Prof Sub 7- Investment & Portfolio
Management
BSBA 3
Week 2& 3
Types of Inflation:
BASIC CONCEPTS OF
INTEREST RATES & Demand-Pull Inflation: Occurs when aggregate
INFLATION demand for goods and services exceeds aggregate
supply.
Cost-Push Inflation: Arises from an increase in
Interest: the cost of production, often due to factors like
rising wages or increases in the prices of raw
Definition: Interest is the cost of borrowing materials.
money or the return on investment for lending Built-in Inflation: Also known as wage-price
money. It is expressed as a percentage of the inflation, it occurs when workers demand higher
principal amount. wages, and businesses pass those increased labor
Borrower's Perspective: When you borrow costs onto consumers in the form of higher prices.
money, you typically pay interest to compensate
the lender for the risk and opportunity cost of Measuring Inflation:
lending you funds.
Lender's Perspective: If you lend money, you earn Inflation is often measured by indices such as the
interest as compensation for the risk and forgoing Consumer Price Index (CPI) or the Producer Price
other potential investment opportunities. Index (PPI), which track changes in the prices of a
basket of goods and services over time.
Types of Interest: The Consumer Price Index measures the
average change over time in the prices paid by
urban consumers for a basket of consumer
Simple Interest: Calculated only on the initial
goods and services.
principal amount.
The Producer Price Index measures the
average change over time in the selling prices
Compound Interest: Calculated on the initial received by domestic producers for their output.
principal and also on the accumulated interest
from previous periods. Connection between Interest and Inflation:
Inflation: Inflation can impact the real return on investments.
If the interest rate on an investment is lower than
Definition: Inflation is the rate at which the the inflation rate, the investor's purchasing power
general level of prices for goods and services is may actually decrease over time.
rising, leading to a decrease in the purchasing
power of a currency. Central banks often consider inflation rates when
Causes: Inflation can be caused by factors such as setting interest rates. They may adjust interest
increased demand for goods and services, rising rates to control inflation by influencing spending
production costs, or factors affecting the supply of and investment in the economy.
money.
Effects: Inflation erodes the real value of money
over time, meaning that the same amount of
money will buy fewer goods and services in the Understanding interest and inflation is crucial for
future. individuals, businesses, and policymakers in
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making financial decisions, managing investments, that may not yield immediate results but are
and formulating economic policies. essential for sustainable growth
Exchange Rate Stability:
Central banks can implement policies to
BANK AUTONOMY & LIMITATIONS address currency-related challenges without
succumbing to political pressures that may
Bank autonomy refers to the independence of a central prioritize short-term gains over the long-term
bank or financial institution from external influences,
health of the economy.
particularly political pressures, in making monetary
policy decisions. Financial Market Confidence:
Investors and financial markets closely monitor
The importance of bank autonomy is widely recognized the independence of central banks. Autonomy
in the field of economics and finance for several fosters confidence that monetary policy
reasons: decisions are driven by economic
considerations rather than political expediency.
Monetary Policy Effectiveness:
Predictability and Transparency:
Autonomy allows central banks to focus on
When central banks operate independently,
long-term economic goals rather than short-
their decisions are less subject to sudden
term political considerations. This
changes driven by political events, providing
independence is crucial for formulating and
businesses and households with a more stable
implementing effective monetary policies that
economic environment.
can address issues like inflation,
Reducing Systemic Risks:
unemployment, and economic growth.
Independent central banks are better
Price Stability:
equipped to identify and address systemic
One of the primary objectives of central banks
risks in the financial system.
is to maintain price stability. Autonomy
International Reputation:
ensures that monetary policy decisions are
often viewed more favorably by global
based on economic fundamentals rather than
investors and institutions, which can positively
short-term political considerations.
impact the country's access to international
Credibility and Trust:
capital and financial markets.
Central bank autonomy enhances the
credibility and trust in the institution. When In summary, bank autonomy is essential for the
the public, financial markets, and international effective functioning of a central bank and the stability
investors, they are more likely to have of the overall economy. It allows central banks to
confidence in its ability to achieve its pursue sound monetary policies, build credibility, and
objectives and maintain economic stability. foster trust, ultimately contributing to sustained
economic growth and stability.
Reducing Inflationary Bias:
Central banks with autonomy are better
positioned to resist pressures to pursue While central banks play a crucial role in managing
policies that might result in short-term benefits monetary policy, ensuring financial stability, and
but lead to long-term inflationary promoting economic growth, they are not without
consequences limitations. Here are some of the key limitations of
central banks:
Long-Term Planning:
Bank autonomy allows central banks to engage
Limited Tools: Central banks may struggle to
in long-term planning and policymaking.
influence the economy if interest rates are
Economic stability often requires measures
already low, and their actions can sometimes
lead to unintended consequences.
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Time Delays: There's often a delay between
implementing policies and seeing their effects,
making it challenging to respond quickly to
economic changes.
External Factors: Central banks can't control
everything; global events, like economic
conditions abroad or natural disasters, can
impact their efforts.
Real Economy Challenges: They have less
control over factors like productivity and
innovation, crucial for long-term economic
growth.
Need for Fiscal Support: Sometimes,
monetary policy alone isn't enough, and
central banks rely on government spending
and taxation policies.
Deflation Risk: Trying to keep prices stable,
central banks may face challenges preventing
deflation, which can hinder economic growth.
Political Influence: Political pressures can
affect central banks, especially in less
independent systems, potentially impacting
the effectiveness of their policies.
Globalization Issues: Coordinating policies
globally is challenging due to economic
interdependencies.
Communication Difficulties: Central banks
must communicate policies clearly; any
confusion can cause market disruptions.
Financial Complexity: Evolving financial
systems and new instruments can pose
challenges for central banks in understanding
and regulating them.
Balance Sheet Risks: Unconventional policies,
like large-scale asset purchases, may pose risks
to central banks' financial stability.
Addressing these challenges often requires a
coordinated approach involving both monetary and
fiscal policies.
