User's blog

Month: June 2022

  • If money doesn’t grow on trees, how and where does it grow?

    How do we grow our money? We all know that unfortunately, we can’t grow our money on trees. But there’s a way to have more money in the future. If we start saving early and make regular contributions to it each month in an interest-bearing account with a bank, our money will grow. I will prove how an economist would do it- you guessed it right, by using graphs and numbers!

    For the younger generation, this post might be particularly useful. As soon as you start getting paid from your first-time job, whether it is a part-time job, or your first full-time job after college, you must learn to save for your future. American economy and many other economies nowadays are very consumption-based economies. People tend to live above their means and take loans to buy luxury things early on in their lives instead of saving money for the future. Our current generation needs to understand that there is no shortcut way to getting rich. Saving a portion of your income every month is key to having a secure financial future.

    A very important factor for anyone’s wealth creation is to learn to start budgeting. Before you spend money on any of your expenditures, you must set aside some money to pay yourself first. By paying yourself, I mean depositing a fraction of your income in a bank account that pays you some interest.

    Banks are considered low-risk and safe places to save your money. In the US, deposits at banks are insured by the Federal Deposit Insurance Corporation, FDIC. Deposits held at credit unions is administered through the National Credit Union Administration, NCUA. Your money is very safe in a savings account and is almost risk-free, hence the return paid on savings is not very high. Risk and return move together. It means higher the risk, higher the return, the lower the risk, the lower the return.

    Inflation erodes money’s purchasing power, so keeping extra money sitting idle at your home is not a good option at all. A portion of your money should be either saved in a savings or time deposit account in a bank and some portion should be invested in high-return, high risk assets. In another post, I will go over where you can invest your savings besides keeping them in a bank. For now, our focus here is to understand how money grows with compound interest over time.

    Just with the power of compounding, you can grow your money by a lot and a few years by just keeping it in a time deposit in a bank. Compound interest, or compounding, means that interest is earned on both the amount you initially deposit, which is called Principal, as well as on the interest you earn each day until you withdraw your deposits.

    The rate of interest that the bank pays us is expressed as a percent. Two main factors will determine how fast money has grown when you withdraw your savings deposit. The first is the time component and the second is the rate of interest.

    Mathematically, we can express this as

    = P (1+i)t/ 100

    Where P is called the Principal amount that we deposit initially in a bank

    i is the nominal interest rate that the bank pays

    t is the time period for how long we’re saving

    I will explain this with a simple example. Let’s assume that I started saving at the age of 17 and initially deposited $1000 in a savings account with a bank at 3% interest rate and kept it for 20 years. Now each month, I started depositing $50 into my account. This means I have deposited $1000 + $12000 during the 20-year period. Are you curious to see what happens to my money in 20 years? With the power of compounding, my money has grown to be at $18,235.85. I magically made an extra $5235, which is $18235.85-$13000.

    If I didn’t make a monthly contribution to my savings of $50, my money would have only grown to $1820.75 in 20 years. Thus, we see that the regular savings contribution is a very important factor in growing your money. Simply putting a certain amount of money into a bank savings account before you pay any bill or buy anything, will help a great deal in growing your money.

    Now, if we assume that this time duration increases from 20 to 50 years with the same monthly contribution of $50 per month and the same initial deposit of $1000 when I retire at the age of 67, I will get $73,939.46. If I add my monthly contribution of $50 each month for these 50 years with the initial deposit of $1000. I would have contributed a total of $30,950 by age 67. This $43,000 got created just with the power of compounding.

    If the interest rate goes up from 3% to 5%, and I keep saving $50 a month with the same initial deposit of $1000, my total money would become $145,551.98 at the end of 50 years. And I will be so happy.

    Now, let’s change one variable of the equation, our time duration t. Let’s assume that instead of starting to save at the age of 17, I started saving at the age of 30. I want to show you the exact figure of how much less money I would be able to collect after 37 years. In this case, the total time is reduced from 50 years to 37 years and even though the rate of interest is higher at 5%. I will only have $70,360.49 instead of $145551.98.

    Thus, by looking at all these examples, we understood that it is just not how much you save but also how early you start that will help your money to grow. The power of compound interest is making your money grow exponentially, doing the job for you. * For our math-savvy readers, did you notice that the time variable t appears as an exponent in the equation above and thus, shows the exponential rather than linear growth.

