In: Economics
Based on the material of the chapter “ money growth and inflation” of your text book explain how inflation starts in an economy? Why multinational companies feel unsafe to invest in those countries that have high inflation rate? Write your answer the light of your text book materials
Answers
explain how inflation starts in an economy?
Inflation is a measure of the rate of rising prices of goods and services in an economy. If inflation is occurring, leading to higher prices for basic necessities such as food, it can have a negative impact on society.
Inflation can occur in nearly any product or service, including need-based expenses such as housing, food, medical care, and utilities, as well as want expenses, such as cosmetics, automobiles, and jewelry. Once inflation becomes prevalent throughout an economy, the expectation of further inflation becomes an overriding concern in the consciousness of consumers and businesses alike.
Central banks of developed economies, including the Federal Reserve in the U.S., monitor inflation. The Fed has an inflation target of approximately 2% and adjusts monetary policy to combat inflation if prices rise too much or too quickly.
Inflation can be a concern because it makes money saved today less valuable tomorrow. Inflation erodes a consumer's purchasing power and can even interfere with the ability to retire. For example, if an investor earned 5% from investments in stocks and bonds, but the inflation rate was 3%, the investor only earned 2% in real terms. In this article, we'll examine the fundamental factors behind inflation, different types of inflation, and who benefits from it.
Why multinational companies feel unsafe to invest in those countries that have high inflation rate?
International investors face a number of unique risks like political risk to currency risk. Inflation represents another risk very important to understand since it can have a profound impact on the economy. It is true not only in unstable countries, like Zimbabwe where inflation soared out of control, but also developed markets worldwide.
Inflation is perhaps most pronounced in bond prices. These prices tend to have an inverse correlation with inflation, since higher inflation leads to higher expected yields, and higher yields lead to lower bond prices. Moreover, ongoing inflation depletes the value of the maturity (principal) payment, since that currency's value is becoming increasingly diluted.
The effects of inflation on bonds can be seen in the difference between "nominal" and "real" returns. Nominal returns are the actual yields, while real returns represent the inflation-adjusted yields paid by borrowers to lenders. Since inflation compounds over time, these differences can add up to significant sums over time.
For international investors, sovereign debt and related ETFs that hold sovereign debt around the world are susceptible to changes in inflation. It's important for investors to watch CPI figures (or unofficial private reports for those countries without reliable reporting) for signs of increasing inflation since that can represents trouble ahead for bondholders.
For international investors, central banks that provide liquidity during times of crisis can help boost equities by promoting economic recovery. But inflation that seems out-of-control could result in lower returns in equities. Again, it's important for investors to watch CPI figures (or unofficial private reports) and measure that against economist expectations.
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