Yesterday, in the news, I read President Biden saying the US had 0% inflation in July. The BLS, the official source of inflation numbers, reported no change in the CPI (Consumer price index) from June.
So did inflation suddenly disappear? Well, it depends on how you measure it.
Sometimes, the way politicians report some facts could give us misleading conclusions. So, the economist in me had to write something today to help my readers understand it better.
How do we measure inflation?
As I said above, the official inflation number in the US comes from the BLS every month. BLS calculates price inflation both monthly and annual.
If you want to know more about inflation in simple words, you can read my previous posts. I described how we can calculate inflation using some simple examples. I also explained what policy measures the central bank takes to control inflation – my most favorite post.
There was indeed no general average price increase from June 2022 compared to July 2022. This meant a 0% monthly inflation.
However, the year-to-year inflation ending July 2022, was 8.5%. This is still very high, compared to the average US inflation of around 2%. Inflation is the percentage price increase of a basket of goods and services people in the urban United States use. This is of course, over a specific period.
But, the good news is that it was somewhat less than the June 2022-to-2021 inflation of 9.1%.
A picture is worth a thousand words
Here is a chart showing category-wise inflation. The food prices continued to rise. Few others, such as electricity, new vehicles, and shelter also rose.
The main reason behind 0% monthly inflation was the falling gas prices. It offset the increase in food and shelter indexes. The lower gas prices finally come as a relief to millions of Americans. We have been experiencing a sharp rise in gas prices for a long time and wanted a break.
Hopefully, Fed’s tight monetary policy will bring inflation down further in the coming months. But, there might be a cost to it- the possibility of a recession. As we say in economics, there is no free lunch. Let’s just hope that even if the R word happens, it is not significant.
Two days ago, President Joe Biden proudly posted that the unemployment rate in the US was 3.5% in July. This matched the lowest rate in the last 50 years. He also said that since he started, 10 million jobs have been created in the US economy.
The Bureau of Labor Statistics (BLS) in the US publishes data for the unemployment and labor force statistics every month. These are based on the data collected from household surveys and establishment surveys on sample-based estimates of employment.
I got this Civilian unemployment rate graph from the BLS. You can see that the US unemployment rate is now at its lowest level at 3.5%. This had happened three times before in Sep 2019, Jan 2020, and Feb 2020, when it hit 3.5%.
But have you ever wondered what is the unemployment rate anyway?
Well, the unemployment rate is the percentage of people who don’t have a job but can work and have actively looked for a job in the past 4 weeks. This is relative to people in the labor force.
According to the BLS, The labor force is the sum of employed and unemployed people ages 16 and older at a given period.
Their recent report about July’s unemployment rate was contrary to what many people would have expected. People were expecting a somewhat slowdown in the job market, but clearly, this hasn’t happened yet. The Fed has been raising interest rates to control inflation. The Fed’s policy aims to cool the overheated economy by reducing overall spending by individuals and businesses.
So what does a low unemployment rate mean for you?
If you are looking for work or want a change of job, right now could still be a good time for that. There’s a huge likelihood of you finding it sooner than later and as per your terms. With many employers paying higher salaries, it is a good time to ask for a raise if you think you deserve it.
When the effects of tightening monetary policy start showing up and we see a reduction in jobs created, it might be a little late to negotiate.
As always, if you enjoyed reading my post and learned something, please feel free to write your views in the comment section below. Thank you, till we meet again next time!
Today, I will introduce you to a very useful concept called Dollar-cost averaging. It is an investment strategy where you invest a fixed amount of money every period, such as every month, despite the stock market trend. You could invest your money in an index or mutual fund, or electronically traded funds (ETF).
So, no matter how the stock market behaves if you keep putting in a fixed dollar amount every period, over the long run, it will surely give you good returns.
Let’s understand this with a help of an example. The dollar amount you contribute each period, divided by the stock price, gives you the number of stocks you buy for that period. So, when you invest a fixed dollar amount (let’s assume you contribute every month), you end up buying fewer stocks when the stock price is high.
Conversely, when the stock price falls, you buy more stocks for the same dollar amount you invested during that month. This way, your average purchase price per stock stays low over time.
There is an excellent example explaining dollar cost averaging that I found on the Charles Schwab website.
To be a successful investor, you need to have patience and invest for the long term. People expect their money to grow overnight and this certainly doesn’t happen.
