To calculate the expected risk premium on a stock, one must subtract the inflation rate from the stock’s expected return.
Inflation rate is the rate at which prices for goods and services rise. Inflation is sometimes classified into three types, those are: demand-pull inflation, cost-push inflation, and built-in inflation. The most commonly used inflation indexes are the Consumer Price Index and the Wholesale Price Index.
High inflation can be harmful, but in the other side, too little inflation can also weaken the economy. While the economy is struggling and inflation is too low, the Fed will take the opposite approach by decreasing interest rates or buying assets to raise cash circulation.
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