INFLATION

Meaning;
Inflation Is A Persistent Increase In The General Price
Level Of Goods And Services In An Economy Over A
Period Of Time.

When the general price level rises, inflation reflects a
reduction in the purchasing power per unit of money
a loss of real value in the medium of exchange and
unit of account within the economy.
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Crowther defined as a inflation is a state in which the
value of money is falling i.e., prices are rising.
Causes for inflation
The two main causes for inflation as follows.
Demand pull inflation; it happens when
aggregate demand is greater than the supply
where is economy demands more goods and
services than what is produces.


Cost push inflation; it refers to increase the
cost of production like cost of raw materials,
labour , overhead cost etc. leads to increase
the price of the product.
other causes are;
Increase in exports
Reduction in taxation
Repayment of past internal debts
Rapid growth of population
Natural calamities
International causes.
Effects of inflation
Effect of inflation on asset value
Effect of inflation on firm value
Effect of inflation on cash flow
Effect of inflation on discount rate


Effects on Asset value
Cash- causes rising interst rates. When
inflation is high, cash tend to earn higher
return.
Bonds- It erodes the fixed payments &
terminal values of bond. Therefore bonds
perform worse when inflation is high.
Stocks- Stocks tend to do best when inflation
is low & predictable, & to fall in either high
inflation or deflation.
Effects on Asset value
Real Estate- higher casshflows & asset values
tend to result in a positive relationship b/n
real estate & inflation.
Effects on firm value
Inflation imposes various costs on firms. Firms
will be worse-off if inflation is unexpected.
Menu costs: These are costs of changing price
lists.
Uncertainity & confusion: If inflation is higher
than expected, then the costs of investing will be
changing frequently. This makes firms less willing
to invest.
Wage inflation: Unexpected inflation may lead to
the necessity of re-negotiating wage deal with
workers.
Effects on Cash Flows
When both net revenues and the project costs
rise proportionately, the inflation would not
have much impact.
The effects of inflation on cash flows is
examined by the difference of nominal cash
flows and real cash flows.
Therefore the finance manager has to
estimate the real inflation rate along with
output price.
Effects on Discount Rate
To be free from inflation bias , the cash flows
should match with discount rate.
Here, nominal rate = real rate +discount rate

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