Investment Overview (PDF)

**Introduction: Overview of Investment** An investment is **an asset** or item acquired with the goal of generating income or appreciation Appreciation refers to an [increase in the value of an asset over time.] When an individual purchases a good as an investment, the intent is not to consume th...

**Introduction: Overview of Investment** An investment is **an asset** or item acquired with the goal of generating income or appreciation Appreciation refers to an [increase in the value of an asset over time.] When an individual purchases a good as an investment, the intent is not to consume the good but rather to use it in the future to create wealth - An asset is anything of value that an individual, business, or government owns or controls, which can generate future economic benefits. Assets can take many forms, including physical items like real estate or machinery, financial items like stocks or bonds, and intangible items like patents or trademarks. In the context of finance, assets are used to generate income, provide security, or store wealth. - An investment always concerns the outlay of some resource today---time, effort, money, or an asset---in hopes of a greater payoff in the future than what was originally put in. - For example, an investor may purchase a monetary asset now with the idea that the asset will provide income in the future or will later be sold at a higher price for a profit. Any action taken in the hope of increasing future revenue can also be considered an investment. ➔ For example, when choosing to pursue further education, the goal is often to increase knowledge and improve skills (with the hope of eventually generating more income). **[A-Investment can be]** 1. Current or Short-Term Investment: Converted into cash or cash equivalent within ONE year 2. Fixed or non-current Investment: Expected life \>1 year like plant, equipment, buildings.Fixed investment undergo depreciation (loss of value) either in proportion method or accelerated method 3. Financial Investment: such as securities; stock, sovereign & corporate Bonds, preferred equity, Hybrid securities etc.. 4. Intangible or non-physical Investment: such as patent: trademark copyrights or goodwill **ARE ALL ASSETS CONSIDERED INVESTMENT?** No, not all assets are considered investments. An investment typically refers to assets that are acquired with the expectation of generating future returns or income, such as stocks, bonds, or real estate. In contrast, some assets, like personal items (a car for personal use or a home you live in), may provide value or utility but are not necessarily acquired with the intention of earning returns. To be classified as an investment, an asset generally needs to have the potential to grow in value or generate income over time. **B-Types of Investment:** 1. **Bonds-Fixed income securities** These investments are a type of loan, usually known as gilts or bonds. Like any loan, it has a repayment date and charges interest. They're used by governments or companies to raise money in the same way that you might borrow money from the bank to buy a car or a house. They are often just called bonds, but UK government bonds are also known as gilt-edged securities or gilts, and bonds issued by companies are known as corporate bonds. Bonds are a relatively secure investment as they usually pay regular interest and are repaid in full on the repayment date. This means they can be useful as fund managers have a secure, stable source of income. 2. **Stocks/equity** Not all companies are listed on the stock market. These are known as **privately held companies**, including wellknown names like Aldi, IKEA, and Mars, as well as many smaller or growing businesses. **Private equity** is a form of investment that provides these companies with capital to fund new technology, acquire other businesses, or improve their balance sheets. Unlike publicly traded companies, privately held companies are not subject to the quarterly performance pressures of stock markets, allowing management to focus on long-term growth without constant shareholder scrutiny. Private equity investments are typically held for medium to long-term periods, with private equity managers often taking an active role in advising company management to help improve profitability over time. Since private companies are not listed on public exchanges, investing in them through private equity is less accessible than buying stocks or shares in publicly traded companies.\" 3. **Real Estate and Property** A lot of people invest in property, whether it's the value of a family home or by buying a second property to rent out. It's been a very profitable type of investment over the last 10 years or so, but direct property investment of this sort can be quite risky and hard to cash in if the property market falls. Fund managers also invest in property -- both residential and commercial. They won't often buy properties directly, although they might depend on the nature of their investment fund. More often they will invest in companies that manage properties. Physical capital refers to tangible assets such as machinery, equipment, buildings, and infrastructure that are used in the production of goods and services. When businesses or governments purchase or invest in physical capital, they are essentially making an investment to improve productivity and long-term economic performance. ***Why is it considered an investment***? - Future Returns: Like financial investments, physical capital is expected to generate returns over time. For instance, a company investing in new machinery aims to produce goods more efficiently and increase profits in the future. - Economic Growth: In a broader economic sense, investment in physical capital leads to higher production capacity and contributes to economic growth, similar to how financial investments are made with the expectation of earning profits. ***Types of Physical Capital Investments:*** - Businesses: Invest in factories, machines, or technology to increase production or improve efficiency. - Governments: Invest in infrastructure projects like roads, bridges, or power plants, which can enhance economic productivity and public welfare. 