Why people need to use this strategy?
People try to buy stocks when their prices are falling and sell when they are rising to make profits. But it is very difficult to time the market. There is no foolproof way to know how the stock price will behave the very next day or coming days.
Sometimes, you may buy a stock thinking it is selling at a low price and will rise in the future. If the stock price rises and continues to rise, you made a good investment decision until you sell it at a higher price and make a profit. However, if the stock price falls further for the next few days, and you end up selling it at a lower price than you bought it for, you made a mistake.
Dollar-Cost Averaging
In reality, people panic and start selling individual stocks when the stock prices are going down. This is actually the wrong thing to do.
Also, people, sometimes, don’t buy those underpriced stocks thinking they are not performing well and will continue to fall.
We, as individual investors don’t have enough information about a specific company and other economic events. Hence, our guesses about market stock price and index movements are not always correct.
How does Dollar cost averaging help?
This can be avoided when we invest a fixed dollar amount. With dollar cost averaging, you can stick with a good investment schedule and will not overthink about when to buy or sell stocks.
I like to invest worry free
Thus, a big advantage of dollar-cost averaging is that it is a worry-free method of investing. The emotions and anxiety associated with investing are taken out and you just invest a fixed amount at a fixed time (such as every month), ignoring the market ups or downs.
An example of dollar-cost averaging investing would be the investments done through your employer’s 401k plan. Here you and your employer contribute a fixed amount of money towards your retirement income.
I hope you learned something from my post today. If you haven’t already, you will start making use of this useful technique in making your investment decisions. Also, please start early, as time is the key. After creating the emergency fund in your savings account, invest your money so it can grow.
Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice. I recommend you consult a qualified financial advisor to make investment decisions.
Saving is the extra money we are left with after meeting our expenses from our income. It is the difference between our total income and our total expenditures.
There are several things we can do with that extra money. We can either leave it at home (the worst option) or keep our extra money in a bank, such as in a savings account or invest it.
In this post, I will cover how much money we should save in a bank vs investing it to grow it.
Advantages of having a savings account in a bank
First, and foremost, we need to understand money loses its value over time because of inflation. So, even though the interest paid on a savings account is not very high, we still get some interest to compensate for loss happening from inflation. Thus, it is certainly better than keeping it in your house, as you don’t earn any interest when you keep it at your house and will lose its value due to inflation.
However, the best part about a savings account is that your money is safe in a bank, as most commercial banks in the US are insured by FDIC. FDIC is Federal Deposit Insurance Corporation that insures that will not lose their money if that bank goes bankrupt.
In other words, people who deposit money in a savings account protected by FDIC for up to $250,000.
So, when looking for a savings account, make sure your bank has FDIC insurance. Also, if you want to select a bank for a savings account, you should look for one that charges the minimum fee for you to hold an account.
Another important use of keeping money in a savings account is that you can withdraw it for expenses such as a down payment for a car or a house.
Get that Emergency fund established first
People also keep money in their savings accounts for emergencies. I strongly feel everyone should create an emergency fund. If something were to happen to our income, we should have at least 6 months’ worth of money to survive.
So, keeping money in a savings bank doesn’t make you rich, but it helps in creating an emergency fund and meeting some big expenditures. So before, we start investing, we should have at least 6 months’ worth of money in a savings account for emergencies.
This can change based on the size of the family and sometimes people need up to 12 months’ worth of expenses if the family size is big.
Anything after that, we should invest if we want our money to grow.
What do we mean by investing?
In finance, investing means when you invest your extra money with the hopes to grow it. The most common forms of investment are stocks, bonds, an index or a mutual fund, commodities like gold and silver, and real estate (property).
If you are interested in learning more about these options, you can check out my post here.
Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice. I recommend you consult a qualified financial advisor to make any investment decisions.
The International Monetary Fund in its latest World Economic Outlook report, published on July 26, 2022, has lowered its estimate of Economic growth for the world economies. This is a downward revision from their April 2022 projections of GDP growth rate for both 2022 and 2023. Below is the chart I took from the IMF website showing their growth projections by region.
