Inflation

Inflation

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Inflation defines as an increase in the price you pay or a decline in the purchasing power of money. In other words, price inflation is when prices get higher or it takes more money to buy the same item. Interest rates are increased to moderate demand and inflation and they are reduced to stimulate demand.

Monetary policy aims to influence the overall level of monetary demand in the economy so that it grows broadly in line with the economy's ability to produce goods and services. This stops output rising too quickly or slowly. If rates are set too low, this may encourage the build-up of inflationary pressure; if they are set too high, demand will be lower than necessary to control inflation. Changes in demand and output then impact on the labor market - employment levels and wage costs - which in turn influence producer and consumer prices. When the Fed increases the discount rate, it does not have an immediate impact on the stock market. Changes in the official Bank rate then affect the whole range of interest rates set by commercial banks, building societies and other financial institutions for their own savers and borrowers. It will influence interest rates charged for overdrafts and mortgages, as well as savings accounts. A change in the official Bank rate will also tend to affect the price of financial assets such as bonds and shares, and the exchange rate. These changes in financial markets affect consumer and business demand and in turn output. Changes in the official Bank rate take time to have their full impact on the economy and inflation. Some influences, such as those on the exchange rate, work very quickly.

In January of 2003, Oil price spiked up 76.82% from the previous January. These have recently been some speculation on the correlation between a sharp rise in Oil price
and a sharp fall in Stock prices. The way the theory goes is that a sharp increase in oil prices on the magnitude of 50% to 100% annual increase has historically resulted in a sharp decline in the stock market price.

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We could possible think of two reasons why this might be the case; 1) A spike in Oil price introduces uncertainty into the market, 2) higher Oil prices increases transportation, heating, and production costs.
In oil based economy like we have in the US the price of oil dictates the price of everything else because we need oil to do everything from heat our home to delivering groceries from the farmer to the store. Any time that the cost of oil goes up, it’s going to reflect on the amount that inflation goes up. Sometimes world events tend to affect our inflation rate more than the cost of the current price of oil. But we are an oil based economy so if our oil goes up so does our inflation.

Meanwhile, the government reported on March 7, 2007 that inflation surged February 2007. Nearly the entire rise in inflation came from energy prices. Overall prices rose 0.5 percent in July - and 3.2 percent from a year earlier - after having been flat in June. If consumers are feeling pressed now by higher gasoline prices, matters could become worse this winter when their heating-oil bills arrive. Some commodity analysts say that is when the full impact of the higher energy costs will be felt.

The other affect that influence the interest rate is Information Technology. According to the Federal Reserve Bank, IT has reduced the rate of inflation from .5% to 11% in the last decade for firms. Advancing technology has made clowns of forecasters for centuries. Technological improvements have basically changes the economy, and that its benefits are structure rather than temporary. Won Sohn, Sung (1999) mentioned in his article Economy in the new millennium that IT, which is six percent o the economy, has produced thirty five percent of economic growth over the last five years. Productivity gains outside information technology have been meager. Productivity gains will be crucial in extending economic prosperity into new millennium. Therefore, high growth and low inflation will continue. Resources will also continue to shift from old style manufacturing to information technology including internet service and software. In the process of doing that, the economy is creating more and higher paying jobs (p. 15).

Technological change has been the main focus to engine of economic growth, but what is significant about the past decade is the acceleration in the pace of change and, as more and more countries have made efforts to improve their macroeconomic and policy environments, technology and technological innovation appear to have entered a “golden age”, a time when they are emerging as the key drivers of growth and development. Therefore, Information Technology affected interest rate in many ways.

Clearly, changes in the discount rate affect the behavior of consumers and business, but the stock market is also affected. One method of valuing a company or person is to take the sum of all the expected future cash flows from that company or a person discounted back to the present. To arrive at a stock's price, take the sum of the future discounted cash flow and divided it by the number of shares available. This price fluctuates as a result of the different expectations that people have about the company/person at different times. Because of those differences, they are willing to buy or sell shares at different prices.

Reference List

How do interest rates affect inflation?. Retrieved February 28, 2007, from
http://www.bankofengland.co.uk/education/targettwopointzero/inflation/
ratesAffectInflation.htm
Mueller, J. (2006). In How Interest Rates Affect The Stock Market. Retrieved February
28, 2007, from http://www.investopedia.com/articles/06/interestaffectsmarket.asp
Won Sohn, S. (1999). Economy in the new millennium. ABA Banking Journal, 91(11),
15.
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