5. **Commodities** Commodities refer to raw materials or primary agricultural products that can be bought and sold, such as oil, natural gas, metals (like gold or silver), agricultural products (like wheat, corn, or coffee), and livestock. Investors typically invest in commodities either through direct purchase of physical goods or via financial instruments such as **commodity futures**, **options**, or **exchange-traded funds (ETFs)**. Commodities are often considered a good way to **diversify** an investment portfolio because they tend to behave differently from traditional financial assets like stocks or bonds. For example, during periods of inflation or market volatility, commodities can sometimes rise in value while other asset classes decline. This makes them attractive for investors looking to hedge against inflation, economic instability, or currency devaluation. Like other forms of investment, commodities carry risks. Commodity prices can be highly volatile, and investing in commodities requires an understanding of the specific factors affecting each market. For instance, oil prices can be impacted by political instability in major oil-producing countries, while agricultural commodities are influenced by weather patterns and global trade policies. 6. **Cryptocurrency** Although Cryptocurrency can be used for transactions (as a medium of exchange), it can be considered as an investment especially when purchased for the purpose of making a profit. Many investors buy cryptocurrencies with the expectation that their value will increase over time, allowing them to sell at a profit. Cryptocurrency is often treated as a speculative investment, where investors aim to profit from price fluctuations. This makes it similar to investing in commodities or stocks that can be bought and sold for a gain based on market conditions. Cryptocurrency is viewed as a new asset class that can diversify an investment portfolio, much like stocks, bonds, or real estate. Some investors see it as a hedge against traditional financial markets or inflation, although this remains a debated topic. ***However, it is a high-risk and highly speculative investment compared to traditional assets like stocks or bonds. In addition, it lacks regulations: Unlike stocks or bonds, which are regulated by government agencies*** 7. **Collectible and Arts (Alternative Investment)** Collectibles can indeed be considered a form of investment, though they differ significantly from traditional investments like stocks or bonds. Collectibles, such as rare coins, art, antiques, vintage cars, stamps, or even trading cards, can appreciate in value over time. Investors often purchase these items with the expectation that their rarity and demand will drive up their prices, allowing them to sell at a profit in the future. In this sense, collectibles are viewed as a potential store of wealth, especially during times of economic uncertainty or inflation, since they are physical assets and may act as a hedge against market volatility. However, collectibles are typically less liquid than traditional investments, meaning it may take longer to find a buyer at the right price. Their valuation can also be tricky, as determining their worth often requires expert appraisal. Prices for collectibles are driven by rarity, condition, and subjective factors such as trends and tastes. This makes investing in collectibles a higher-risk venture because the market can be volatile, and demand may fluctuate over time. Unlike stocks or bonds, collectibles do not generate regular income, such as dividends or interest payments. Instead, any return on investment comes from selling the collectible at a higher price than what was originally paid. While they offer potential for significant gains, the risks and challenges involved in selling, valuation, and market demand make collectibles a unique, but sometimes uncertain, type of investment. **8- Private Debt** **Private debt** refers to loans provided by non-bank entities, such as institutional investors or private equity firms, to businesses or individuals. Unlike public debt, private debt is not traded on open markets and is typically used to finance companies that do not access traditional public debt options. Private debt offers higher yields and flexibility, with customized loan terms negotiated between the borrower and lender. Common types of private debt include direct lending, mezzanine debt, distressed debt, and venture debt. Companies use private debt to access capital without going through public markets or traditional banks, often because of the need for tailored financing. For investors, private debt offers diversification and higher returns but comes with increased risks, such as illiquidity and potential borrower default. These investments are generally less liquid and require careful due diligence due to their complexity and the financial risk involved. In summary, private debt is an alternative form of financing that offers both opportunities and challenges for businesses and investors alike. **9. Precious metals** Yes, **precious metals** can be considered a form of investment. Precious metals like gold, silver, platinum, and palladium are commonly used as investment assets because they hold intrinsic value and are widely accepted as stores of wealth. Precious metals are often viewed as a **hedge against inflation** and economic instability. During times of financial crisis, currency devaluation, or high inflation, investors tend to flock to precious metals because their value tends to remain stable or even increase when other assets, like stocks or bonds, may lose value. This makes them a relatively safe haven in turbulent markets. Investors can purchase precious metals in various forms, such