Basic Economics - Inflation, deflation, and fiscal/monetary policy
Let's start with some basic economics to get the ball rolling. Money makes the world go around. It's plan and simple and nobody has ever said any differently. With that being said, there had to be a starting point where someone had something and it had to either grow or go down. This my friends is what we call inflation and deflation.
Inflation can best be described as a loss of capital (money) that was caused by rise in general prices. In normal terms, it just means that the price of things is going up so the money you had is worth less than it once was. Imagine you just bought a six pack of soda for five bucks. A week later you find yourself at the store eyeing the same six pack of soda but now it's six bucks. You didn't do anything but your money did. The cash you have just isn't worth what it was once. You've lost purchasing power. This is important because you need to think about the amount of your dollar and how much is buys today versus what it will buy tomorrow. If you don't grow your dollar fast enough to keep up with inflation, you won't be able to survive. Enter in a savings account to save the day. You place your money in savings, it grows at a small rate, generally less than a few percent and you're going places. Easy, right? Wrong. The problem arises when your savings account doesn't pay enough interest to keep up with inflation. Your savings account may pay you even as good as a 2% interest payment every year but that might not keep up with the 3% inflation rate that the entire country feels that very same year. That sucks, right?
On the other hand, the opposite can happen. The country could move into an area of deflation. Deflation is when your dollar becomes even stronger. Where it could buy a six pack for five dollars one week, it can buy a 12-pack the next! It's important to watch the ever changing economy to track these trends and it's even more important to stay ahead of them. Generally, the economy of the USA grows at a rate of 2-3% a year. This is average and generally accepted by the government. In fact, they try to control the dollar to make sure that it's never much higher or lower than that. This means that if you want to stay ahead, you'll want to be making at least 3% a year just to keep up and stand your ground. Strictly speaking, you're probably not going to achieve that by placing your money in a savings account. This is where investing comes in but we're not quite to that topic just yet.
First we need to talk about interest rates as they can become an even bigger factor in your investing decisions than you'll ever realize. If you don't understand what an interest rate is, I'll try to shed some light on it. Suppose you need a few thousands to try to buy that awesome car you've been wanting. Chances are, you probably aren't sitting on the tens of thousands you might need. This means you've got to borrow it. The amount of money that you'll be borrowing is referred to as the principal of a loan and the cost that is charged to you in order to borrow it is called an interest rate. There's a lot of money to be made in interest for lenders. This is because lenders are giving you their hard earned money so that you can spend outside your means. With this being the case, if there are few lenders, you'll have to pay a premium to borrow their money. On the other hand, if there are too many lenders, you could get a better rate because they will be more willing to drop their rate in order to get you to borrow from them. They've got to make money. That's how profits are made. Where there is competition, you can make out like a bandit.
Before you can make out with the cash however, you have to understand what can change rates through policy and fiscal avenues. Fiscal policy is change that comes through the enactment of policies that change taxing and spending. For instance, if the economy needs a boost, lower taxes and leave more money in the pockets of Americans. They in turn can use that money to buy things and reinvest into the economy. Spending on the other hand can be done through the purchase of various articles that are produced in the country you live in to stimulate it manually. For instance, the government could buy a huge order of tanks that are manufactured by a defense contractor.
On the flip side, if you wish to attack the problem through monetary supply directly, you can simply change interest rates so that the amount of money that is being loaned out is limited or supplied readily. How would the government do this though, you ask? That's easy - they put a reserve requirement on the banks. This requires banks to have a certain amount of cash always on reserve. If the economy needs more money to be flowing through it, the reserves can be set very low so that banks can keep loaning out cash so it can be spent by the people. The reverse is true as well if it needs to be slowed. They can require more money to be held so that the people can't have the money to buy the things they need loans for.
With all of this being said, you should now have a general understanding of how interest rates work, what it means when the news says that the dollar is inflated or deflated, and where economic changes are coming from when they are changed either through fiscal or monetary policy. You're now ready to move onto the next section.
No comments:
Post a Comment