Getting even with Inflation

Time to take stock of things before we continue with our journey.

We have made three friends so far - 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?

Too many questions and all will be answered in good time.
Let us first assume you have Rs500 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 Rs550 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 Rs500 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 Rs500 urgently. He is willing to return Rs550 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 Rs600 (instead of Rs550) six months down the line?

You will lend him that Rs500 without any second thoughts, as you will not only be able to buy the shirt six months down the line, but also have Rs50 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 Rs500 but he returns Rs550 six months later. That is your friend gives you Rs50 extra when he returns your money. In the second case, he returns Rs100 extra. The money that you lent him is called 'Principal'. The extra money that your friend gives is called 'Interest'.

'Interest' defined the textbook ishtyle

"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% (Rs50 interest on a Rs500 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.

We will understand the relationship between Interest and Investment next time. Have a happy weekend J