as **physical bullion** (coins, bars) or through financial instruments like **exchange-traded funds (ETFs)**, **futures contracts**, or **mining stocks**. Buying physical bullion gives the investor direct ownership of the asset, while financial instruments provide exposure to the price of metals without needing to store or secure them. However, investing in precious metals also comes with some risks. Their prices can be volatile in the short term, driven by changes in supply and demand, geopolitical events, or shifts in investor sentiment. Additionally, unlike stocks or bonds, precious metals do not generate income, such as dividends or interest. Investors rely solely on price appreciation to make a profit. In summary, precious metals can certainly be considered an investment, especially as a way to diversify a portfolio or protect against inflation and financial uncertainty. However, like any investment, they come with risks, particularly related to market fluctuations. **Question to Students:** **Is Labor (Work) an Asset ?** Labor is not an asset Labor is a capital Labor is the work carried out by humans and they are paid as wages or salary **Do not confuse working capital:** It is the difference between a company's current assets (what you have) and liabilities (what you owe). Thus, it measures how efficiently you're operating, your company's liquidity, and its short-term financial health. Without working capital, it's difficult for a company to grow, pay off debts and become (or remain) profitable. **C- The Success of any Investment depends:** There are dozens of factors contributing to the success of an investment, however the most important ones are: 1- Risk Management, 2- Market Condition, 3- Diversification, 4-Cost and Fees. 1. **Risk Management and Timing:** Every investment carries a level of risk, and understanding and managing that risk is critical. Investors need to balance the potential return with the amount of risk they are willing to take. For example, higher-risk investments like stocks or cryptocurrencies may offer greater potential returns, but they can also result in significant losses. Success often comes from knowing how much risk you can tolerate and making informed decisions to minimize unnecessary exposure ➔ Technical analysis is needed. Timing is crucial in most types of investments. Buying an asset at the right time---when its price is low---and selling it when its price is high can make the difference between profit and loss. This is particularly important for assets like stocks, real estate, and commodities. However, trying to perfectly time the market can be difficult, so many successful investors focus on long-term growth and avoid short-term speculation. 2. **Market Conditions** The broader economic environment plays a major role in investment success. Factors such as inflation, interest rates, market volatility, geopolitical events, and economic cycles (booms or recessions) can greatly influence the performance of investments. For example, during periods of economic growth, stocks and real estate may perform well, whereas during recessions, safe-haven assets like bonds or gold tend to be more stable. 3. **Diversification:** Spreading investments across different asset classes (stocks, bonds, real estate, commodities, etc.) and sectors reduces exposure to the volatility of any single investment. Diversification helps minimize losses when one asset class underperforms, as gains from others can offset those losses. Successful investors often maintain a diversified portfolio to reduce risk and enhance potential returns. 4. **Costs and Fees:** Minimizing transaction costs, management fees, and taxes can significantly impact investment returns. High fees can erode profits, especially in long-term investments like mutual funds or exchange-traded funds (ETFs). Successful investors are mindful of these costs and choose investments that offer good value in relation to their expense ratios. **D- Why is investment so important?** Investment is important for an economy because it triggers the **multiplier effect**, which amplifies its impact on overall economic growth. The multiplier effect refers to the idea that an initial investment doesn\'t just have a direct effect, but also generates further rounds of spending and income generation, leading to a greater overall impact on the economy than the initial amount invested. 1. **Initial Investment**: When businesses or governments invest in capital, infrastructure, or technology (e.g., building a factory or improving transportation), they directly spend money on materials, equipment, and labor. This direct spending increases demand for goods and services, creating income for workers and businesses involved in the production of those goods. 2. **Increased Income and Spending**: The people who earn income from this initial investment---such as workers who are paid to build the factory or suppliers who sell the materials---now have more money to spend. They might spend this money on groceries, housing, or other goods and services. This increased consumption further stimulates demand in other sectors of the economy. 3. **Ripple Effect Across the Economy**: As more people and businesses receive this additional income, they, in turn, spend more, creating additional demand for products and services. For example, a worker who receives wages from the initial investment may spend money at local businesses, increasing sales for those businesses, who then may hire more employees or purchase more supplies. 