Guess who’s back…back again…Mr. Nahas is back…tell a friend! I’m excited to back with today’s topic – Economics. I think understanding even a basic level of economics will really help you become more money conscious and help you understand what is happening around us. Economics is all around us whether we notice it or not, and it’s important to understand how it works, so that you are able to take advantage of it. Formally, Economics is defined as the study of scarcity and how to efficiently and effectively allocate scarce resources to people and the world as a whole for production, distribution, and consumption. What I mean by this is that even with advanced technology today, our resources are still finite, and we must decide how to allocate them efficiently. There are a number of ways to do so, for example, supply and demand drive who gets what in the market. There are so many topics and interesting things that economics has to offer; I love it. Today, I wanted to focus on basic topics that relate to personal finance in a way. The topics we will discuss today are: Inflation, Supply and Demand, and Interest Rates. Let’s get it started kids!
I dub this guy the silent robber. He comes in, steals some of your money, and leaves and the funny part is that it keeps happening year after year. You won’t even know how or why he is stealing your hard-earned money unless you understand the concept. That is why it is so important for you to comprehend what inflation is and how to combat it. Inflation is the general rise in the price of goods and services over time as illustrated by the picture below.
As you see in the example above, a $20 bill in 1998 would get you a lot more than in 2005, and in 2005, you would get more with the bill than in 2013 and in 2013, you would get more goods than in 2020. As inflation rises, the general prices rise as well, thus, limiting how far that hard earned $20 goes, we call this purchasing power. Purchasing power is the amount of goods and services that can be purchased with a unit of currency. Your purchasing power is decreasing over time as inflation rises, limiting the amount of goods and services you can buy with the same bill. Mr. Nahas, what causes inflation? Good question! Some of the main factors that cause inflation are illustrated in the picture below.
Another important cause not illustrated in the picture above is Built-in Inflation, which is caused by past events. So, as prices rise for goods and services due to the other factors, people expect that their wages to rise in order to keep up with the cost of living. I hope that you see the dilemma here. Prices rise because of an increase in the cost of raw materials, which then forces the company to increase the cost of the products and as the cost of products rise, people then expect their wages to rise as well to keep up with those prices but then if wages rise, the cost of production will increase, thus, forcing the company to raise prices. It goes on and on and, we didn’t even introduce the other factors such as money and credit, which greatly affect inflation. So, the average inflation rate or the target inflation rate is about 2% a year. Mr. Nahas, I got a raise from my job that exceeds the inflation rate, aren’t I keeping up with inflation? Well, technically, yes because your current pay is keeping up BUT your savings account isn’t. When you save, you are putting purchasing power of the year you saved the money in into the bank for later use, but as we just explained, inflation decreases your purchasing power over time, so that means you are losing money year over year in your savings account because of inflation. Mr. Nahas, how do I stop this? I love the questions; the class seems to be active today! The last post is a great example of a way to combat inflation from the individual’s point of view– index fund ETFs! Index funds are great tools to not only build wealth over time but to also fight off inflation. Real estate is also a great way, assuming that you purchase it at a fair price. Inflation actually works in favor of real estate because the price of the property will rise. From the individual’s standpoint, investing in appreciating assets is essential to fighting off inflation, not only will you stop inflation from eating into your net worth, but you will accumulate wealth by investing. Now, it is important to have cash on hand for unforeseen circumstances like the world we live in today or for investment opportunities that we are seeing today as well. Now, on the other hand, A LIMITED amount of inflation is a good thing. But Mr. Nahas, you said that inflation robs you of your wealth, how can it be good? Well, a little amount of inflation is good because it means our economy is growing as a whole, a small amount of inflation like 1%-2% is seen as healthy. The problem arises when it gets out of hand.
Supply and Demand:
Supply and Demand is essential; it’s prevalent in our lives today and is an important topic to cover. Demand can be summarized as what people want and are willing to consume at a given price. Supply can be defined as what people have and are willing to sell at a given price.
