Friday, October 29, 2010

Fractional reserve banking - The money multiplier

Origin of the Banking System
Prior to the 1800s, savers looking to keep their valuables in safekeeping depositories deposited gold and silver coins at goldsmiths, receiving in turn a note for their deposit . Once these notes became a trusted medium of exchange an early form of paper money was born, in the form.

As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. The goldsmiths change from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional reserve banking was born.

However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks.

The Fractional reserve banking
Fractional reserve banking is the banking practice in which a bank lends out most of the funds deposited and keeps the remaining fraction in reserve (as cash and other highly liquid assets), while simultaneously maintaining the obligation to redeem all deposits upon demand. Fractional reserve banking necessarily occurs when banks lend out funds received from deposit accounts, and is practiced by all modern commercial banks.

Repeated bank failures and financial crises led to the creation of central banks – public (government) or privately owned institutions that regulate commercial banks, impose reserve requirements, and act as lender-of-last-resort if a bank is low on liquidity. The emergence of central banks mitigated the dangers associated with fractional reserve banking.

Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled.

The money multiplier
The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio.

In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money.

For example, the reserve ratio of 10 % can be expressed as a fraction:

reserve ratio = 1 / 10 = 0.1

So then the money multiplier, will be calculated as follow:

money multiplier = 1 / 0.1 = 10

This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to. For instance, in this case, the bank can lend 90 monetary units for each 100 monetary units deposited, while keeping 10 monetary units as a reserve. Only 10% of the deposited money should be kept by the bank, and on lending these 90 monetary units to another bank, the process start over again.

In conclusion
The creation of money out of nothing by banks, allowed by the fractional reserve banking , increases the money supply of a country. According to the quantity theory of money, this larger money supply leads to more money 'chasing' the same amount of goods, which leads to a higher price level. It is the major cause of the inflation (see Inflation - Your money's worst enemy).

Since the amount kept in reserve by the bank is so small compared to the lended amount, the net effect is to artificially expand the money supply far beyond what physically exists. Today, more than 90 percent of the money in circulation is “credit” or money that originated as part of a debt transaction and exists only as numbers associated with an account.

So, what do you think about this? Please, leave your comments.

Wednesday, October 20, 2010

Deficit - What does that mean?

The Latin word deficit means deficiency and has other definitions, e.g.:

1. The general approach:
  • Inadequacy or insufficiency: a deficit in grain production.
  • A deficiency or impairment in mental or physical functioning.
  • An unfavorable condition or position; a disadvantage.

2. The financial approach:
  • The amount by which a sum of money falls short of the required or expected amount; a shortage: large budget deficits.
  • A business loss.

What Does Deficit Mean Financially
Talking in financial terms, deficit means a situation in which liabilities exceed assets, expenditures exceed income, imports exceed exports, or losses exceed profits .
A deficit is the opposite of a surplus (superavit). If a country imports more than it exports, it is said to have a trade deficit.
Primary Deficit and Total Deficit
The Primary Deficit is the result of government revenue minus expenses, excluding debts interest payments. Roughly speaking, it is the government's cash generation.

The Total Deficit is equivalent to raising taxes minus expenses, including debt interest. It is far more complete, since the number represents the total borrowing of the public sector.
Trade Deficit
The Trade Deficit — the excess of imports over exports — has a direct and serious effect on the value of country money. As long a country continue having big trade deficits, it means spending more money outside the country than making at home.
For instance, If your family spends $3,000 for every $1,500 you bring home, something eventually gives way.
So, likewise, If the government's deficit wasn't well managed it might lead to catastrophic consequences.
The government deficit is good or bad?
If the government borrows (runs a deficit) to deal with a severe recession (or depression), to help self-defense, or spends on public investment (in infrastructure, education etc.), the vast majority of economists would agree that the deficit is bearable, beneficial, and even necessary.
On the other hand, if the deficit finances wasteful expenditure or current consumption, most would recommend tax cuts to stimulate private investment as a way to balance the budget.

United States deficit or surplus percentage 1901 to 2006
The Deficit Snowball
Each year, the deficit is added to the government debt. The Treasury, to raise the money to cover the deficit, must sell Treasury bonds.
Treasury bonds are a marketable, fixed-interest government debt security that make interest payments semi-annually.
This is known as the public debt, since these bonds are sold to the public.