4. **Further Investment and Economic Growth**: As businesses see rising demand for their products due to the initial investment, they may respond by further investing in production capacity, expanding their operations, or hiring more workers. This additional investment generates even more spending, contributing to sustained economic growth. If the government invests \$1 billion in building new roads, the construction companies receive contracts, workers get wages, and suppliers of materials see increased orders. Those workers and suppliers spend their earnings on housing, food, and other services, which support local businesses. The cycle continues as these businesses, in turn, hire more workers or invest in more resources, leading to a broader economic expansion that exceeds the initial \$1 billion investment. If the multiplier is 2, for example, this initial \$1 billion could ultimately result in a \$2 billion increase in GDP. That is why many countries offers Several countries offer residency or citizenship through investment programs, commonly referred to as \"Golden Visas\" or \"Citizenship by Investment (CBI)\" programs. These programs allow individuals to obtain residency or even citizenship in exchange for making a significant financial investment in the country\'s economy, typically in real estate, government bonds, or business ventures. Caribbean: -------------------------------------------------------------------- -- 1\. Saint Kitts and Nevis (Citizenship by Investment): 2\. Dominica (Citizenship by Investment): 3\. Antigua and Barbuda (Citizenship by Investment): 4\. Grenada (Citizenship by Investment): 5\. Saint Lucia (Citizenship by Investment): America: 1\. United States (EB-5 Visa): 2\. Canada (Quebec Immigrant Investor Program): 3\. Panama (Friendly Nations Visa and Qualified Investor Program): 4\. Argentina (Residency by Investment):  Question to students: ***[Is Research and Development considered as Investment?]*** **Pharmaceutical companies** **Energy companies** **Tech Companies** **R&D in US Billion Dollar (2022)** **Research and Development (R&D)** is considered a form of **investment**, although it differs from traditional financial investments like stocks or bonds. When companies invest in R&D, they are allocating resources (money, time, and effort) to develop new products, technologies, or processes that are expected to improve their competitive position and generate future returns. **Future Returns**: The goal of R&D is to create innovations that lead to new products or services, improve existing ones, or enhance operational efficiency. These innovations can increase a company\'s future revenues and profitability, similar to how a financial investment would generate returns. **Long-Term Growth**: R&D investment is focused on the long term, with companies expecting that the knowledge gained or products developed will pay off in the future, either through higher sales, lower costs, or market expansion. **Intangible Capital**: R&D contributes to the creation of **intangible assets**, such as patents, intellectual property, and proprietary technologies, which can add significant value to a company and be a source of competitive advantage. **Risk and Uncertainty**: Like any investment, R&D carries risks, as not all R&D projects will result in successful products or technologies. However, the potential rewards can be substantial when innovations succeed, leading to breakthroughs that drive future profitability and market leadership. **Chapter One: Capital and Investment** **[In General]**, it includes population; intangible items such as skills, abilities, and education; Land, buildings, machinery and equipment of all kinds. All stocks of goods - finished or unfinished - are in the hands of firms and households. **[In Business]**, it refers to an item on the balance sheet that represents that portion of an enterprise\'s net worth that is not provided by the enterprise\'s operations. **[In Economics]**, the word capital is generally limited to "real" assets as opposed to only "financial" assets such as Cash, stocks, bonds, mutual funds, and bank deposits are all examples of financial assets. The latter are not considered as capital in economics. Capital is Something that was produced in the past and used in the present to produce something else in the future ➔ [**Machines and Equipment** ➔ **Physical Capital**] Capital refers to assets or resources that are used to generate income or produce goods and services. It can be **physical** (machinery, equipment, buildings), **financial** (money, stocks, bonds), or **human** (skills and education). Investment is the process of using resources (such as financial capital) to acquire assets or develop projects with the goal of generating future returns, either through income (like interest or rent) or appreciation in value. ***Relationship Between Capital and Investment:*** 1. ***Investment Creates Capital:*** Investment is the process of acquiring or building new capital. When businesses or individuals invest in physical assets (like factories, equipment, or technology), they increase the capital stock available for future production. For example, a company might invest in new machinery, which adds to its physical capital and enhances its ability to produce goods or services. 2. ***Capital is Used for Investment:*** Investment requires capital, particularly financial capital, to fund new projects, acquisitions, or innovations. Individuals, businesses, and governments use their existing financial capital to make investments that they expect will lead to future growth. For example, a company may use financial capital (money) to invest in research and development (R&D) or real estate, hoping for future returns. 3. ***Investment Enhances Productivity of Capital:*** By investing in new technologies or upgrading existing capital, businesses can improve the productivity of their capital. For example, investing in modern machinery or software can make the production process more efficient, leading to higher output with the same or even less input. 4. ***Capital Accumulation Through Investment:*** Over time, sustained investment leads to capital accumulation, meaning a larger stock of physical and financial capital is available for future economic activities. This accumulation drives economic growth because a larger capital base supports more production and innovation. 