Supply and Demand affect the prices of goods and services; it even affects prices of investments like stocks and real estate. Before we start with the curves, I wanted to note the difference between Supply and Demand vs Quantity Supplied and Quantity Demanded. Supply and Demand refers to the curve as whole while Quantity Supplied and Quantity Demanded refers to a single point on their respective curves. Now, let’s begin with the demand curve. You see that it is downward sloping, which means there is an inverse relationship between quantity demanded and price. As quantity demanded increases, the price goes down and vice versa. The supply curve is upward sloping, which means there is a positive relationship between quantity supplied and price. As quantity supplied increases, so does the price. The optimal quantity and price is when the two curves intersect; this is called equilibrium. There is a difference in moving along the curve and a shift in the curve. A change in price causes movement along the curves, not a shift as you see in the graph above. A shortage as you see above is when the quantity demanded exceeds the quantity supplied. A surplus is when the quantity supplied exceeds the quantity demanded. A shift in one of the curves will produce a new equilibrium. A shift in the curves occurs when the quantity demanded, or quantity supplied changes while the price stays constant, and this can happen for a number of reasons. The result of a shift in one of the curves will change the equilibrium as you see below.
As you see in each of the examples above, a new optimal price and quantity is generated, which results in a new equilibrium. Examples of a shift in the demand curve would be if the income of consumers changed or if the price of a related good changes (Example: Coke is now more expensive than Pepsi). An example of a change in supply would be a change in the cost of production. A great example of supply and demand is the stock market. The price fluctuates based on the number of buyers and sellers. The same applies to real estate market. Entrepreneurs have made money by finding where the consumer demand is and supplying the good or service to the market. The guy who made silly bandz made millions of dollars off of animal shaped rubber bands. It doesn’t have to be the next Microsoft or the next “big thing.” It could be simple; it just needs to be demanded by consumers and supplied by you.
This is an important topic in the realm of economics and finance. Interest is the cost of borrowing money and is usually expressed as a percentage of the money borrowed. For example, let’s say that I need a new car, but I don’t have the whole cost of the car in cash, in this case, I have to go to the bank and apply for a loan. The cost of using the bank’s money is interest. The higher the interest rate, the more it costs to borrow money. When it comes to borrowing, it’s important to know how the interest is applied, whether it’s simple interest or compound interest. Simple Interest is the principal (P) multiplied by the interest rate (r) and the term of the loan (T). The formula is A = Prt where A is the final amount. For example, I borrow $100 at a 10% interest rate for one year. After that year is over, I pay the $100 in principal back and pay an extra $10 in interest as the cost of borrowing. Compound interest on the other hand is the calculation of the principal and the interest from the previous periods. It’s basically paying the interest on the interest if that makes sense. The formula A = P (1 + r/n) ^nt where n is the number of times interest is applied per time period. Let’s use the same example above. I borrow $100 at a 10% interest rate compounded monthly for one year. After one year, I pay back around $100.47. Mr. Nahas, the extra $0.47 is not a lot. Yes, I know. Compounding interest takes time to show its true colors. Let’s do the same example but extend the time frame to 6 years. At the end of the 6 years, you would pay $160, $100 principal and $60 in simple interest. At the end of the compounding interest rate example, you would pay a total of $181.76, $100 in principal and $81.79 in interest. The simple interest formula for that example would be A = $100 * .10(interest rate expressed as a decimal in this formula) * 6 years and A would equal $160. For the compound interest example would be A = $100 (1 + 0.10/12) ^12*6 where 12 is the number of times interests is compounded (12 would be for each month of the year). 1 would be annually, 2 semi-annually, 12 is monthly, and 365 for compounding daily. This also works for investing that has compound interest. The rule of thumb is you want to pay simple interest but receive compound interest. Mr. Nahas, how is the interest rate determined? Great question! Technically, your bank determines the interest rate for consumers like us, however, the central bank (Federal Reserve in the United States) sets interest rates that corresponds to certain policies (we will get into this in another post). I don’t want to dive in too deep but just know that the central bank sets the interest rate, it applies to the commercial banks and corporations and then the commercial banks set the interest rate for you based on your credit score. When interest rates are low, investing in real estate or starting a business is enticing because the cost of the loan would be lower than usual; it would be better to invest the cash rather than leave it sitting in the bank account. When interest rates are high, investing in real estate becomes more expensive and it discourages some investors to invest in real estate and entices them to either leave the money in cash or invest in stocks and bonds. Although, even if the rate is high, if you find an amazing deal, you should invest and when interest rates go down, refinance it. Interest rates can dictate where the best place to put our money is.
This is a lot of economics information to take in; I know but it’s crucial to know important concepts in economics because in one way or another, it can change the way you live and how you decide to use your money. Finance and Economics are like Yin and Yang; you can’t have one without the other. As always, if you have any questions, please feel free to ask! Until next time kids!
P.S – I would love to collaborate with other bloggers on posts about personal finance whether we are in the same niche or not! Just let me know!