CHAPTER SIXINFLATION IN THE U.S.Slide 3Slide 4Slide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12STOCK RETURNS AND INFLATIONSlide 14Slide 15Slide 161CHAPTER SIXINFLATION2INFLATION IN THE U.S.•INFLATION–DEFINITION: the percentage change in a specific cost-of-living index at various points in time.3INFLATION IN THE U.S.•INFLATION–cost-of-living index•the “overall” price level computed for a “basket of goods”4INFLATION IN THE U.S.•PRICE INDICES–measure changes in prices relative to a fixed period in time usually called the base period5INFLATION IN THE U.S.•PRICE INDICES–the Consumer Price Index (CPI) is calculated by the U.S. Bureau of Labor Statistics in the Department of Labor– the Bureau uses a “market basket” of over 2000 U.S. consumer goods and services6INFLATION IN THE U.S.•NOMINAL AND REAL RETURNS–Fisher Model of Real Returns stated that real returns are important to investors–they represented how much purchasing power has changed7INFLATION IN THE U.S.•NOMINAL AND REAL RETURNS–price change may impact an asset’s nominal return8INFLATION IN THE U.S.•NOMINAL AND REAL RETURNS–adjustments to the nominal return are needed to remove the effects on purchasing power of inflation or deflation9INFLATION IN THE U.S.FORMULA FOR CALCULATING REAL RETURNSwhere C0 = CPI at the beginning of period C1 = CPI at the end of the period NR = the time period’s nominal return RR =the real return for the period101CNRCRR10INFLATION IN THE U.S.•NOMINAL AND REAL RETURNS–a quick calculation of the real returnNR - IR = RRwhere IR = the rate of inflation for the periodNR= the nominal returnRR= the real return11INFLATION IN THE U.S.•THE EFFECT OF INVESTOR EXPECTATIONS–investors’ attitudes toward inflation show they are concerned with real returns12INFLATION IN THE U.S.THE EFFECT OF INVESTOR EXPECTATIONS Looking to the futureE(RR) = E(NR) - E(CCL)whereE(RR) = the expected real returnE(NR) = the expected nominal returnE(CCL)= the expected inflation rate13STOCK RETURNS AND INFLATION•OVER LONG PERIODS OF TIME–common stocks generated large, positive real returns14STOCK RETURNS AND INFLATION•OVER LONG PERIODS OF TIME–T-bills produced much lower, positive real returns15STOCK RETURNS AND INFLATION•OVER SHORT PERIODS OF TIME–stock returns are not positively related to either actual or expected rates of inflation16STOCK RETURNS AND INFLATION•OVER LONG PERIODS OF TIME–stock returns are positively related to both actual and expected rates of