Sunday, January 2, 2011

Inflation

Inflation is the process whereby prices generally increase. Inflation is typically measured by the Consumer Price Index (CPI), or some variation thereof; inflation is also measured by the price deflator which is part of a country's national accounts or Gross Domestic Product (GDP) reports. Basically inflation is when the CPI index is rising, which indicates that the general level of prices is rising e.g. a beer costs more today than it did last year, etc. The opposite of inflation is deflation which is when prices are falling, believe it or not, but this is a bad situation. Both deflation and high inflation are bad because they distort economic signals and can stymie economic growth. A steady and relatively low level of inflation is generally accepted as the optimal outcome. Inflation needs to be considered by investors because another way of looking at inflation is that the value or spending power of your money is decreasing i.e. While $1 used to be able to buy 5 'widgets' now it may only be able to buy 3 'widgets'. The key distinction to make is between nominal and real rates of return - nominal is the gross return, while real returns are adjusted for inflation (i.e. inflation is subtracted).

Synonyms: CPI, Real returns, Nominal returns, Price increase

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