[MUSIC] In this lesson, we have explored the many mysteries in inflation and inflationary spirals. At this point, you should be tuned into the need to follow inflation indicators, like the consumer price index, to track inflation as part of your macroeconomic forecast. You should also have a fairly sophisticated understanding of how supply-side shocks can trigger cost push inflationary pressures. And, based on our discussion of the key concepts, like the Keynesian dilemma, the Phillips curve, the natural rate of unemployment, and the three ranges of the economy. You should see why inappropriately applied discretionary, fiscal, and monetary policies can sometimes contribute to an inflationary environment, or even an inflationary spiral. To end this lesson, let's work our way through some of the strategies that business executives and investors use to hedge against various inflation risks. [MUSIC] Suppose, then, that you are a wealth fund manager. And you have a new client who comes into your office with $10 million and asks you to build for her a low-risk and conservative investment portfolio with these funds. In more specifically explaining her investment goals, she explicitly insists that her portfolio be relatively protected against what she believes will be a significant run-up in inflation over the next five years. And she also tells you this investment portfolio must generate significant amount of cash flow to cover her annual living expenses. So here's the question. Where do my bonds fit into the portfolio you are going to construct for her? Should bonds be a large or small part of that portfolio, and if you are going to buy any bonds at all, what types should they be? And what about gold? Is that likely to gain or lose value in an era of inflation? So take a minute now to think about bonds and gold as you jot down some ideas for your client's portfolio. And as a hint here, on the gold question, do you remember the various kinds of money we talked about in an earlier lesson? [MUSIC] Okay, and let's start with the bonds part of the questions. Investment professionals often allocate a large fraction of bonds to a portfolio when they want to generate income, because bonds offer a steady flow of cash in the form of interest payments. There is a very big problem, however, with bonds when it comes to inflation. What do you think that problem is? Jot down some ideas, please, before moving on. [MUSIC] While the problem that inflation causes for bond investments is that inflation typically causes interest rates to rise. But because bond prices are inversely related to interest rates, that means inflation will cause bond prices to fall. So, if you buy a bond, today, and Inflation and interest rates rise, that bond will be worth less tomorrow. To hit against this inflation risk, investors can purchase fixed income instruments indexed to inflation, so-called inflation-linked bonds. For example, Japan's Ministry of Finance offers inflation-linked bonds tied to the Japanese Consumer Price Index, while the Bank of Canada issues real return bonds linked to Canada's All Items CPI Inflation Index. Typically, with such bonds, the outstanding principle of the bond rises as inflation rises. And so, therefore, that's the face value of the bond [SOUND]. So for this particular client, seeking a high cash flow and a low-risk portfolio, inflation-linked bonds can play an important role. [MUSIC] Now what about gold as part of your client's portfolio. Why buy gold when it doesn't generate income at all? Well, gold is generally regarded as an excellent hedge against inflation. The reason is pretty simple [SOUND]. During inflation, paper money, also called fiat money, declines in value with inflation. However, commodity money, like gold, tends to hold its value. One big reason is that investors will tend to trade in their paper money for gold during periods of inflation. [MUSIC] Okay, we've covered the investor side of strategically managing the inflation risk. Now, what about the business side, and suppose, here, that you are a chief executive officer of a manufacturing [SOUND] company. And your company's leading economic forecaster has just informed you of a rapidly approaching perfect storm of inflationary pressures on both the demand pull cost push size. In his forecast, he sees upward pressure on wages, rising costs for the assembly's components and raw materials that your company needs for production, and, of course, rising interest rates. So what are some of the strategic steps you can take to anticipate and, perhaps, hedge some of this inflation risk? And what might be your pricing strategy as inflation raises your costs and eats away at your profit margins? Take a few minutes now to think about this as you jot down some ideas. When you are ready, let's close this lesson with a discussion, some of the strategic possibilities. [MUSIC] So how are you going to strategically manage your inflation risk? Here's just some of the rules of the strategic management role. [MUSIC] On the labor front, when the economy's growing rapidly, workers have their strongest bargaining power, both individually and, perhaps, in union bargaining units. So be careful not to sign any long-term contracts that might saddle you with high labor costs, once wage pressures subside. [MUSIC] And what about the assemblies, components, and raw materials in your supply chain that you may need to produce your products? Here, you may want to increase your inventories before prices rise. You may also want to consider locking in fixed prices for this material by signing long-term contracts, now, with your suppliers before the prices rise. And, as a general principle, you want your supply chain to be diversified. That is, you typically want to obtain your production inputs for more than one supplier so that these suppliers will compete amongst themselves for your business. In this way, the invisible hand of market forces should help hold costs down. [SOUND] [MUSIC] Now what about debt management and capital financing? Well, in anticipation of the rise in interest rates that come with inflation, you may want to convert some short-term debt into long-term debt, and thereby lock in lower interest rates before rates rise. And to finance any additional capital investment, you may also want to reduce your debt/equity ratio, by using relatively more equity financing than debt financing, to finance that capital investment [SOUND]. The idea here is that, if stock prices are rising with inflation, it may be more prudent to raise additional company funds for new investment by selling newly issued shares of company stock. Rather than by issuing new bonds at higher interest rates. [MUSIC] In terms of your pricing strategy, and this is where a knowledge of microeconomics, to go with your growing mastery of macroeconomics, can help. The microeconomics idea, here, is to always be aware of how sensitive customer demand is to price changes [SOUND]. Is the demand for your products relatively price elastic, whereby consumers are highly sensitive to price changes? If so, it will be very difficult for you to pass on increases in the costs of your production to your consumers. So be careful here. A lot of companies have lost a lot of customers and money by trying to simply pass on the costs of inflation, rather than controlling those costs and prudently setting prices. [MUSIC] Well I hope you have found this lesson both interesting and valuable, as inflation is one of the most difficult challenges you will face in your personal and professional lives. And although I have just scratched the surface of strategically addressing the many issues that inflation creates with business executives and investors. You at least have gotten some of the idea of the need for strategic thinking in the macroeconomic environment. So, you take a breather now, and a very well-earned rest. When you are ready, let's move on to our next lesson where we will tackle yet another big mystery. Why is it that some companies grow rapidly and prosper, while others remain mired in poverty? It's a fascinating story that is also an essential story for anyone investing or doing business in the global environment. From the Merage School of Business at the University of California, Irvine, I'm Peter Navarro. [MUSIC]