5. ***Returns on Capital Depend on Investment:*** The return on capital depends heavily on how effectively it is invested. If financial capital is invested wisely--- such as in profitable ventures or productive assets---it generates income or appreciation, leading to an increase in the overall capital base. Conversely, poor investments can lead to a loss of capital. 6. ***Human Capital Investment:*** Investment is not limited to physical or financial assets. Human capital---the skills, knowledge, and experience possessed by individuals---can be enhanced through investment in education, training, and health. This investment in human capital increases productivity and income-generating potential. Capital and investment are closely linked, as capital provides the resources for investment, and investment leads to the creation and enhancement of capital. Through investment, businesses and economies can grow their capital stock, which in turn boosts productivity, generates returns, and fosters long-term economic growth. ***Physical and Fixed Capital*** **Physical capital** refers to tangible, man-made assets used in the production of goods and services. It includes items like machinery, buildings, tools, equipment, and infrastructure that help in the production process. These assets are essential for increasing productivity and efficiency, and they are different from financial capital (money) or human capital (skills and labor). Physical capital is a key. Physical capital includes all tangible assets used in production, whether they are long-term or short-term. These assets can be used up, depreciate over time, or get replaced regularly. 1. Raw materials (e.g., wood, metal, fabric) 2. Office supplies (e.g., computers, printers) 3. Vehicles used for delivery (short-term use) 4. Tools and equipment (e.g., hand tools or small appliances) 5. Inventory (products stored for sale) **Fixed capital**, a subset of physical capital, specifically refers to **long-term physical assets** that are used repeatedly in the production process over several years. Examples include factories, machinery, and infrastructure. These assets are not consumed or used up in a single production cycle. Fixed capital refers specifically to long-term, durable assets that are repeatedly used in the production process over a long period and are not consumed or replaced quickly. 1. Factory buildings 2. Heavy machinery (e.g., industrial machines in a manufacturing plant) 3. Office buildings or warehouse 4. Company-owned truck or planes used for years 5. Infrastructure (e.g., bridges, power plants) Human Capital ------------- **Human capital** refers to the skills, knowledge, experience, and abilities possessed by individuals that contribute to their productivity and economic value. It is developed through education, training, and experience, and plays a crucial role in enhancing an individual's or organization's capacity to perform work and create value Reputational or Social Capital ------------------------------ Financial Capital ----------------- **Financial capital** refers to the funds or monetary resources that individuals, businesses, or governments use to invest in assets, projects, or operations with the expectation of generating future returns. It includes cash, stocks, bonds, and other financial instruments that can be used to support growth, production, or investment activities. **Capital Classification Exercise:** classify different types of capital based on the following list of assets. indicate whether each one is an example of **physical capital**, **human capital**, or **financial capital**. 1. **A factory building** ➔ **Physical Capital** 2. **A software engineer\'s knowledge and skills** ➔~Human\ Capital~ 3. **Cash reserves in a company's bank account** ➔ ~Financial\ Capital~ 4. **Machinery used in manufacturing** ➔ Physical Capital 5. **Education and training provided to employees**: ➔Human Capital 6. **Stocks and bonds owned by a firm** ➔ Financial Capital 7. **A fleet of delivery trucks** ➔ **Physical Capital** 8. **An entrepreneur's experience and expertise** ➔ Human Capital 9. **A loan provided by a bank to a business** ➔ ~Financial\ Capital~ A. loan is part of financial capital, as it represents funds that can be used for investment. 10. **Patents owned by a company** ➔ ~Intellectual\ Capital~ 11. **What is an asset?** 12. **Is money in a savings account considered an asset? Why or why not?** 13. **What is the difference between a financial asset and a physical asset?** B. financial asset is intangible and represents a claim on future income (e.g., stocks, bonds), while a physical asset is a tangible item (e.g., land, buildings) that has intrinsic value. 14. **Is a car you own for personal use considered an investment? Explain.** 15. **Why is owning shares in a company considered an investment asset?** 16. **How would you classify a house you rent to others? Is it a personal asset or an investment asset?** C. house rented to others is considered an investment asset because it generates rental income. Chapter Two: Investment, Inflation and Interest Rate ---------------------------------------------------- **Investing** can be a strategy to **hedge against inflation**. By putting money into assets like stocks, real estate, or commodities, which typically appreciate over time, investors aim to preserve or increase the value of their wealth, as these investments often outpace inflation and protect against the eroding effects of rising prices. **Inflation** is the general increase in the overall price level of goods and services in an economy over time. As prices rise, the value of money decreases, which leads to a loss of **real income** (the amount of goods and services that can be purchased with a given income) and ultimately results in a reduction in **purchasing power**---the ability to buy goods and services with the same amount of money. Inflation ≠Not **[one]** price or a price of some products, BUT ALL products. **It is usually represented by a supermarket kart, because this is where "all" products are found and purchased.