I have tried to summarize the main points of the report for you. If you are interested in reading the full report, please click here. https://www.imf.org/en/Publications/WEO/Issues/2022/07/26/world-economic-outlook-update-july-2022
Lower GDP growth but higher inflation globally in 2022-23
The GDP of the World is now expected to grow at 3.2% this year and 2.9% next year, compared to what they had predicted in April to be 3.6% in both 2022 and 2023. While they predicted lower GDP growth across the globe, they raised their inflation estimates. The report predicts a 6.6% inflation in advanced economies and 9.5% in emerging and developing economies.
What are the main factors behind this?
The report cited various reasons for its downgrade revision. On top of the pandemic after effects, higher-than-expected inflation has been a major cause of worry worldwide, especially in the US and major European countries. This has caused the central banks of these countries to raise interest rates, making financial conditions tighter.
Additionally, China’s economic slowdown has been worse-than-expected due to its zero covid policy. This has caused longer lockdowns, affecting their exports to the major US and European economies, and causing supply chain issues. This has also led to a supply-induced inflation.
The report fears that given the current scenario, the Russian – Ukraine war could continue for long and sanctions associated with it could go up further. This will, unfortunately, cause more problems in energy and food markets’ supply.
They also ran an alternative scenario of a possibility of a full shutdown of Russian gas flows to Europe by the end of 2022. If that happens, GDP global growth might fall further to 2% next year. The report also stated that since 1970, global growth has only been lower five times, so this does look very gloomy.
What should the countries do to overcome this?
The report suggests that controlling elevated inflation should remain the priority of policymakers around the world. This requires tightening monetary policy, and many central banks have started to do that already, both in advanced economies and emerging markets.
They also noted the role of Fiscal policy is important here to protect the vulnerable population. But it is important that the fiscal policy (like in the form of subsidy or stimulus payments) should only target the weaker population and should not interfere with the overall disinflationary motive of monetary policy. Because a lot of inflation in the advanced economies was caused by this issue, where too much money was chasing too few goods. In other words, people got the money to spend, but not that many goods and services were getting made, causing excess demand and inflation.
The report concluded that policymakers must continue to work on increasing vaccination rates to protect against future outbreaks. Lastly, countries must collaborate to address climate change and speed up the green transition to avoid their dependence on oil.
Please let me know in the comment section your feedback on what topics you would like me to write about.
Ending their two-day meeting, the Fed (central bank of the US) has once again raised interest rates. The reason for the hike is to control inflation. The United States Congress has given the Fed a dual responsibility – to achieve maximum employment and keep inflation around the rate of 2% over the longer run.
The average consumer in the US has been feeling the burden of rising prices, especially since the start of this year, esp. in gas, housing (including rental), and food prices. The Consumer Price Index, which measures inflation in the US has been at an elevated level for quite some time. In their press release, as of July 13, 2022, the BLS published inflation at 9.1%.
How does the interest rate affect inflation?
Going back to today’s news, let’s understand how the interest rate mechanism works. The FOMC (Federal open markets committee) is responsible for determining the federal funds ratetarget range. This is the rate at which banks borrow from each other. The Fed doesn’t set this rate, but market forces determine it.
The reason this rate is very important to us is through its linkages to other rates. This federal funds rate impacts all the other interest rates such as on credit cards, housing, auto, and education loans.
How much did Fed raise interest rates?
In today’s meeting, the Federal open market committee decided to raise the target range for the federal funds rate from 2.25% to 2.5%. This increase has moved the Federal funds rate to its highest level since December 2018. During their June 13, 2022 meeting, they increased the target range for the Federal funds rate to be 1.25% – 1.75%. You can see the graph of this rate over time here.
So how does the Fed steer the federal funds rate?
It uses “interest on reserves balance” as its main monetary policy tool for that. To understand it better, you can read my article here, which explains this in detail. When the Federal funds rate (borrowing costs of banks) is high, banks will pass on these added costs to their final consumers. These consumers include people like you and me, and businesses.
In a nutshell
The main idea behind this repeated increase in the interest rate is that expensive loans will discourage people from spending. When the cost of borrowing (interest rate) is high, general consumers (households) borrow less for a big purchase such as a car or a house. Similarly, businesses also invest less in the expansion of their plant, inventories, machinery, buildings, etc. All of this will reduce the demand for goods and services these businesses make and they will also hire fewer workers. And when the excess (increased) demand is lower, the prices will eventually start falling, which will control high inflation. Thus, interest rate hikes are the Fed’s main tool to control inflation.
