You can expect a few inflation-related questions on the CFP® exam. Let’s discuss the concepts you need to get the points then briefly examine where the U.S. is in 2015 with regard to inflation and what it means for the economy.

 

Inflation is an increase in the general level of prices. Deflation is a decrease in the general level of prices. These are measured by:

 

  • Consumer Price Index (CPI) – retail prices
  • Producer Price Index (PPI) – wholesale prices

 

What kinds of questions might you see on the CFP® exam about inflation?

 

Inflation and GDP

How do we think of inflation in conjunction with GDP? GDP does not measure inflation, but is adjusted for inflation. If we’ve got full employment, what’s going on with inflation? It’s going up because companies have to pay higher wages and higher prices for factors of production.

Inflation in the Business Cycle

In the business cycle, when is inflation about to slow down? It will slow in the mid-contraction or trough phase and then continue to fall in trough back up to mid-expansion. It keeps rising through mid-expansion to peak and from peak to mid-contraction.

 

Inflation and Who It Affects

When inflation is at, say 6%, who is most hurt by it? Lenders at a fixed rate of interest will be hurt because money costs more to them now than when they lent the money out, but the borrowers get to pay them back at the fixed lower rate. The borrowers, on the other hand, will benefit because they get to repay with cheaper dollars. Defined benefit pension plan recipients will also be hurt because their dollars will buy less. Social Security recipients will, for purposes of the CFP® exam, not be hurt because benefits are indexed for inflation.

 

Stagflation

Stagflation results when production is stagnant and prices continue to rise (as happened in the U.S. in the 1970’s due to oil prices rising). Which way would the supply and demand curves move in this situation? Prices rise, so supply curve moves left. Consumers demand fewer goods so price moves higher on an unchanging demand curve.

 

Calculate Inflation Rate

The math (know this formula):

 

Change in index                    

Beg.-of-year value of index               = Rate of inflation

 

So if CPI rises from 176 to 179.5, inflation rate is (179.5-176) divided by 176, or 1.99%.

 

Inflation in 2015

We’ve added jobs and reduced unemployment in 2015, so according to the theories we’re being tested on, inflation should be going up. Why isn’t it? An Associated Press article suggests that competing global workers, a disproportionate amount of entry-level hiring, the rising dollar (although this trend is slowing of late), and robotized factory trends are keeping inflation low. Allen Sinai, chief global economist at Decision Economics, says that “inflation’s recent performance has challenged the economic profession’s basic assumptions about the behavior of prices.” Sinai concludes by saying that “inflation is a mystery.”

 

So if a PhD economist is stumped by current inflation behavior, a CFP® registrant shouldn’t feel too bad if he or she doesn’t fully understand its depths. Learn the basics; get the points; pass the exam!

 

Sources

 

Boak, Josh and Christopher S. Rugaber. “Four Reasons Inflation Is Staying Ultra-Low While Job Growth Is Surging.” Chicago Sun-Times. 11 Jan. 2015. http://chicago.suntimes.com/business/7/71/282695/4-reasons-inflation-staying-ultra-low-job-growth-surging.

Robb, Greg. “Central Bankers at Jackson Hole Search for Answers on Low Inflation.”” MarketWatch. 27 Aug. 2015. http://www.marketwatch.com/story/central-bankers-at-jackson-hole-search-for-answers-on-low-inflation-2015-08-27?page=2.