Getting even with Inflation

Getting even with Inflation

Let us get to briefly know the terms- Saver,Borrower and Investor.

Saver, like many of us, saves now to consume at a later date, when he may not have an income to meet his various needs. Hence, he saves for the rainy day.

Borrower, on the other hand, spends more than his means allow at a given point of time. He hopes that he will earn enough in future, when he will not only repay his creditor(s) but will also have enough money left to spend on food and other necessities.

Investor is the person with a glint in his eyes. He invests in a business that is essential to us all. He hopes to sell his products year after year. Of course, we figured out that he is the one who takes the big bets.

Interestingly, all of us keep switching roles from Saver to Borrower or even Investor.

We have made another discovery - the 'purchasing power of money' declines with time, thanks to the monster called Inflation.

Interestingly, Inflation bares its fangs only at Saver. It is a saviour of Borrower and a boon to Investor.

We have also learnt an important lesson: Investing is a good way to offset Inflation.

After understanding all this, we stopped ourselves to ask if it is worth saving.

We realised that something was missing from the picture.

And then, a bolt from the blue told us that it is 'Interest' that completes the big picture.

Question hour again
So, what is Interest? Why do we need it? How does it tilt the balance in favour of Saver?

Let’s get to the Answer
Let us first assume you have $500 to spare. You have two options as to what to do with it - you can either buy a shirt today or you can save the money and buy a shirt six months later, during Diwali. Mind you, the same shirt will cost you $550 by Diwali time. So, what do you do?

You are obviously muttering: "what a stupid question!" After all, it will make a whole lot of sense to buy the shirt now as your $500 will not be able to fetch you the same shirt six months down the line. And why save anyway?

Hold your horses while we add another twist to the options that you have.
Assume a friend of yours needs $500 urgently. He is willing to return $550 six months hence. What will you do then?

Well, if he is a very good friend you will give him the money and postpone your plan to buy a shirt. After all, you can buy the shirt once your friend returns your money.

Another twist: what if your friend promises to repay $600 (instead of $550) six months down the line?

You will lend him that $500 without any second thoughts, as you will not only be able to buy the shirt six months down the line, but also have $50 to spare.

Lessons:
1. It does not make sense to save if you have not been compensated for Inflation.
2. In order to boost your saving instinct, you need to be compensated at least for the loss of your purchasing power. That is you need to be compensated for Inflation.
In our examples, we have seen that a borrower is willing to repay a higher sum in order to compensate the lender for the loss of his purchasing power.

Some very basic arithmetic now
In the first example, you lend your friend $500 but he returns $550 six months later. That is your friend gives you $50 extra when he returns your money. In the second case, he returns $100 extra. The money that you lent him is called 'Principal'. The extra money that your friend gives is called 'Interest'.

'Interest' defined the textbook style
"Interest is the price paid for money lent by one person for the use of others." In other words, Interest is in no way different from wages that are paid as a price for the use of labour.

What is Interest Rate then?
Interest paid on principal expressed as a percentage of the principal. Hence, in our second poser, Interest Rate was 10% ($50 interest on a $500 principal). While Interest Rate in the other example was 20%.

Now we know what Interest Rate is.

The battle lines have been drawn
Interest Rate aids Saver by compensating for the ravages caused by Inflation. On the other hand, Borrower has to think twice before borrowing since he needs to pay a price.

What about Investor?

Investor now starts having second thoughts too.

He uses money to set up a business. Last time, we discovered how uncertain investing can be, as many things can go wrong with the business. However, the expected rewards (profit) offset the risk (uncertainty) and hence, Investor goes ahead.

However, now he has the option of earning Interest on his money if lends it to Borrower. Which is why he needs to make at least as much profit as he would have earned as Interest if he had given the money to Borrower.

The cycle is complete now.

When Inflation rises, Borrower and Investor have a distinct advantage.

Borrower rushes to borrow more to spend now while Investor smells higher profit from its business. Saver knows that he is at the receiving end and insists on higher Interest Rate, reestablishing the balance.

Pack up time
We have learnt how Interest swings the balance of power back in Saver's favour. Interest induces saving.

Time value of money

Time value of money

We have three friends - Saver, Borrower and Investor and their tryst with Inflation?

Inflation is detrimental to Saver but favourable to Borrower and Investor.