Inflation happens because of strong consumer demand, which supply can’t match. Supply bottlenecks with China during the Covid pandemic, Ukraine war, etc have all contributed to a weaker supply of many essential items we use every day. Since many of the supply chain issues will take a long time to fix, the Fed is trying to control the demand aspect of inflation. By raising interest rates, and making borrowing more expensive, the Fed is hoping to weaken Americans’ willingness to spend money and ultimately bring inflation close to its 2% target level.
Today, I explain some of the most widely used macroeconomic terms relating to a country’s economic performance. These are the terms we often read in the news, so we need to understand what they are and how they affect us. My list is not comprehensive, but I feel it is a good start. In my future posts on Economic Glossary, I will be explaining the meaning of some other important economic terms, so please stay tuned for that. For now, let me explain the ones that are coming to my mind as I type.
Interest rate: Itis the cost of borrowing money or the return we get from saving our money. By changing interest rates, the Fed (central bank) can influence economic growth. Low-interest rates encourage spending and investments and make the economy grow. On the other hand, rising interest makes loans more expensive and lowers investment. This reduces firms’ hiring, employment, and thus total demand in the economy and can lower both inflation and GDP growth.
GDP: It measures the size of the economy. It is the market value of everything (final goods and services) produced in a country, whether it is made by its citizens and companies or by the rest of the world. Market value is how much we pay for something, such as the market price for that bread we eat or the plumbing service we get. The US GDP number is published every quarter to see its trend. Economists at the U.S. Bureau of Economic Analysis estimate GDP by using a lot of data gathered by other federal agencies and private data collectors. As of Q1, 2022, the US Real GDP was $19.7 trillion. The US is the number one economy in the world when measured by real GDP.
GDP Per capita is the GDP divided by the total population. It shows the standard of living of its people and this number is published once a year. Real GDP is the GDP at constant price or base year prices. This measure removes the effect of rising prices on GDP. GDP growth rate is a % measure that calculates real GDP growth as compared to the previous quarter or the previous year. This could be a positive or negative % depending on an increase or decrease in real GDP. To know more about US GDP growth, click here.
Recession: A recession is a significant fall in the economic activity of an economy. It is mostly seen as a decrease in income and employment. During a recession, there is a significant drop in consumer spending. Some businesses can go bankrupt, people out of school don’t find good jobs and people might lose their homes when housing prices fall. If you want the exact definition of recession or expansion in the US, here’s a good source https://www.nber.org/business-cycle-dating-procedure-frequently-asked-questions
Inflation: The inflation rate is a sustained rise in the average price level during a specified period, usually a month or a year. It is calculated as a % increase or decrease in prices from the previous period. Inflation exists when prices increase but our purchasing power reduces over some time. As seen in my post here, demand, supply, and future expectations about inflation affect inflation.
US Government and the Fed both measure and publish inflation numbers every month. They use CPI and PCE respectively for measuring inflation. Sometimes, the CPI can give us misleading information because it includes food and oil/gas prices. These numbers are usually more volatile. The core inflation rate excludes food and energy prices and thus is a better measure of the inflation rate. The Personal Consumption Expenditures price index is another measure of inflation. It includes more business goods and services than the CPI. For example, health care services paid for by health insurance companies are part of PCE and not CPI.
Unemployment rate. Every country sets a target unemployment rate that it seeks to achieve. In most advanced economies it is a lower % compared to developing economies. In the US, The BLS publishes this % every month. The Fed aims to keep the unemployment rate around 4%. The unemployment rate represents the number of unemployed people as a percentage of the labor force. People in the labor force include people 16 years of age and older, who are either employed (have a job) or unemployed (those who have looked for a job in the past 4 weeks but couldn’t get one).
As of June 2022, the unemployment rate in the US was 3.6%. The total number of unemployed persons was 5.9 million.
Monetary policy or the Fed: Federal Reserve is the central bank of the U.S. The Fed performs many important functions such as supervising the nation’s commercial banks, conducting monetary policy and providing financial services to the U.S. government. It also promotes the financial system’s stability by taking measures to prevent crises like recession and bank failures.
The Fed is not just one bank but consists of 3 main components.
Seven Board of governors guide the entire monetary policy and set the discount rates for member banks
12 regional federal reserve banks are located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St, Louis, and San Francisco.
FOMC, the Federal open market committee. It meets eight times a year and makes decisions that help promote the health of the U.S. economy and the stability of the U.S. financial system.