    You just have to put your saving in a safe interest-bearing account such as CDs or time deposits with a bank and make routine contributions to it, and please start early. Once you have the job, you can get the money directly deposited from your paycheck each month into your account.

    So yes, always remember to pay yourself first.

    As I wrote earlier in my post, there are a few other options available in the market to save and invest your money. Some of these options can give us higher returns than banks do but they also pose higher risks as well. A recent article by Bankrate lists some savings and investment options in the US with no to very low risk. We will go over those in my next post.

  • What makes money, money?

    By definition, money is anything that is accepted as a medium of exchange. When we use the term “medium of exchange,” we mean we can use it to buy or sell anything (good or service) and that the other person will easily accept and use it for his/her transactions. Money is also a measure of value, which means a product’s worth (value) can be measured in the monetary unit. Just like gold and precious metals, money is also a store of value* (see note below), and a standard of deferred (future) payment, which means you can use the money to pay someone in the future and it will be acceptable by that person.  

    How did money come into being?

    Long time ago, when coins and currency were not there, people used to exchange goods for goods. That system was called a barter exchange system. But there were several problems with it. The most important was the lack of double coincidence of wants. Let’s understand this with an example. If, person A is growing rice and has extra rice than he needs, he has an option to trade it with someone who wants rice in return for something he wants. Now let’s assume person A actually wants wheat, he will have to find a person who has extra wheat and at the same time that other person (person B), must want rice in return for this trade to happen. But if person B doesn’t want rice instead wants something else, then there is going to be a problem in doing this commodity to commodity exchange.

    This Barter exchange system became very difficult to continue as the population grew, because searching for the “right” person to exchange one’s extra produce was not easy.

    Another problem with the barter system was that it didn’t have a store of value. Perishable items like milk, meat, and vegetables that people wanted to trade couldn’t be stored for a long time and would lose their value once they went bad. Nonperishable items may have a store of value but, were not always easily convertible into other things with universal acceptability.

    This lack of store of value also made this barter system very difficult to carry on. Also, the barter system could not make future payments.

    People needed something intermediary, something that both parties could accept to help the exchange of goods and services. Thus, all of these problems were eliminated by the introduction of money. As I mentioned in the first paragraph, there were various advantages of having money. The most important being its universal acceptability of being a medium of exchange and a measure of value. It also is a store of value and can be used for future payments. Though when inflation is really high (above the target level), money can lose its capacity to act as a store of value.

    The currency and digital money that everyone is using nowadays only came a few decades ago. Money had evolved over time into different types, and various items were used as money at different periods in history.

    In the past, people had used cows, salt, and stone wheels as money, as they were widely accepted as a medium of exchange for goods and services. The central bank of Brazil published this article about the origin and evolution of money. However, there was always the risk of diseases and death with cows, and people wanted something easier to carry.

    Then, there was commodity money like gold and silver coins, which people could use in exchange for goods and services and they also had their own intrinsic value as well. By intrinsic value, I mean gold and silver always have had worth to people because of their uses for jewelry, etc. The minting of gold and silver coins prevailed for many centuries.

    Then came the representative money which was a paper certificate that you could exchange for gold in a bank for the underlying commodity. As people started trusting these paper certificates same as much as gold, it led to the creation of modern money which is also known as the Fiat money.

    Fiat money does not have any value of its own, (just a piece of paper or metal) but it has a guarantee from the government of the issuing country.

    It is declared as the legal tender and is an acceptable form of payment backed by that country’s Central bank. We all know if we have paper currency or coins, we can use them anywhere and they will be accepted as a form of payment. In today’s modern economy, most of the time we don’t even hold currency, as all the payments and receipts can happen online, where the money gets debited or credited directly in your bank account from another person’s bank. A lot of countries have gone virtually cashless because a large number of people use smartphones nowadays and internet access has become much cheaper and wider. This has made the digital transfer of funds between two people just with a click of a button on phone. It is important to note that a credit card is not considered money* (read the section below Supply of money).

    Is there a thing called a Money market?

    Just like any commodity, money also has a demand and supply, and thus, has a market. The interest rate at which we borrow money is the price of money.

    Demand for money

    We hold money for two reasons. First is to make transactions, so we can make payments for our various expenditures. The transaction demand part is positively proportional to the real GDP and price level. In other words, people will demand more money when there is inflation and higher real GDP. It is simply because they will need more money to be able to purchase more goods and services (real GDP) and at higher prices (inflation).

