High inflation – lets borrow and spend?
I spoke to a friend the other day, and said that i have decided to prepay my mobile bill, as i was charged penal rates sometime ago. He says he waits until the phone is barred, and then he pays the bill. Anyways, he went on to say that financial theory says that one should borrow and spend during high inflation, and negative returns (i.e. our interest rate, is below the inflation rate); thus his desire to not settle the bill when due.
I think what financial theory says is borrow and invest, and not borrow and spend… You borrow and spend, you reduce you own disposalable income (unnecessarily) due to added interest cost. But if you borrow and spend (invest?) it on some money making venture, you would probably generate real returns. You may not probably want to save (excess amounts), but you will not be better off by borrowing and spending (unless needed).
With certain credit cards offering zero interest instalments, it would make sense to use them – you could actually make a tiny bit of money (after deducting the stamp duty on credit card purchases of course…)
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In theory your friend is correct in theory. You can borrow and spend. But you can’t keep the loan repayment in terms of money:
Presently interest is at about 14% and inflation is about 20% (I think). The real interest rate, defined as the difference between the two, is -6%.
Let’s say you take out a loan for Rs 100. In one year, you will have to pay back Rs 114 to the bank. The loan plus the interest.
But in terms of real interest, you are only paying back Rs 94. The actual Rs 114 you pay back to the bank is worth only Rs 94 in today’s terms.
So in theory, you can take out a loan for Rs 100, keep Rs 94 to pay back the loan, and spend Rs 6. Ah – but at the end of one year the bank will ask you for Rs 114, and you will have Rs 94.
This is why you can’t keep the Rs 94 in money terms. Inflation will decrease it’s value. You have to keep it in another currency (which would be subject to exchange-rate issues), or keep it in terms of goods or services, the value of which will increase with inflation. Maybe the stock market, but that’s risky too.
So when your friend doesn’t pay his mobile bill on time, he is borrowing from the mobile company, yes. But unless his salary is increasing with inflation, he is losing. Because the money he saves today to pay his mobile bill in the future is worth less in the future, so in fact he is paying out more. But if he gets an increased income in the future, due to inflation, then in effect he is saving the repayment money with his employer, who are increasing that money in value, to keep in line with inflation.
Same with credit cards. You don’t gain unless your salary is increasing with inflation, or you keep the repayment money in terms of goods and services which increase in price over the year, as inflation increases the general price level.
So yes, you can gain when the country has a negative real interest rate. But it’s not easy for individuals. Easier for businesses, who invest the loan money into a revenue-generating asset, which produces something whose price can change with inflation.
This is a long boring answer but I am an Econ student with exams coming up! I hope my answer is correct, if not, please someone correct me as I should know this stuff properly… :)
that’s a pretty clear explanation.
You can profit from inflation by borrowing money to buy property, the values of which still go up in Sri Lanka. Or gold, or something stable. Most working people, however, get screwed cause wages don’t keep up. People with capital do OK, but wage earners don’t.
Property is a great example. Totally slipped my mind. Good thinking, Indi. Land value increases in line with inflation pretty well (unless of course there is a crash in the property market).
The primary reason that wages don’t go up easily – they are said to be rigid – is that wage-earners are not willing to allow their wages to go down.
If wages were fully flexible, meaning employees allowed their wages to fluctuate upwards AND downwards according to the general price level, then employers would be quite happy to raise wages today, safe in the knowledge that they could reduce wages in the future, if the price level fell.
But that’s not really possible. Unions, wage-earners and politicians all want wages to increase, and never to decrease. That ain’t good economics, sadly.
The fact is, wage-earners have only themselves to blame for the fact that their salaries are slow to increase in line with inflation. Employers will only raise salaries when they really have to, even if they are selling their products at inflated prices (and getting increased profits).
Inflation hits wage-earners much harder than business-owners etc. But they don’t really understand that. This government was voted in primarily by wage-earners, not the business community. Yet the government is screwing their voters by printing money and raising inflation.
See, in economic theory, if wages and prices were fully flexible, inflation would not be a major problem. As prices rose (i.e. inflation), wages would rise, and businesses would earn the same profits, relatively speaking. The main costs of inflation would then be menu costs (the cost of having to change listed prices on menus etc), and shoeleather costs (the cost of walking to the bank to keep withdrawing money, as late as possible, to earn maximum interest).
Thank you Oscar for all the points! i didn’t think about wage inflation, but i think i will still think about it and see.. (borrowing and spending). My econ knowledge is limited – so thank you, and all the very best for the exams :) Hope you ace it…
btw, i was told that i should someday follow up on both econ and stat together, for those with both the skills are in limited supply… hm….
Indi.. hm… i cannot afford to buy property…but perhaps some shares in the stock market or something… not too sure about buying gold because of VAT etc at the moment, but i guess i could think about buying gold from out side LK…
http://spicyfoodgood.wordpress.com/2007/05/05/how-much-do-you-pay-for-gold-in-lk/
the capital keeps on spinning money, and the wealth disparity keeps on increasing….