Inflation

A period of inflation is a time when costs are rising faster than productivity. The rising prices decrease the purchasing power of a dollar, meaning that a dollar does not buy as much as it did before. To prevent inflation from growing too quickly, the Bank of Canada raises the rate of interest that it charges banks for the money it lends them.

Commercial banks raise interest rates on their loans to compensate for the greater interest that they must pay the Bank of Canada. Since many companies carry large loans to finance their operations, the higher interest reduces their profitability and hence their desirability as investments. Usually the demand for these stocks decreases and the stock market falls. This prompts many investors to sell their stocks and buy treasury bills or bonds to take advantage of the higher rates of return and protect against the risk of losses in the stock market. Decisions by the Bank of Canada to stabilize or stimulate the Canadian economy by raising or lowering interest rates is known as monetary policy.

In 1923, inflation in Germany turned into hyperinflation and prices rose so quickly that restaurant patrons would ask for the bill before receiving their meals because the price was rising while they ate! As a result the German currency (called the "mark") became virtually worthless. The United States and Canada have never suffered hyperinflation, but did sustain significant inflation in the 1970s and 1980s.

The Market Is Bearish When...

1. There is general optimism about the health of the economy.
2. The prices of stocks are rising.

 

Deflation

As noted above, the Bank of Canada may raise interest rates to slow down the rate of inflation. A substantial increase in interest rates by the Bank of Canada is referred to as a tight monetary policy. If a tight monetary policy is in effect for a prolonged period, it could induce a period of deflation. Deflation is the economic opposite of inflation. It is a time when the cost of goods and services is decreasing, that is, the purchasing power of a dollar is increasing. The high interest rates discourage borrowing and reduce the demand for credit to expand business. Furthermore, people anticipating further decreases in prices postpone purchases and economic activity begins to slow. (Economists call this the Mundell effect.)

One of the worst periods of deflation occurred in the period from 1929 to 1939, called the Great Depression. The causes of the Great Depression are complex. However, there is some consensus among economists that tight monetary policy was a principal factor. The ensuing drop in investment was signalled by the crash of the New York stock market in the fall of 1929.