    The second reason why people demand more money is for speculative reasons. To understand the speculative reason, first, we must understand that when we hold money, there is an opportunity cost for it. Opportunity cost, in economics, means the cost of missing the next best possible use of something. Which in this case is the sacrificed interest that we could have received if we had saved money in a time deposit with a bank instead. When there is extra money in people’s hands (high money supply), they can use it in two ways- spend it or save/invest it.

    When banks are charging and paying a higher interest rate, demand for money gets low because of two reasons. First for a borrower, the cost of borrowing money gets high, so he will borrow less and hence demand less money. Second reason is that when interest paid on our deposits are really high, we will expect interest rate to fall in future and want to convert their money in bonds. Bonds pay fixed interest and principal at maturity, and the interest promised at maturity doesn’t change with market interest rates changes. Thus, it becomes safer to invest our extra money in bonds than in a savings or time deposit with the bank. Interest rates are paid on time deposits, which can vary according to the central bank monetary policy tools. In this case, when the interest rates are high, the demand for money is low. With the same logic, when interest rates are very low in the economy, people expect them rise in future and will demand more money compared to bonds. So, speculative demand for money always has a negative relation with interest rates.

    So, the total money demand is equal to the money demanded for transactional and speculative purposes.

    Supply of Money

    The money supply is the total amount of money that the people in an economy are holding at a particular point in time.

    Central bank of a country has the authority to issue the currency of any country. This currency issued by the central bank is held by the public and by commercial banks.

    In the US, the Fed controls the money supply of the country through various tools by changing interest on reserve balance and thereby controlling the federal funds rate and other interest rates in an economy. You can read about this in more detail in my post here.

    The money supply is a stock concept, which means it is measured at a particular point in time and a country’s central bank usually publishes the total amount of money periodically.

    Money is a financial asset that we can spend to purchase goods or services. When calculating the money supply, the central bank includes financial assets like currency and deposits. On the contrary, credit card debts are liabilities. With each credit card transaction, a new loan is created for the credit card issuer, which needs to be repaid with a financial asset called money. 

    The two establishments in any country, the Central bank and commercial banks play an important role in deciding how much money is circulating in an economy at a particular time.

    Since different assets can be used as money, the central banks give various categories and definition to keep track of it. In the US, there are two commonly used measures of money, known as M1, M2.

    M1 is the most liquid and widely accepted. It includes paper currency and coins held by the public + demand deposits of public at commercial banks, + other highly liquid accounts called other checkable deposits. Prior to April 24, 2020, savings accounts, deposits were not part of M1. Savings are now more liquid and part of “M1 money”. Regulation D by the Fed has made savings deposits as convenient as currency. The Fed published data on M1 and M2 every month, As of April 2022, the United states had $20.6 trillion in M1.

    M2 = M1 + small-denomination time deposits of under $100,000 + balances in retail money market funds. As of April 2022, The United States had $21.7 trillion in M2.

    https://www.federalreserve.gov/releases/h6/current/default.htm

    If you are interested in learning about the linkages between banks and the central bank, please click here.

  • What role do models and graphs play in economics?

    Our economies are complex, but by making some simple assumptions, we can focus on what is most relevant in explaining something. For this reason, economists use models to give us logical and precise reasoning behind many questions that come to our minds. Sorry, if you thought of this model as the one who walks on the ramp or does an ad on TV. Unfortunately, here we are talking about a little bit boring, economic models. Unlike attractive human models, these models generally consist of a set of mathematical equations, which are a simplified depiction of the real world. So, even if they are not pretty looking, they serve a very important role in economics. They try to precisely (like theories in science) describe how and why, we, as economic agents, act and are likely to act in future.

    One of the most important models in economics is the demand and supply model, together they explain how the price of anything gets determined.

    Economists use models for a variety of reasons, some of these include:

    • To assist in academic research that supports a proposed economic theory
    • To make economic forecasts so that we can understand the conclusions based on the assumptions made
    • To influence policy making relating to larger economic activities or at macro level
    • To explain and influence company strategies for businesses
    • To explain the growth pattern among countries
    • To understand banking, investment and saving behavior
    • To explain decision making at household level

    And many more…

    Even though, no economic model is a perfect description of reality, the process of making, testing, and revising these models forces economists and policymakers to think logically when trying to propose something. With the help of these mathematical models, they try to accurately depict how the economy works, and what drives economic behavior in people at large. This in turn helps them answer what they should or should not do when proposing a particular policy.