The government debit, plus the interest rates, should be paid someday and the taxpayers will do so. They will have to pay higher taxes to pay the interest on the debt.
Treasury bonds mean the taxpayer's promise to pay the bills. If there's too much debt, the taxpayers might become incapable to do so and this will lead to the bankruptcy.
In conclusion
Deficit is not necessarily good or bad!
Deficit intrinsically implies in debt, and debt is like double-edged sword. It can either save you or hurt you.

The real challenge is learning how to deem which debt makes sense and which does not, and, then, wisely managing the money you do borrow. Avoiding debt isn't always smart because it could mean cleaning out your precious cash reserves if an emergency arises.

Tuesday, October 19, 2010

How inflation erodes your investments

What is Inflation?
The economic concept of inflation can be defined as the devaluation of the currency that causes a rise in the general level of prices of goods and services in an economy over a period of time (see Inflation - Your money's worst enemy).

Due to the huge inflation, the Zimbabwe's bill below can not even buy a donut!

How can Inflation affect me?
The rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss in spending power over time. Inflation also tells investors exactly how much of a return (%) their investments need to make for them to not to lose money on an investment

Suppose you can buy a good for $10 today and inflation rate is 5% an year. Theoretically, 5% inflation means that next year the same good will cost 5% more, or $10.50.

Regarding your investments, if the inflation rate it's not considered, your rate of return is a nominal rate of return and not the real rate of return.

The Real Rate Of Return is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects. This method expresses the nominal rate of return in real terms, which keeps the purchasing power of a given level of capital constant over time.

For example, if you invest in a fund that pays you interest of 5% per year and the inflation rate is currently 3% per year, then the real return on your savings today would be 2%. In other words, even though the nominal rate of return on your savings is 5%, the real rate of return is only 2%, which means that the real value of your savings only increases by 2% during a one-year period.

Let's follow the example:

You could calculate the return from $10,000 invested at a nominal interest rate of 10%, with a real interest rate of 7%, accounting for inflation, for 20 years with interest compounded annually, using this formula:

Future value (FV) = 10,000 x (1 + rate of return) ^ period of time

Using the nominal rate of return you'll get:

FV = 10,000 x (1 + 0.1) ^ 20 = 67.275,00

Using the real rate of return, i.e. accounting inflation, you'll get:

FV = 10,000 x (1 + 0.07) ^ 20 = 38.697,00

A very meaningful difference, isn’t it? So, whenever choosing investments it would be wise to always consider inflation and determining the real return rate your investment will have.

In conclusion
If the inflation rate is significant, your investments return rates will be smaller than the announced nominal interest rates. Savers will lose out if nominal interest rates are lower than inflation rate.

As inflation erodes your investments, you should consider it when decide between investments options since there is a meaningful difference between real and nominal return rates!

Monday, October 11, 2010

Inflation - Your money's worst enemy

What is Inflation?
The economic concept of inflation can be defined as the devaluation of the currency that causes a rise in the general level of prices of goods and services in an economy over a period of time.
The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods.

When the currency devaluates, the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy (the currency).

With the prices rising, a currency bill buys less each year; in other words, when inflation is present, your money is worth less and less...

The magnitude of inflation - the inflation rate - is usually reported as the annualized percentage growth of some broad index of money prices.

United States historical inflation rate

How Inflation works?
Increases in the quantity of money or in the overall money supply (or debasement of the means of exchange) have occurred in many different societies throughout history, changing with different forms of money used.

For instance, when gold was used as currency (see The Gold Standard - Money versus Currency), the government could collect gold coins, melt them down, mix them with other metals such as silver, copper or lead, and reissue them at the same nominal value. By doing this, the government could issue more coins without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the consequence is inflation.

This practice would increase the money supply but at the same time the relative value of each coin would be lowered. As the relative value of the coins becomes less, consumers would need to give more coins in exchange for the same goods and services as before. These goods and services would experience a price increase as the value of each coin is reduced.

The adoption of fiat currency (paper money) (see The Gold Standard - Money versus Currency) by many countries, from the 18th century onwards, made much larger variations in the supply of money possible. Since then, huge increases in the supply of paper money have taken place in a number of countries, producing hyperinflations - episodes of extreme inflation rates much higher than those observed in earlier periods of commodity money. The hyperinflation suffered by the Weimar Republic of Germany is a notable example.
How you are affected by inflation?
It is a fact of life that people often confuse nominal and real values in their everyday lives because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income.

