The Importance of Inflation And GDP

The Importance of Inflation And GDP 

INFLATION
Inflation means that more money is floating within the market, which means that the supply of the money exceeds the demand resulting in a decreased value. It is a rise in the general level of prices of goods and services in an economy over a period of time. Inflation can mean either an increase in the money supply or an increase in price levels. Generally, when we hear about inflation, we hear about a rise in prices compared to some benchmark. It is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. If the money supply has been increased, this will usually result in higher price levels.
GDP
This is an abbreviation for Gross Domestic Product, which is the total value of all goods, services, agricultural produce and minerals extracted in a country or area, usually in one year. The monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory. The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country’s economy. It represents the total dollar value of all goods and services produced over a specific time period – you can think of it as the size of the economy.
RELATIONSHIP BETWEEN INFLATION AND GDP
During peak periods of the business cycle when the economy is experiencing rapid growth in GDP, employment will increase, and vice versa unemployment will decrease, as businesses seeks workers to produce a higher output. If GDP grows too quickly, however, it can cause price inflation as firms are forced to bid against one another for increasingly scarce workers. For stock market investors, annual growth in the GDP is vital. If overall economic output is declining or merely holding steady, most companies will not be able to increase their profits, which is the primary driver of stock performance. However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money (and future corporate profits) less valuable.
Inflation causes many distortions in the economy. It hurts people who are retired and living on a fixed income. When prices rise these consumers cannot buy as much as they could previously. This discourages savings due to the fact that the money is worth more presently than in the future. This expectation reduces economic growth because the economy needs a certain level of savings to finance investments which boosts economic growth. Also, inflation makes it harder for businesses to plan for the future. It is very difficult to decide how much to produce, because businesses cannot predict the demand for their product at the higher prices they will have to charge in order to cover their costs. High inflation not only disrupts the operation of a nation’s financial institutions and markets, it also discourages their integration with the rest of the world’s markets.
Over time, the growth in GDP causes inflation, and inflation begets hyperinflation. Once this process is in place, it leads to a cyclical loop. The reason for this is because in a world where inflation is increasing, people will spend more money because they know that it will be less valuable in the future. This causes further increases in GDP in the short term, bringing about further price increases. Also, the effects of inflation are not linear; how? Because 10% inflation is much more than twice as harmful as 5% inflation.
So how much is too much? Asking this question uncovers another big debate. This debate is going on the world over. There are those who insist that advanced economies should aim to have 0% inflation, or in other words, stable prices. Of-course this is not possible in the real world. The general consensus, however, is that a little inflation is actually a good thing.
IMPLICATIONS TO INVESTORS
Inflation causes uncertainty about future prices, interest rates, and exchange rates, and this in turn increases the risks among potential trade partners, discouraging trade. As far as commercial banking is concerned, it erodes the value of the depositor’s savings as well as that of the bank’s loans. The uncertainty associated with inflation increases the risk associated with the investment and production activity of firms and markets. Keeping a close eye on inflation is most important for fixed-income investors, as future income streams must be calculated by discounting them by the rate of inflation to determine how much is the value of the money will have in the future. For stock investors, inflation is what motivates us to take on the increased risk of investing in the stock market, in the hope of generating the highest rates of return. The impact inflation has on a portfolio depends on the type of securities held in that portfolio. If one invests only in stocks one may not have to worry about inflation.  In the long run, a company’s revenue and earnings should increase at the same pace as inflation.  But inflation can discourage investors by reducing their confidence in investments that take a long time to mature.  The main problem with stocks and inflation is that a company’s returns can be overstated.  When there is high inflation, a company may look like it’s doing a great job, when really inflation is the reason behind the growth.
@ SURESH REDDY