INFLATION

INFLATION - WHAT IS INFLATION

A. A INCREASE IN THE GENERAL LEVEL OF PRICES ECONOMY WIDE.

CONSUMER PRICE INDEX - A MEASURE OF INFLATION, CALCULATED BY THE BUREAU OF LABOR STATISTICS, ORIGINALLY INTENDED TO MEASURE CHANGES IN THE PRICES OF GOODS AND SERVICES PURCHASES BY URBAN WAGE EARNERS LATER EXPANDED TO COVER ALL URBAN CONSUMERS.

WHY IS INFLATION A PROBLEM FOR AN ECONOMY?

INFLATION HURTS:

A. CITIZENS LIVING ON FIXED INCOMES - RETIRED.

B. LENDERS - AS INFLATION INCREASES THE VALUE OF BONDS DECLINE AND THE FUTURE VALUE OF MONEY DECLINES.

EXAMPLE A $1,000 BOND PURCHASED TODAY, MATURING IN 30 YEARS, WITH A CURRENT INTEREST RATE OF 7% WOULD PAY A INTEREST PAYMENT OF $70 PER YEAR. TODAY'S INFLATION RATE IS 3%. REAL RATE OF RETURN IS 4%.

LETS ASSUME TWO YEARS FROM NOW, INFLATION INCREASED TO 8% AND 30 YEAR TREASURY BONDS ARE NOW YIELDING 11%.

WHAT HAPPENS TO YOUR TREASURY BOND. IF YOU WENT TO SELL YOUR TREASURY BOND AT THE FAIR MARKET VALUE WHAT WOULD YOU GET?

FIRST, IN ORDER TO BE COMPETITIVE YOU WOULD HAVE TO ALSO PAY A YIELD OF 11% BUT YOUR COUPON IS ONLY $70 PER YEAR. TO COMPENSATE FOR THE RISE IN INTEREST RATE YOU MUST SELL THE BOND FOR A LOWER PRICE - $636.

NOW LET SUPPOSE THAT INSTEAD OF A SMALL INVESTOR YOU ARE A LARGE INSURANCE COMPANY. DUE TO MARKET OPTIMISM YOU PURCHASE $10,000,000 WORTH OF "SAFE" GOVERNMENT BONDS IN 1997 AT A RATE OF 7%.

IF INTEREST RATES RISE TO 11% IN TWO YEARS AND YOU ARE FORCED TO SELL THE BONDS YOU WILL RECEIVE $6,360,000. A LOSS OF 3.64 MILLION DOLLARS. -(HOWEVER DURING THAT TIME YOU WILL HAVE RECEIVED $140,000 IN INTEREST PAYMENTS SO YOUR LOSS WILL BE "ONLY" 3.50 MILLION DOLLARS.

B. ANOTHER GROUP THAT IS HURT BY INFLATION IS SAVERS. EVEN THOUGH "THEORETICALLY" YOU CAN NOT "LOSE" MONEY IN A BANK CERTIFICATE OF DEPOSIT SUPPOSE THAT YOU INVEST IN A TEN YEAR BANK CD PAYING 6%. LETS ASSUME THAT INFLATION RISES TO 8%. WHAT IS YOUR REAL RATE OF RETURN ON YOUR INVESTMENT.

BANK CD 6%

INFLATION 8%

REAL RATE OF RETURN -2%.

EVEN THOUGH YOU ARE GUARANTEED THE PRINCIPAL AND INTEREST PAYMENTS YOUR PURCHASING POWER IS DECLINING.

HOW DOES INFLATION OCCUR?

PRIMARILY FROM TWO MEANS.

EXCESS DEMAND DRIVING UP PRICES.

LAST YEAR DURING THE INTERSESSION WE HAD A TERRIBLE BLIZZARD. PEOPLE WERE UNABLE TO GET TO THE STORE FOR 5 DAYS. PEOPLE BEGAN RUNNING OUT OF MILK AND BREAD. A GROUP OF KIDS STARTED SELLING MILK ON THE STREET CORNERS IN D.C. FOR $10 PER GALLON.

DURING PERIODS OF FAMINE AND DROUGHT THE PRICE OF FOOD IN FAMINE STRICKEN NATIONS SHARPLY RISE. THE DEMAND IS THERE BUT THE SUPPLY IS NOT ADEQUATE.

THE SAME THING HAPPENED THIS CHRISTMAS TO "TICKLE ME ELMO " DOLLS. ONE PERSON WAS SELLING THE $30 TOYS IN THE PAPER FOR $900 EACH. ANOTHER PERSON IN THE WASHINGTON AREA TRADED HER DOLL IN FOR A ROUND TRIP TICKET TO CALIFORNIA TO VISIT A SICK RELATIVE.

BIDDING WAR FOR BROWNIES - INCREASE AMOUNT OF MONEY.

DIVIDE CLASS INTO SMALL GROUPS, ONE GROUP IS MARKED AS SAVERS - THEY WILL LEND MONEY TO ANOTHER GROUP AT 10% INTEREST.

ANOTHER GROUP IS BORROWERS THEY WILL BORROW THE MONEY FROM THE SAVERS.

TWO OTHER GROUPS ARE CONTROL GROUPS THEY WILL HAVE INCREASED PAY CHECKS.

SESSION ONE - EVERY ONE RECEIVES THE SAME AND BIDS AS THEY WISH.

SESSION TWO - BORROWS BORROW TWO PAYCHECKS FROM SAVERS TO BUY BROWNIES.

SESSION THREE MONEY SUPPLY INCREASES.

SESSION FOUR MONEY SUPPLY INCREASES.

SESSION FIVE BORROWERS REPAY SAVERS.

EXCESS MONEY SUPPLY DRIVING UP PRICES.

IN OUR EXAMPLE IN BROWNIE SALE - I DID NOT INCREASE DEMAND - THAT WAS THE SAME-