But this lop-sided scenario can't last forever. Saver can't always be the 'poor guy'. And Borrower and Investor can't benefit endlessly at his expense.

We surely know why. If things continue as they are, then all of us would want to be borrowers and investors! And nobody would bother to save!

So, the stage is set for a new character, who would balance the disequilibrium. Enter Interest, the great balancer.

Interest tilts the balance in favour of our friend Saver, thereby levelling the playing field for our three friends. But how does he do that? Saver demands interest for postponing his consumption while Borrower and Investor have to pay up Interest for using Saver's surplus.

Hence, what Saver loses owing to Inflation, he gains through Interest.
Now that we have seen how Interest restores the balance, it is time for us to move on...

Assume that your friend calls and offers you $1000. He says that you can have it either now or tomorrow. What would you choose?

Pretty simple, eh? Your voice is loud and clear as you say, "I want now."


So, why did you choose to have the $1000 NOW?
You obviously are thinking of the many things that you can do with that money. You can buy a couple CDs or a pair of new jeans or even the pair of shoes teasingly displayed at the shoe shop on the way home. After much deliberation, you decide to go for the pair of shoes. With the cash in your pocket, all you need to do now is go to the shop and buy.

However, your friend is too busy and is unable to give you the money today, but he promises that you will get it a month later. You are sorely disappointed. All your plans of buying that pair of shoes lie shattered.


"Or what if somebody else buys those pair of shoes, which may well be the last such pair on earth?"

"Or what if your friend delays his gift by another month?"

'If' - the root of all uncertainties! What we commonly term as 'Risk' and what can ruin all your well laid plans...
Hence, if you have a choice, you would rather go to see this friend at his office and collect your money today.

Why would you do that?

This brings us to a fundamental truth: Time has value.
We all know that the value of a rupee does not stay the same across time horizons. Due to Risk and Inflation, a rupee today is worth more than a rupee tomorrow on the time line.

In simpler words, we are saying that the value of the same rupee differs at different points of time. This difference in value arises due to the passage of time. Hence, it is called the 'Time Value of Money'.

Expressing this in numbers, if you believe that you can buy the same pair of shoes with $1100 a month later, then the time value of money for you is $100 for a month.

Twist in the tale
Now, let us assume that your friend actually turns up and gives you $1000. But while on the way to the shoe shop you meet your old classmate who badly needs $1000. In that case, will you part with the money?

You would, provided he promises to return at least $1100 a month down the line, so that you can buy the same pair of shoes. (We know that, in real life, you would not take a penny more than what you have lent to your classmate, but just for academic purposes!)

So, what do you call this extra payment that you demand over and above the amount you have lent?

If the answer is 'Interest', you are right. But then what is Interest? And why is it charged?
Let me explain. When you are lending the money to your friend, you forego an opportunity to buy the shoes and use them when you wanted. Hence,you would charge the cost of losing this opportunity, commonly termed as 'Opportunity Cost', to your friend in the form of Interest.

One last exercise before we bid goodbye to 'Time Value of money' and 'Opportunity Cost' for now.

What is the Opportunity Cost for our friends, Saver, Borrower and Investor?

Saver:
Saver is a lot like you. He needs to get compensated for the erosion in his purchasing power with time as also the risk associated with postponing consumption.

Borrower:
Now that Saver has an ace up his sleeves in the form of Interest, Borrower needs to evaluate his decision to borrow and consume now. Why? Now there is interest to contend with.

Lost? If your classmate is borrowing $1000 from you today to meet his needs and is repaying $1100 a month later. Then, he is better off fulfilling a need of his that will be worth at least $100 more a month later.

Investor:
Our most enigmatic friend, Investor has several opportunities knocking at his door. He can set up a beer factory or open a restaurant among other things. We could actually exhaust this page writing about the options that he has staring at him. As we all know, our clever friend hopes to maximise his profits and minimise his risks.

In case he decides to set up a beer factory, the profits he would have earned by setting up a restaurant are considered as his 'Opportunity Cost'!

He also has a very basic 'Opportunity Cost'. He can opt to lend his money to Borrower in return for Interest payment. Thus his investment needs to fetch him enough profits to compensate for all this.

Hence, Investor needs to know the value of his future profits in today's terms for all the investment opportunities. Only then can he make the best choice.