Inflation
We have now discussed all violations from the assumptions necessary for our perfect market Utopia. So, what are we doing now? If you return to our perfect markets assumptions, you will see that “no inflation” was not among them. Inflation is the process by which goods cost more in the future than they cost today—in which the price level is rising and money is losing its value.
So, inflation is actually not a market imperfection per se. If today we quoted everything in dollars, and tomorrow we quote everything in cents—so that an apple that cost 1 currency unit today will cost 100 currency units tomorrow, an inflation of 10,000%—would it make any difference? Not really. The apple would still cost the same in terms of foregone other opportunities, whether it is 1 dollar or 100 cents.
However, we have made a big assumption here—inflation applied equally to everything, and especially applied equally to all contracts across time. See, if you had contracted to deliver apples at 1 currency unit tomorrow, whatever currency units may be, you could be in big trouble—you would have promised to sell your apples at 1 cent (1 currency unit) instead of $1. Most financial contracts are denominated in such “nominal” terms—that is, in plain currency units—so inflation would matter. Of course, inflation would not be much of a concern for a financial contract that would be “inflation-indexed.”
What effect does inflation have on returns? On (net) present values? This is the subject of this post. As before, we start with interest rates and then proceed to net present values.