground beef and butter were slightly less than the CPI average. For the selected items presented here, only the average price for used cars and trucks rose at a rate significantly lower than the average rate of inflation.

Year 1980 2000 2020 Annual Change
College tuition and fees 70.8 331.9 877.3 6.49%
Rent 80.9 183.9 341.5 3.67%
Used cars and trucks 62.3 155.8 144.2 2.12%
Ground beef 104.6 125.2 296.2 2.64%
Butter 89.4 135.9 248.7 2.59%
CPI (1982 to 1984 = 100) 82.4 172.2 258.8 2.90%
Table 12.3 Changing Consumer Price Levels—Selected Goods (source: US Bureau of Labor Statistics, Consumer Price Index)

Using Graphs and Charts to Plot Inflation Behavior

The CPI is a measure of how prices have changed for a basket of goods across the United States. Figure 12.5 shows the eight major categories of expenditures included in the CPI.16 Different regions of the country and population subgroups may experience different rates of inflation. Retired people may spend a greater portion of their income on healthcare than someone in their twenties.17 Residents on the East and West Coasts spend a higher percentage of their earnings on housing than those living in the Midwest.18 As such, there are several different measures of inflation based on geographic region or other factors.19 It is worth noting that a basket of goods and services that cost $100 in 1984 would cost approximately $260 by the end of 2020, an increase of 160% (see Figure 12.6)! Over that same period, the average annual rate of inflation as measured by the CPI was 2.55%. These numbers make it easy to see that even a relatively modest annual inflation rate, lower than the long-run annual US inflation rate of 3%, results in significant price increases.

A diagram of the Market Basket Categories of Consumer Price Index. There are eight major expenditure groups: Food and Drink, Housing, Apparel, Education & Communication, Transportation, Other Goods & Services, Recreation, and Medical Care.
Figure 12.5 The Market Basket Categories of the CPI
A graph from the US Bureau of Labor Statistics that shows consumer price index consistently rising from 1984 to 2008. There is a slight dip between 2008 and 2010 before the data shows a consistent rise again till 2020. What cost $100 in 1984 would cost $260 in 2020.
Figure 12.6 United States Consumer Price Index (CPI) 1984–2020 (data source: US Bureau of Labor Statistics)

Concepts In Practice

Profile of Janet Yellen

Profile picture of Janet Yellen.
Figure 12.7 Janet Yellen (credit: “Janet Yellen Official Federal Reserve Portrait.” United States Federal Reserve/Wikimedia Commons, Public Domain)

Janet Yellen has led a life of firsts. After graduating as valedictorian of her high school class, Yellen later attended Yale University and was the only woman in her 1971 PhD graduating class in economics. Men have long dominated the “dismal science” of economics, but Yellen has proved to be an exception.

Motivated by an undergraduate economics professor at Pembroke College of Brown University, Yellen realized how much the US central bank, known as the Federal Reserve, could influence the lives of ordinary people. She changed her major to economics, and the rest, as they say, is history.

In her first stint working with the Federal Reserve in 1977, Yellen met and married George Ackerlof. Ackerlof would go on to win a Nobel Prize in Economics. Ackerlof and Yellen eventually established themselves as faculty members at the University of California, Berkeley. Yellen was twice named Outstanding Teacher in the Haas School of Business and was recognized for her award-winning research.

In 1993, Yellen began her second tour at the Federal Reserve as an appointed member of the Board of Governors. She left this position in 1997 to head President Bill Clinton’s Council of Economic Advisers. Yellen became just the second woman to head the presidential council.

She then returned to California and the Bay Area, eventually becoming president of the Federal Reserve Bank of San Francisco from 2004 to 2010. Later that year she became the vice chair of the Federal Reserve. Four years later, in 2014, Yellen assumed leadership as the first woman chair of the Federal Reserve System.

As Fed chair, Yellen earned an enviable record. During her four-year tenure, the rate of unemployment decreased by more than 2.5%, and employment increased in every month of her term. This is the first and only time in the history of the Federal Reserve that the board chair has overseen continuous increases in employment over their entire tenure.

Now, another first: In 2021, President Joe Biden appointed Yellen as the first woman Secretary of the Treasury. Yellen has a storied career and a long list of accomplishments, but surely her record of firsts will prove to be an important and lasting legacy for women in business, government, and economics everywhere.

(Sources: Ann Saphir. “Factbox: Janet Yellen’s Road to US Treasury Secretary.” Reuters. November 24, 2020. https://www.reuters.com/article/idUSKBN2832WS; Ylan Q. Mui. “New Fed Chief Janet Yellen Lets a Long Career of Breaking Barriers Speak for Itself.” Washington Post. February 2, 2014. https://www.washingtonpost.com/business/economy/new-fed-chief-janet-yellen-has-long-history-of-breaking-barriers/2014/02/02/9e8965ca-876d-11e3-833c-33098f9e5267_story.html; Stephanie Grace. “Banker to the Nation.” Brown Alumni Magazine. October 30, 2013. https://www.brownalumnimagazine.com/articles/2013-10-30/banker-to-the-nation)

Footnotes

  • 14Jeremy J. Siegel. Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies. McGraw-Hill, 2002. First published 1994.
  • 15Sam Ewing. “Sam Ewing Quotes.” Brainy Quotes. https://www.brainyquote.com/authors/sam-ewing-quotes
  • 16US Bureau of Labor Statistics. “Consumer Price Index.” US Bureau of Labor Statistics. https://www.bls.gov/cpi/
  • 17Chris Farrell. “The Truth About Health Care Costs in Retirement.” Forbes. June 28, 2018. https://www.forbes.com/sites/nextavenue/2018/06/28/the-truth-about-health-care-costs-in-retirement/
  • 18US Department of Housing and Urban Development, Office of Policy Development and Research. “Rental Burdens: Rethinking Affordability Measures.” PD&R Edge. September 22, 2014. https://www.huduser.gov/portal/pdredge/pdr_edge_featd_article_092214.html
  • 19Khan Academy. “How Changes in the Cost of Living Are Measured.” Khan Academy. https://www.khanacademy.org/economics-finance-domain/macroeconomics/macro-economic-indicators-and-the-business-cycle/macro-price-indices-and-inflation/a/how-changes-in-the-cost-of-living-are-measured-cnx
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