** In economics, the **Consumer Price Index (CPI)** is measured using a **basket of goods and services** **(G&S)** that reflects the consumption habits of a **middle-income, urban person** because this group represents a large portion of the population and their spending patterns tend to be more stable and indicative of broader economic trends. Middle-income households are considered a good average for the typical consumer, and urban areas are selected because they have higher population density and more diverse access to goods and services. Focusing on this demographic helps provide a more accurate and relevant measure of the changes in the cost of living for the majority of the population. We calculate the (percentage) growth rate of the prices of the basket of G&S using the formula:  the basket includes household goods like **furniture** and **appliances**, and personal care items such as **toiletries and cosmetics**. The composition varies by country based on consumer spending patterns, but these are the common categories. **Year** **CPI** ---------- --------- 2021 220 2022 230 2023 245 ***There are many reasons, but the most important ones are:*** ### ***Demand-pull inflation, Cost-Push inflation (supply side) or Monetary Phenomenon*** **Demand-pull inflation** occurs when the demand for goods and services exceeds the economy\'s capacity to produce them, leading to higher prices. This typically happens in periods of strong economic growth when consumers and businesses have more money to spend, driving up demand and pushing prices higher. ➔ We can call it good inflation or justified inflation P2\>P1 and this is due to the overall increase of all the demand. The reasons behind Demand-Pull Inflation are the following: **Increase in consumer spending** (rising incomes or increased access to credit), **Government fiscal policies** (tax cuts or increased public spending) **Expansionary monetary policy** (lower interest rates set by central banks). **A booming export market** can lead to higher demand for domestically produced goods, **Cost-push inflation** (supply-side inflation) arises when the costs of production for goods and services increase, such as from higher wages or rising prices of raw materials. Producers pass these higher costs onto consumers, resulting in higher overall prices. **P2\>P1** Cost-push inflation occurs when the cost of production for goods and services increases, leading producers to raise prices to maintain profitability. Key reasons behind cost-push inflation include: **Rising wages**, as higher labor costs force businesses to charge more for their products. **Increases in the prices of raw materials**, such as oil, metals, or agricultural products, also contribute, especially when essential inputs become more expensive due to supply chain disruptions or scarcity. **Supply shocks**, such as natural disasters or geopolitical tensions, can reduce the availability of key resources, further driving up production costs. **Additionally, higher taxes or tariffs** imposed on imports can raise the cost of goods, forcing producers to pass those costs onto consumers through higher prices.  #### Money Supply and Inflation: Monetary Phenomenon is driven by an excessive increase in the money supply relative to the amount of goods and services available in the economy. When too much money is in circulation, it reduces the value of the currency, leading to price increases. This view is often associated with monetary theories, such as those of **Milton Friedman, who argued that inflation is always linked to money supply growth.** **If Money Supply (MS)** ➔ **Inflation WHY?** **Imagine that the economy's production (GDP) is represented by the OREOs.** **[Initially, in 2017] assume that the money supply was 2 dollars and GDP is 2 oreos. As a result, 1 oreo = 1 dollar OR 1 dollar = 1 oreo** **[In 2018], assume that GDP increases from 2 to 3 oreos but also the money supply increases from 2 to 6 dollars. We have 6 dollars = 3 oreos OR 3 oreos = 6 dollars** ➔ **1 oreo = 2 dollars** ➔ **Inflation**  Continue in class the analysis of the next years with the appropriate interpretation **We cannot have GDP growth without inflation, but sustainable inflation is an inflation that is justified by economic growth.** Inflation targeting is a monetary policy approach where central banks set a specific target or range for the inflation rate and adjust monetary policy tools to achieve that target. The primary goal of this framework is to maintain price stability, which supports sustainable economic growth and provides a stable environment for decision-making by businesses and consumers. Central banks influence inflation by adjusting interest rates---raising them to cool the economy and curb inflation, or lowering them to stimulate spending and investment when inflation is too low. Developed countries like the **United Kingdom** and **Canada** have successfully implemented inflation targeting policies, with both aiming for an inflation target of **around 2%.** **The European Central Bank (ECB)** also uses inflation targeting, aiming for a range of **"close to, but below 2%"** over the medium term. These inflation targets help anchor public expectations and provide transparency in monetary policy, ensuring that inflation remains stable and predictable. **Hyperinflation:** Hyperinflation is an extremely high and typically accelerating rate of inflation, often exceeding 50% per month (for three consecutive months). It occurs when a country\'s currency rapidly loses its value, leading to skyrocketing prices for goods and services. Unlike normal inflation, which is usually gradual and predictable, measured on a yearly basis or quarterly or monthly, hyperinflation in a inflation on a daily or hourly basis. It can destabilize an economy, making it difficult for individuals and businesses to plan and function. The main causes of hyperinflation include: *Excessive money supply*: When a government prints too much money to finance spending or cover debts, it leads to a devaluation of the currency. *Loss of confidence*: When people lose faith in the value of the currency, they rush to spend it, worsening inflation. Famous examples of hyperinflation include post-World War I **Germany** (the Weimar Republic), **Zimbabwe i**n the late 2000s, **Venezuela** in recent years and **Lebanon.