In This Fragile Economy, Leverage Your Money

As the house and senate pass the bailout bill for the countries major financial institutions, it remains important to understand the basic economics of our money system.  If more people were educated about how money works in this new age, many of our financial problems would begin to solve themselves.  Not to say that any of the failed banks are innocent; not in the least bit.  But a little dose of economics wouldn’t hurt anyone.

First off, let’s go over something everyone should understand now.  It no longer pays to save your money.  And if it does, it’s a terribly low rate.  “Well, I’m getting 3% or 4% on my high interest savings account, that’s a good rate, right?”  Wrong.  Basic economics uses the Fisher Equation to determine the real rate of return on investment, based on the nominal rate and the current inflation rate.  Sounds like nonsense, right?  Well, here’s the Wiki on the Fisher Equation, but it’s a bit confusing in its derivation.  Here’s the gist of it.

You’re interest rate, on your savings for example, is a standard rate of return for the money you leave in the bank.  That’s pretty self explanatory, and almost everyone understands that.  Here’s the tricky part.  That rate does not account for inflation.  The rate of inflation is measured by the government according to an index of common goods.  It measures the rate at which the purchasing power of your dollars changes, usually declining.

So if this year you have $100, you can get a certain amount of goods.  However, if the inflation rate is 3%, for example, then the next year you will only be able to purchase $97 worth of goods.  The inflation rate, so long as it’s a positive rate, is the rate at which your money loses purchasing power.

So the Fisher Equation, r = i − π, describes the situation created, where r represents the real rate of inflation, i represents the nominal rate, or the rate you receive, and π represents the inflation rate.  So the actual rate of return is the rate you receive minus the inflation rate. 

The inflation rate as of this article is 5.37%.  So if you are earning any less than 5.37% on your savings, you are effectively losing purchasing power by saving your money.  Your money is worth less every day.  In our example, the 3% you are receiving on your high interest savings account is actually -2.37%.  So, although by saving you are losing less that you would be losing normally, you are still losing.  The Fisher Equation applies to all areas of finance, such as mutual funds, IRA’s, etc.  If you aren’t beating the inflation rate, then you are losing money. 

So how can you solve this?  Leverage your money.  Let the banks absorb the consequences of inflation.  I don’t mean leverage with things like credit cards, that’s almost never a good idea.  I mean using banks money to purchase assets that produce money instead of losing it.  I’ll explain how in my next post.

Tags: banks economy, fisher equation, inflation, leverage, Money