Your investments could be seriously affected by the inflation (see How inflation erodes your investments). Savers will lose out if nominal interest rates are lower than inflation – leading to negative real interest rates. For example a saver might receive a 3% nominal rate of interest on his deposit account, but if the annual rate of inflation is 5%, then the real rate of interest on savings is -2%.
In conclusion
Inflation is entirely and only due to an increase in the money supply in the economy and the prices will rise as an inevitable consequence of inflation.

The main consequences of high inflation are:
  • Increase in the cost of living;
  • Low levels of domestic and foreign investments due to the economic and political instability;
  • Savings will be discouraged since the real value of savings declines;
  • Long-term investments will be discouraged;
  • Real wages fall sharply;

Thursday, October 7, 2010

The Gold Standard - Money versus Currency

Before money shows up
Since the beginning, our society felt the need of a way to exchange resources. The Barter probably was the first founded solution to exchange of resources or services for mutual advantage.

From 9000-6000 B.C., livestock was often used as an unit of exchange. Later, as agriculture developed, people used crops for barter.

Bartering has several problems, most notably the coincidence of wants problem. If a wheat farmer needs what a fruit farmer produces, a direct swap is impossible as seasonal fruit would spoil before the grain harvest. A solution is to trade fruit for wheat indirectly through a third, "intermediate", commodity, this way, the intermediate commodity money makes the market more liquid.

The writing, invented in Mesopotamia about 3100 B.C., had its main use, and probable motivation for its development, for keeping accounts of the exchanges made between people.

Stamped money
The first stamped Money was an Electrum (naturally occurring alloy of gold and silver) stater of a lion's head, coined at area of Lydia, and date about 610 - 560 B.C.

Although gold and silver were commonly used to mint coins, other metals could be used. For instance, ancient Sparta minted coins from iron to discourage its citizens from engaging in foreign trade.

An important effect of coins was that governments now controlled the release of money into the market. They could also manipulate the money supply. This was done by various Roman emperors, who would reduce the precious metal content of Roman coins when they needed money.

The birth of Banking
The Banking concept was originated in Babylonia about 3000 B.C., due the activities of temples and palaces which provided safe places for the storage of valuables.

By the sixteenth century a new form of money had appeared. Instead of taking the form of gold or silver coins, the new money comprised promises written on pieces of paper.

The money changers of the time were the goldsmiths, they had the premises and equipment necessary for working with precious metals. So began the practice of storing gold for other people, a service for which the goldsmith would charge a fee; the foundation of our modern banking system.

The Gold Standard
The Gold Standard is a monetary system in which the standard economic unit of account is a fixed weight of gold.
Under this kind of system, the money is said to be "backed by gold" and national money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price.

After the extinction of the gold standard, the governments could print as much money as it wanted because the money was no longer regulated by gold, thereby making it a Currency, and there is a huge difference between money and currency.

The Fiat money
Enters the scene the Fiat money. Fiat money refers to money that is not backed by reserves of another commodity.

The term derives from the Latin fiat, meaning "let it be done", as the money is established by government decree. Where fiat money (money that is intrinsically useless; is used only as a medium of exchange) is used as currency, the term fiat currency is used. Today, most national currencies are fiat currencies, including the US dollar, the euro and all other reserve currencies, and have been since the Nixon Shock of 1971.

Almost every country is on a system of fiat money. The value of money is set by the supply and demand for money and for other goods and services in the economy. The prices for those goods and services, including gold and silver, are allowed to fluctuate based on market forces.

So the government is free to produce their own money in any amount desired. When government produces money more rapidly than economic growth, the money supply overtakes economic value. This drives to a economic phenomena called Inflation (see How inflation erodes your investments).

Therefore, it is not surprising that the intrinsic value of gold has risen so much since then, as we can see below:

In conclusion
Money have a real intrinsic value, i.e., can be exchanged, at any time, by the commodity by which it is backed - such as gold, silver or precious stones.

Currency, that have no real value, is a form commonly acceptable as a medium of exchange. Since it is not backed by anything, its value is based in its ability to be circulated or be accepted by people.