** **Deflation:** Deflation is the general decline in prices of goods and services over time, leading to an increase in the purchasing power of money. While it might seem beneficial, deflation often signals economic trouble. It usually occurs due to reduced consumer demand, overproduction, or tight monetary policies that restrict money supply. Deflation can result in a downward spiral, where people delay spending in anticipation of further price drops, leading to reduced business revenues, job cuts, and economic stagnation. The economic implications of deflation are often severe. As prices fall, the real value of debt increases, making it harder for borrowers to repay loans, which can lead to more defaults. Prolonged deflation can trigger recessions as businesses and consumers reduce spending, deepening economic woes. Producers will no more produce and will be obliged to cut wages or fire employees which will lead to unemployment. In recent years, there have been a few notable instances of deflation in different parts of the world. Some of the most famous cases include: 1. **Japan's Deflation (1990s to 2020s):** Japan is one of the most well-known examples of long-term deflation. After the collapse of its asset bubble in the early 1990s, Japan experienced a prolonged period of economic stagnation and deflation, known as the \"Lost Decade.\" Despite various stimulus measures by the government and the Bank of Japan, deflation persisted well into the 2000s and beyond. Prices remained stagnant or even fell as weak consumer demand and declining wages continued to impact the economy. Even today, Japan still faces deflationary pressures. 2. **Eurozone Deflation (2014-2015):** Following the European sovereign debt crisis, some countries in the Eurozone experienced periods of deflation between 2014 and 2015. The combination of weak demand, austerity measures, and low oil prices led to falling prices in countries like Greece, Spain, and Portugal. The European Central Bank responded by launching a largescale quantitative easing (QE) program to combat deflation and stimulate inflation. 3. **United States (Brief Deflation in 2020):** During the initial months of the COVID-19 pandemic in 2020, the U.S. briefly experienced deflationary pressure. With widespread lockdowns, a collapse in consumer demand, and a sharp drop in oil prices, inflation dipped, and some sectors saw falling prices. However, this deflationary episode was short-lived as massive government stimulus programs and economic reopening eventually reversed the trend, leading to higher inflation in the following years. 4. **China's Deflationary Concerns (2023):** In 2023, China showed signs of deflation due to a slowdown in consumer spending, weakening exports, and a slump in the property market. Consumer prices saw near-zero growth, raising concerns about prolonged deflationary pressure. China\'s government and central bank responded by implementing measures to stimulate economic activity and avoid long-term deflation. **While deflation is less common than inflation, it poses serious risks to economies by reducing consumer spending and increasing the burden of debt, which can lead to economic stagnation and even recession if not properly managed. Disinflation:** Disinflation refers to a slowdown in the rate of inflation, meaning that prices are still rising, but at a slower pace than before. It is not the same as deflation, which involves a decrease in the overall price level. Instead, during disinflation, the inflation rate declines, signaling that prices are increasing more moderately. For example, if a country's inflation rate drops from 5% to 3%, that is disinflation. Prices are still going up, but not as quickly as they were previously. Disinflation typically occurs when a central bank or government implements policies aimed at controlling inflation, such as raising interest rates or reducing the money supply. This can help stabilize an economy that is overheating without causing a recession or deflation. Disinflation is often considered a positive sign, especially if the economy is moving from a high inflation environment toward a more stable, moderate inflation rate. A recent example of disinflation can be seen in the **United States in 2023**. After the high inflationary period following the COVID-19 pandemic and supply chain disruptions in 2022, the U.S. inflation rate began to slow down in 2023. In response to climbing inflation, the Federal Reserve (Central Bank) raised interest rates aggressively starting in 2022 to cool down the economy and curb inflation. By mid-2023, the inflation rate, which had peaked at around 9% in mid-2022, gradually fell to lower levels. This decline in the inflation rate is a clear example of disinflation, where prices were still rising, but at a slower rate compared to the previous year. **Stagflation:** Stagflation is an economic situation characterized by the simultaneous occurrence of three conditions: **high inflation**, **high unemployment**, and **stagnant or slow economic growth**. It presents a unique challenge for policymakers because the typical tools used to fight inflation (like raising interest rates) can worsen unemployment and slow growth, while measures to boost growth (like lowering interest rates) can exacerbate inflation. Tu sum-up: **Inflation**: A positive increase in prices (inflation rate \> 0). Year Inflation Rate (%) Type of \_\_\_tion ------ -------------------- ------ ----- -------------------- 2018 2.4 2.8 3.9 2019 1.8 2.3 3.7 2020 -0.5 -3.5 6.7 2021 1.2 5.4 5.4 2022 8.5 3.2 4.2 2023 4.2 