Everyone can remember when they sat down with their grandpa and said he could buy a can of soda for 5 cents. This is a simple example of inflation.
Why does the government inflate the money? The Federal Reserve inflates the money, because it allows them to protect the country from deep recession and depression. However, it also serves as an indirect form of taxation. Basically, inflation occurs, because the Federal Government increases the supply of money.
It’s 2012 and a kid named David loves milk, so he does some chores to earn money to buy milk. David works for his parents by taking out the trash which costs $4. Money is nothing more than a symbol of work performed. David performs work; his parents give him money. He takes that symbol of work performed which is $4 and goes to the super market and buys milk.
David performed the work in 2012, but what if he waited until 2013 to buy milk? The cost of milk in 2013 is now $4.12.He still performed the same amount of work paid at $4, but with $4 in 2013, he couldn’t buy milk anymore because within one year, it has increased $4.12.That was because of inflation. What caused the price of the milk to go from $4 to $4.12?
Look at this other demonstration. Here are 4 people in year 2012 who symbolically represent all the people across our entire country. The federal government puts $1000 into the system of people who are working, and that $1000 is what they have to use to trade amongst each other. Remember, money is just a symbol of their work. They can trade it amongst each other. As they continue to trade that $1000, the value of each dollar is dependent on what that person might need whether it’s food, clothes, transportation, etc.
Now it’s year 2013. There is a change of curve. Instead of putting $1000 between these 4 people, the Federal Government put $1200 between them. Same number of people, different supply of money, which is the symbol of the work they’re performing. Since they’re working and there’s money in the system, the value charged for services or products they create is higher. Are understanding inflation more?
Going back to 2012, whenever there is $1000 in the system, one of these people could buy milk for$4, but since there’s $1200 in 2013, money increased. People could now buy milk for $4.12. Whatever the case might be, it’s a higher cost, because it’s relative that everybody in the system didn’t change in population, but the money supply did. Inflation, indeed.
The FED is controlling and just gradually increasing the amount of money in the system, and that’s how inflation occurs. How does the FED control that? There are many different ways. They can physically print more money, but the most common way is through banks.
The FED sets the Reserve Ratio. The Reserve Ratio is the portion (expressed as a percent) of depositors’ balances banks must have on hand as cash. In this scene, the Reserve Ratio is 20%. William takes $1000 and saves it into bank. The bank then puts it into his digital account, which he checks into his computer. The bank takes the money, and they now have the ability to lend it to somebody else.
What a lot of people don’t realize is that the bank based on that Reserve Ratio, that’s how much money they’re allowed to lend out from the money they have received. Since the bank received $1000 from William, they have to keep $200 and they can lend out another $800. When the bank lends out that $800 to a woman named Anne, she saves the $800 into another bank. Based on the rules, the second bank where Anne has gone to holds 20% of that $800 which is $160. They have the power to lend $540. Remember, we only started with $1000 we already have another $800 in the system. The bank can lend out the $540 to another customer named John. John saves $540 to another bank, so again, the bank has to keep 20% which is $108 on hand and can lend $432 until the next person comes along. The process goes on and one and on – a contribution to inflation.
As the process continues on, $1000 initially saved in the system actually turns into $5000. Take 1 divided by the reserve ratio. That will give you the actual amount that you need to multiply the based amount of money by. Let’s take 1 divided by the .2 (the 20%), that gives you a five. You multiply 5 times 1000 and that gives you 5000. That’s how it is calculated.
What happens when that ratio changes? What would happen if the reserve ratio is 10%? Go through that whole scene again. When a person buys $1000 at 10%, the Reserve Ratio would actually turn into $10000. Take 1 divided by .1 (the 10%) that gives us 10. 10 times 1000 gives us 10000. When the FED adjusted the Reserve Ratio from 20% to 10%, they just created another $5000 in the system. That’s just if it’s $1000, but realistically speaking, there’s a lot more money going in and out of the bank. The FED can quickly adjust how much money is in the system just by adjusting the Reserve Ratio, and this is just one way the FED causes inflation.
As investors, you need to know how inflation of money affects your investment. When the FED adjusts the rates, they inflate the money more. How does that affect the bonds and stocks?
How does inflation impact your bonds? Dan lends $1000 to Alice, and Alice is basically selling Dan a bond for $1000. The coupon on that bond is 5%. Assume that this bond is a one-year bond to easily spot the impact of inflation. $1000 to Alice and Alice has to give that back after one year. She has to pay 5% on it. During that year from 2012 to 2013, 5% inflation occurs during the time frame. 2013 comes along and Amy has to return Dan’s $1000. She also has to pay him a 50-dollar coupon which is the 5% interest on that $1000. Therefore, Dan has $1050 in 2013. However, due to the 5% inflation, $1000 in 2012 money is actually equal to $1050 in 2013 money. Those two numbers are equal. Even though Dan thinkks he made $50, he actually made no money, because his buying power is exactly the same in 2013 as it was back in 2012. How does inflation impact bonds? It drastically impacts bonds.
To see what the actual yield is, bond yield minus inflation rate equals actual bond yield. In the last scene, the bond yield was 5%, but the inflation rate was also 5%. Therefore, the actual bond yield is 0%. Now a caveat to this is called TIPS – Treasury Inflated Protected Security.
How does inflation impact stocks? Dan buys ownership of apple at $1000 worth of share. During his ownership in 2012 to 2013, the same 5% inflation occurs.
Now looking from Apple’s standpoint, in 2012, the cost of material is $100. Their sales price, the price they sell their product, is $200. By the way, these are just numbers I’m coming up. It costs them a $100 to make a product and they sell it for $200. Their net income is $100.
Looking at year 2013, because of the 5% inflation, the cost of material went up by 5% and it costs now $105 to buy their materials. Because of that increasing cost, they’re now able to go ahead and sell their product to a higher price, because there’s more money in the system. People can afford that, because there’s more money. They translate that cost over to their customers instead of themselves. Their sales price now becomes $210 – a 5% increase. Subtract the price from the material to get a net income of $105 (which is a 5% increase). From 2012 to 2013, Apple automatically adjusts because the cost for them to do business increased by 5%. They translate that cost over to their customer which gives a price increase of 5%. Their net income was raised by 5%.
In 2012, Dan bought ownership of Apple, and it was trading in a multiple of the earnings, which the net income was $100. He purchased his shares for 10 x the earnings, which is $1000. Looking at the 2013 numbers, Dan’s shares are now worth $1050 if the multiple was exactly the same. His shares automatically adjusted with inflation, because the net income increased the $105. The value of Dan’s business (Apple) actually maintained its value with inflation. But remember, the net income of $105 was also paid to him either as a dividend or equity back into the company’s account.
Again, how does inflation impact stocks? As resolve, stocks with no debt are generally unaffected. If inflation moves the price point of a product outside of the market’s desire, inflation will impact a stock’s performance. Generally speaking, stocks are not really affected all that much by inflation like bonds are.
In this lesson, students learned about the impacts of inflation. By understanding what causes inflation, we can then understand how it destroys the yield of a loan and sustains the value of corporate ownership.
We learned that inflation is generally caused when the government increases the supply of money in the financial system. When this occurs, members of the system have more money to spend and the price of goods and services go up.
This increase in price can drastically destroy a long term investment if the investor doesn’t account for the compounding inflation rate.
The most important thing you can learn from this lesson are the two following points:
- Bonds are completely affected by inflation.
- Stocks are not necessarily affected by inflation.