The Fed is an independent entity and is not affected by U.S. politics. Congress has given Fed a dual mandate of stable inflation and maximum employment. The Fed tries to keep prices stable with a long-term 2% inflation target and also promotes maximum employment. Please see my detailed post on how Fed in the US uses its monetary policy tools to keep inflation in the target range.
Fiscal policy : Fiscal policy is the term used to describe the spending and taxation decisions of a government that can influence an economy. For example, the government can lower taxes and raise spending to boost the economy when needed. Governments often spend on infrastructure projects to create jobs and grow income to take the economy out of a recession.
Similarly, the Fed increases business investment and spending by lowering interest rates. In a boom situation, when the economy is overheating with high inflation and very low unemployment, they do the opposite. The government reduces its spending and raises taxes. Alternatively or in addition, the Fed raises the federal funds rate which in turn increases all the other interest rates in an economy and thereby puts a break on overall economic activity. Thus, either fiscal or monetary policy or both can be used to expand or contract the economy.
If you like my posts or think I can do better, please provide your feedback in the comment section below. I will be happy to research and write about any topics you might be interested in learning more about. Thank you!
These are all examples of externalities. Sorry, if this sounds too complicated at the beginning, it will all make sense as you read along. Externalities can happen when the after-effects of certain actions can spill over to other people not directly involved in it. These could be either positive or negative spillovers.
Externalities can arise between producers, between consumers or between consumers and producers. Externalities can be negative when the action of one party imposes costs on another, or positive when the action of one party benefits another.
Let’s look at an example of a positive externality. Vaccination for any infectious disease would be a positive externality because vaccination will reduce the overall severity, symptoms, and thus the possibility of spread of infection of that particular disease. This will also benefit people who are not vaccinated through positive spill overs by others who are. People who didn’t receive the vaccine are less likely to get an infection if more and more people around them are vaccinated. Vaccination also reduces the burden on a country’s healthcare and benefits society. Most recent example of this is the Covid 19 vaccine, which was provided mainly by the government in many countries to stop the spread of infection.
In both positive or negative externalities, government intervention is required to make sure the businesses that create externalities get the benefits for positive externalities or pay the price for negative externalities.
If a factory is producing toys but at the same time polluting the environment, people are bearing the cost of pollution. This is a negative externality. From an economic perspective, the business is transferring some of its cost of production to society. Without any tax on pollution, that business factory’s actual cost of production is less than what it should be, so it can charge lower prices from the people for the toys it produces. This reduced price creates more demand for toys, making the business produce more and more toys and thus polluting the air more.
In our first example above, the factory will find ways to reduce its chimney smoke from polluting air if it has to pay the price for its pollution. Government can impose taxes in these cases. Tax will also increase the overall cost of production for the business. The business will be forced to charge higher prices from the consumers, which will, in turn, reduce the demand for it and the over-pollution problem will be solved to some extent. Similarly, water pollution that is caused by industrial effluents can harm ocean life, other plants, animals, and humans. The government imposing a tax on factories creating water pollution can limit it to some extent. In economics, the use of tax to limit negative spillovers is known as internalizing the externality.
Another type of negative externality is caused by smoking. The government wants to discourage smoking and thus impose heavy duties and taxes on cigarette manufacturers because active or passive smoking both are harmful to society. Thus, cigarettes sell at a fairly expensive price. People who can’t afford to buy can refrain from consuming it. Also, smoking is banned in public places and to minors, these are all attempts to reduce the consumption of smoke.
Similarly, to encourage businesses with positive externalities, government can provide subsidies to those producers. When producers get subsidy it lowers their cost of production and it encourages them to produce more. Also, the subsidy is a government expenditure, which government meets through taxation on general public. This taxation on general public is either form of direct tax (like income tax) or indirect taxes (like those paid on goods and services when we buy them.) Thus, the society who is reaping the fruits of a positive externalities ultimately ends up paying the price of subsidy.
One example of this is public (government funded) education, when the government subsidizes public education, a greater quantity of education (more schools and colleges) is made and the society as a whole reaps the spillover benefits of more educated people. Also, parks, the police force, and public hospitals provided by the government provide benefits to any person who lives in the neighborhood. These are called public goods with positive externalities that are nonexcludable and benefit the larger public who indirectly pay for them through taxation.
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.
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.