2.1 3.8 **B-The effect of Inflation: Nominal and Real** **Case of GDP** Gross Domestic Product (GDP) measures the total output of a country produced within a specific period (a year or quarter or month). However, since different types of production are measured in various units, such as hours of teaching, number of patients, or number of calls, a common denominator is needed to calculate GDP. This denominator is the value of production expressed in monetary terms, such as USD, Euro, or Pound. This is known as NOMINAL GDP, which is the quantity produced time the price = Nom GDP. When comparing a country's GDP across two different years, two variables can change: the quantity of output produced and the price of goods and services. Comparing GDP with both variables changing would be challenging. Therefore, to accurately compare production, we hold prices constant (using a base year) and examine changes in output, allowing us to determine whether production has increased or decreased. This is known as REAL GDP where we look at the changes of output while keeping fixed the price. In this case we can easily compare the production of both years. For example: Assume we are in Lebanon, in 2023 I was in a Medical Doctor meeting on average **5 patients** per day and each patient pays 50 thousand LBP per visit. In 2023, my daily GDP was 5\*50 thousand = **250** thousands LBP In 2024, I earn on average **500** thousand LBP per day. Does it mean I am producing more, and my GDP increase from 250 to 500 thousand LBP? Scenario 1- I may be producing more Scenario 2- I may be producing the same as 2023 Scenario 3- I may be producing less than 2023 **Scenario 1**- If I meet on a daily basis 10 patients instead of 5 and each one pays 50 thousand LBP, in this case I am earning 500 thousand LBP which means my GDP doubled. **Scenario 2**- If I am still meeting on average 5 patients per day, but because of the hyperinflation that happened in Lebanon, each patient is paying 100 thousand LBP instead of 50 thousand LBP, in this case I am earning 500 thousand BUT I AM NOT PRODUCING MORE. The value/number in GDP increased because the amount of money people pay increased, and not because my productivity increased. I AM STILL PRODUCING/MEETING 5 patients which is same quantity as in the previous year. **Scenario 3**- What If I meet on average 4 patients only but because of inflation everyone is paying 125? In this case my GDP is 500 thousand, which is in number bigger than 2023, however in terms of production, I am producing less because I meet only 4 on average instead of 5. To have the correct answer, we look at real GDP, **we fixed the price of 2023** and look at the quantity produced: if I meet 4 patients or less per day ➔ My GDP decreases If I still meet 5 patients per day ➔ My GDP is constant If I meet 6 patients and more per day ➔ My GDP increases **If "before" Pizza Hut in Lebanon produced for 20.000 LBP (2 medium pizza, each at 10.000 LBP)** ---------------- Before in 2019 ---------------- --------------- Later in 2023 --------------- **Later, in 2023 I earned 2.200.000 LBP, does it mean I produced hundreds (220 or 110) units of pizza??** ##### 12\$ ➔ ➔➔➔[GDP = 10\*12=120\$] 0 -- -- ------------ -- -- -- ---- -------- -- P~19~=12\$ 12 =120\$ 0 0 2 0 **There is another way to calculate inflation using nominal GDP and Real GDP:** How much was the inflation rate in 2020? ➔ it was (150/120) \*100 ➔ 125 \>100 by 25% ➔ inflation rate 25%. **Calculate the inflation rate in 2021, 2022, 2023 and 2024** **CPI** calculation consists of taking SAME BASKET OF GOODS AND SERVICES (SAME QUANTITY) BUT DIFFERENT PRICES➔ QTY = ; Price ≠ **DEFLATOR** calculation consists of taking same price level but different quantity ➔ Qty ≠; Price = **Interest rate is:** - the price of money - the price of lending money - the cost of borrowing the return on saving **expressed as a percentage of the total amount of a loan or investment.** Imagine I loaned Maria \$100, and she has to pay me back next year. What does \$100 represent? I explain to her that it means the equivalent of 100 burgers at McDonald\'s. When she pays me back, I want the value to remain equivalent to 100 burgers to maintain stable purchasing power. A year later, there is inflation, and each burger now costs \$1.10. If Maria only pays me back \$100, I will be able to buy only 91 burgers instead of the original 100. I refuse this and ask her to pay me \$110 instead. By paying \$110, I can buy the same 100 burgers as before, preserving my purchasing power. In this case, the nominal interest rate is 10%, meaning she borrowed \$100 and repays \$110, reflecting an interest rate of 10%. This 10% interest rate corresponds to the inflation rate, as it shows how much the loan amount should be increased to maintain stable purchasing power and the same standard of living. **The correct example:** Assume that Maria asks to borrow \$100 from me, with the agreement that she will pay it back next year. I project that the inflation rate over the course of the year will be 10%. Based on this expectation, we agree in the contract that she will pay me back \$110 instead of \$100. This way, the repayment will account for the expected inflation rate and preserve the purchasing power of the money. ➔ **A nominal interest rate refers to the total of the real interest rate plus a projected rate of inflation.** There are three scenarios: ### Scenario 1 After one year, the inflation rate was exactly as expected, at 10%. Maria pays \$110 as agreed, and I receive \$110. This is a fair outcome since the loan covers the inflation rate as projected. ### Scenario 2 After one year, the inflation rate is 8%, but Maria still has to pay \$110, as specified in the contract (the original \$100 plus \$10 for inflation). In this case, Maria loses 2% because she paid 10% to cover inflation when the actual rate was only 8%. I gain 2% because I received 10% while inflation was only 8%. Therefore, the **real interest rate** (the profit) is 2%.