    These economic models use a lot of mathematics, as one of the key contribution of economics to mankind is how to think on the margin. That means calculating the additional benefit, and the additional cost of any particular action. Knowledge of calculus comes in handy in finding these solutions. So, if you or someone you know are planning to study economics in college, make sure they are good at calculus and algebra.

    Economists also use a lot of graphs, as these are a good visual representation of these economic models. The charts and graphs are relatively easier for people to understand as compared to mathematical models. So for my blogs, I will stick to graphs only. 🙂

  • How price of anything is set?

    The answer to this complex question is simpler than you might think.

    Do you think a business can charge whatever price it wants, to get the highest possible profit? But consumers who demand those products would like to buy them at the cheapest price, so how do they come to a consensus? In markets that are highly competitive (see footnote)*, meaning there are many producers and consumers of a specific good or service, the price of that product or service gets determined by the interaction of supply and demand forces. These forces work together in the same manner as the blades of the scissors cutting the paper.

    Wait, but what are these supply and demand forces?

    First, let’s understand them individually, and later we will see how they interact to set the “right” price.

    Demand

    In economics, we assume that people buy more of something when its price is lower. This negative or inverse relationship between price and quantity demanded is called the law of demand. This means the higher the price, the lower the demand is, and the lower the price, the higher the demand is for any normal good or service. Undeniably, a change in people’s tastes, income, and preferences can affect the demand for something, but we will assume that these other factors don’t change, so we can only focus on the relationship between price and quantity demanded.

    Let me explain this with a simple example of the demand for bread. The prices are shown on the Y-axis and the quantity that people are demanding is on the X-axis. You can see this inverse relationship in the graph below that slopes downward.

    If the price of one loaf of bread is $10 there is going to be very less demand for it, let’s say only 10 loaves of bread will be demanded. Once the price is lowered to $6, a few more people will be willing to buy it, so the quantity demanded increases to 20. And if the price is further lowered to $2, more people would be willing to buy it, as more can afford it, so the quantity demanded now is 40.

    Supply

    Now let’s look at the supply pattern. For a producer, if he gets a higher price for bread, he will be willing to make more bread and supply more of it. A higher price or reward encourages producers to supply more, and you can see this positive relation in the graph below as an upward-sloping supply curve. So, the law of supply states that there is a positive relationship between the price of a good and quantity supplied. This means the higher the price, the more businesses or producers are willing to supply, and the lower the price, the less they would like to supply. In the graph below, we can see at $2, producers are only willing to supply 10 loaves of bread, at $4, 20 loaves, and at $10, 40 loaves of bread will be supplied.

    Now when we plot both of them together in one graph, we will see there is one price, where both these curves meet. In economics, we call it an equilibrium point, where the price is just right for the producer/seller and the consumers. In the graph below, this happens at point A, where demand and supply meet or cross each other. The price is set at $4 and the quantity demanded and supplied is 25 loaves of bread. Thus, we saw no one individually impacted the price, but producers’ supply and consumers’ demand worked together to set the price that makes everybody happy.

    You understood how prices can influence how much people want to buy and produce. Now, let’s understand also, how it works the other way round, meaning how much people demand and businesses supply can influence the prices as well.

    If there’s more demand than supply for something (such as point B above), this will send a signal to the producers to increase the price from $2 to $6, because they understand that people are prepared to pay more to receive that good or service. In this case, there is an incentive for the producers to increase the price. If the price goes up to $6, some consumers will drop out as they won’t be able to afford bread at price $6.

    On the other hand, if there is more supply than demand (shown as point C above), this is a signal to the producers to lower the price from $6 to $2, because the price at $6 was too high and there is a very limited number of people who are willing to buy it. Now some producers, might drop out and can’t lower the price to $2, because they can’t cover their cost of production.

    Over time the price will keep moving upwards or downwards until it reaches a point where demand is equal to the supply, at point A ($4).

    Today, you learned two fundamental concepts in economics: the law of demand and the law of supply.

    If you are wondering about whether it is possible to plot these demand and supply curves in real life, the answer is, yes? In economics, a graph is just a simple representation of economic principles or behavior observed. Economists survey people and collect data and plot that data using easy-to-understand graphs. In the demand and supply curves we looked at today, the slope could be steeper or flatter. In order to learn what decides how steep or flat (demand or supply) curve will be, we will have to look into another important principle in economics called elasticity. More on that will be in my future posts. For now, if you just want to know why economists use models and graphs to solve real-world economic problems, please read my post here.

