How credit drives inflation and why interest rates change

When we buy something on credit, we promise the lender to pay it back at a later point in time. So credit is an asset to the lender but a liability to the borrower. When you borrow money, you are basically spending more than you make. This means that at a future time you will have to spend less than you make to pay back the loan. If you look at borrowing from another perspective, you are basically lending money from your future self.

Why credit is used

Credit is used to buy things we can’t afford. When you buy goods or services on credit, you decide to get the benefits now and pay for them later. This isn’t necessarily a bad thing, it depends on what the credit is used for.

When credit doesn’t stimulate productivity

Credit is bad when it is used to fund liabilities. Liabilities are things that cost us money. If we, for example, buy a luxury car on credit, that car is going to cost us money on maintenance. Therefore, the car won’t increase our productivity and to pay off the loan we would have to address other funds.

When credit stimulates productivity

However, credit is good when it is used to fund assets. While liabilities cost you money, assets make you money. If you are, for example, a gardener and you buy a new lawnmower on credit. That lawnmower increases the number of lawns you can mow on one day and it will, therefore, increase your earnings. The increase in earnings will pay for the loan and maybe there will be some money left to reinvest into the business. Therefore credit is good when it increases productivity.

vladimir-solomyani-rKPiuXLq29A-unsplashPhoto by Vladimir Solomyani on Unsplash

How is productivity measured?

There are different ways to measure productivity. An individual can, for example, look at how much an hour he or she makes. Or that gardener from the previous example can look at how many gardens he can mow a day. But when we want to measure the productivity of a country, we look at GDP-growth.

What is GDP?

GDP stands for “Gross Domestic Product” and it is used to measure a country’s growth and the health of its economy.

How is GDP calculated?

GDP is the total market value of all the finished goods and services produced within a country during a specific period.

There are many variants of GDP used to measure different aspects of a country’s wealth and economy.

What is the correlation between GDP and credit?

GDP and credit both go hand in hand. The reason for this is that GDPgrowth is stimulated by credit. Take the previous example of the gardener who buys a lawnmower on credit to be able to mow more lawns. This is a simplified example of how an investment can provide GDP growth.

How credit drives inflation

Nevertheless, credit isn’t always used to invest in things that increase our productivity or GDP growth. Sometimes, credit is used to buy a big TV or a big couch. Inflation can, therefore, occur when credit (call it money supply) grows too much in comparison with the GDP (call it our productivity).

When credit is easily available, let’s say because of low-interest rates, there are more people able to buy things on credit. And if the demand for goods and services rises faster than the production of goods and services (let’s call it productivity), prices increase. This means your money will buy you less.

How inflation is controlled

In the old days, the value of money was measured against gold, called the gold standard. 

” The problem with fiat money is that it rewards the minority that can handle money, but fools the generation that has worked and saved money.” ~ Adam Smith

Nowadays, we call it “fiat money” and its value is controlled by the government. The government uses specific methods to increase or decrease the amount of money in the system.

So how does the government control inflation?

In general, the government sets an inflation rate target of 2% – 3%.

Let’s take a closer look at the two main ways of controlling inflation.

  • Printing money: The government (The Federal Reserve) can decide to start printing money to increase the money supply.
  • Adjusting interest rates: The Federal Reserve can decide to increase (or decrease) the interest rates on borrowing for commercial banks. This results in commercial banks increasing (or decreasing) their rate of interest on credit for the public.
Effect of adjusting interest rates

When commercial banks decide to change interest rates, it also changes how many people are willing (or can afford) to borrow. What in turn will determine how much people are spending.

Take for example when interest rates are low. Borrowing is cheap, this means more people are able to afford things. Let’s say you want to buy a car that’s priced at 50.000 $ but you can only afford a 30.000 $ car. When borrowing is cheap, you might decide to borrow 20.000 $ and buy the 50.000 $ car. If, on the other hand, borrowing is expensive, you might have decided to buy a cheaper car.

When the fed raises interest rates, the money supply shrinks and therefore, prices drop or stabilize which usually makes rates of inflation go down. When the fed decides to lower interest rates, rates of inflation tend to go up.

etienne-martin-2_K82gx9Uk8-unsplash
Photo by Etienne Martin on Unsplash

 

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*DISCLAIMER: The content on this website is made in good faith and I believe it is accurate. However, this content should be considered informative and not for making financial decisions.

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