    *In non-competitive markets, like monopolies, where one company controls the market, it gets more control in setting the price. The demand and supply forces don’t work very well here. Producers want to get the maximum profits by setting the price higher and can do that as well. In the absence of other competing businesses, consumers who want to buy their product or use their service, don’t get other options. Hence, they end up paying a higher price than they would have paid if more companies were in the market for that product or service. Usually, to prevent businesses from exploiting consumers, some government intervention is required so these monopolies don’t create artificial barriers to entry.  

    It is worth noting that, some monopolies can happen naturally and not all monopolies are bad. We will look at this more in detail with real-world examples in another post.

  • What are our real earnings when we deposit money in our savings accounts?

    If I asked, “What’s the interest on your savings account?” many of you will tell me the interest rate that the bank is stating. However, you need to understand the difference between nominal and real interest rates.

    In this post, you will learn about the true return you get by saving your money in a bank.

    What is a nominal interest rate?

    When you deposit money in your savings account at the bank, you get something called nominal interest. So, if your savings account has a 2.5% interest rate, that is actually a nominal interest rate.

    A nominal interest rate is the interest rate banks and financial institutions give to you. It is the actual rate they will pay on your savings balance. This interest rate is not adjusted for inflation.

    Before we dig into real interest rates, we need to understand what inflation is and how it impacts the real return on savings.

    What is Inflation and how does it affect your actual return?

    Inflation is the general increase in the prices of everyday goods and services we use. It is important to note that the price of one item can go up and down, but the increase in any single item won’t qualify for inflation. Inflation happens when price rise for a majority of goods and services we use. In other words, inflation only happens when the average price level is going up. For example, when the prices of food, housing, gas, and other items we use, all rise for a while. I have written a detailed post on inflation in another post if you are interested.

    Real interest rate – the one that actually matters!

    If there is any inflation in an economy, money loses its value or purchasing power. So, the interest you earn from the bank won’t buy the same amount of things it could before the price rise. Thus, we need to calculate the real interest rate. This is the rate we get after subtracting the inflation rate from the nominal interest rate your bank quoted to you. So, the real interest rate r is

     r = nominal interest rate- Inflation rate

    This is called Fisher’s equation in economics, named after American economist Irving Fisher. He explained the difference between true or real interest from nominal interest.

    Thus, we will only earn interest income on our savings, when the real rate of interest is positive. If this number is positive, we haven’t lost money and actually gained some by keeping it in bank.

    Let’s learn this by an example. Think of a big balloon with some air. Here air is the money you deposited in your savings account (balloon). Now, let’s think of the “nominal interest” you earn on your savings as the rate you are blowing air in the balloon to make it bigger. But let’s suppose there is a hole in the balloon, which is making the air come out of it as well. This air coming out of the hole is representing inflation in an economy.

    If you’re blowing faster than the air that is coming out of the hole, your balloon will become bigger. And if your balloon is getting bigger, then purchasing power of your money in a savings account will grow over time. This is when you are earning interest in a real sense, and you will be able to buy more things.

    But if the hole is bigger, the air will come out faster than the air going in. This will cause your balloon size to decrease, which means your purchasing power will go down.

    So even if you are getting a nominal interest on your savings account from the bank, because of inflation, you will only be able to buy fewer things with that money in the future.

    So, the real interest rate could be positive, zero, or negative depending on whether the inflation rate is less, equal, or more than the nominal interest rate.

    If the real interest rate is zero or positive, then saving your money in a bank is still better than keeping it with you.

    When you keep money in your house, it certainly will depreciate by the rate of inflation. The only time keeping money in the house will help is when there is a deflation, which means the general price level is going down.

    In the chart below, you can see how inflation affects your true savings return.

    Does anyone benefit from stable inflation?

    Savers, borrowers, and lenders all benefit when the inflation level is stable and low (around 2%). For borrowers, it helps them pay off their loans because they are paying a little bit less in real terms.

    Banks know the target rate of inflation, so they keep their nominal lending rate of interest higher than that. This helps them get some real return on lending money.

    Similarly, for depositors, if inflation is stable, they get the real return as the excess of nominal return over the inflation rate.

    However, if inflation is more than the normal 2%, then both lenders and depositors will lose money.

    To learn about what measures the Fed takes to keep inflation stable at around 2%, please click here.