You know, I can really rattle on to talk about financial planning non-stop in machine gun speed. It’s really my passion + a hinge of some expertise. ;) It dawned on me that I have never understood how money really works, until recently. I knew things like if interest rate increases, price of bonds decreases. Too much money = inflation. But I never really knew exactly WHY in the first place. It's like going through secondary (or high) school phase without going through primary (preliminary) school. And this freaked me out a little. So I decided to read up more.
So for those who would like to know about interest rates and money supply or probably learn something about economics, continue reading on. In case you think its stuff that works like sleeping pill, I'll keep it simple, I promise ;)
Now for a moment, let’s just think of your favourite chicken rice.
Yup, chicken rice. Damn, doesn’t it look tantalising? I'm hungry already. :P
-A smack right through my face-
Ok apologies. Anyway, pretend this plate of chicken price is money and the interest rate is the price of your chicken rice.
- Now if the price of the chicken rice is too low, everyone wants to eat chicken rice. Stall holders may not want to sell chicken rice anymore because of the low profit margin.
- Now if the price of the chicken is too high, nobody wants to eat them. However, there will be more stall holders since selling chicken rice meant big money.
- If more people want to eat chicken rice than the amount of chicken rice available, it is going to be harder to buy chicken rice since people (or chicken rice lovers) are willing to pay more to eat chicken rice.
- On the contrary, if there are more chicken rice available than the number of chicken rice lovers, stall holders are going to lower prices so to attract more people to buy chicken rice to eat.
Moral of story? The prices will keep changing until the number of chicken rice lovers = number of chicken rice available. It's actually just supply and demand from economics 101.
Now let’s replace chicken with money, and prices with interest rates.
- If interest rates are low, people will want to borrow money. However, people may not want to lend or even save up the money their POSB account
- If interest rates are high, people will not want to borrow money. If your POSB account interest rates suddenly increase to 5%, do you think you want to save more money now?
- If there are more borrowers than lenders or even savers, loans are much harder to get since banks may not have that reserve. In this case, there are some borrowers who are willing to pay higher interest just to get hands on their loans.
- Conversely, if there are little borrowers and more lenders (means everyone got money to spare), there are some lenders who are definitely willing to lend money at a lower interest rate just to earn some profitable returns on their money.
In theory, interest rates will keep changing until there are equal number of borrowers and lenders. In reality? Not so simple, we can never reach an equilibrium (which means equal ratio) because economics is really based on human behaviour albeit seemingly to be topic of numbers and formulae. Human perception and behaviour really. To quote an example, if the Government announces higher interest rates for POSB account to 2%, will you deposit more money in? Well, it really depends on you right? You might have recently lost money in investment so 2% may suddenly seem so viable to you. If you have always gotten 10% returns in your investments, you might probably not be bothered with the 2%.
Now you get the drift of the relationship between money and interest rates, you might ask: so why don't we just print more money, make everyone happy. All the aunties and uncles won’t complain so much about the Government? Say the Government decided to print so much more money till the point that everyone gets $1 million dollars. My dear reader, if you suddenly have an additional of $1mil, what are you going to buy? In this hypothetical situation, say you decided to buy your favourite Lamborghini. However, now instead of only you are buying, everyone is buying one. The problem is that the number of Lamborghinis is limited. So the price of the car will definitely go up! You see, increasing money supply without increasing the supply of goods will result in inflation.
So like that... hmm...
Why don't we print less money and prices will start to fall down, so now I can have chicken rice at only $1! Isn't that great? It isn't so great if it applies to your pay now, is it? Imagine the stall holder only gets a profit margin of 50cents per plate instead of the usual $1. Imagine your house is worth lesser and lesser every year. Now, the problem lies not because of the devaluation, again I'll like to remind you that economics is really about human behaviour :) Isn’t it demoralising to learn that the value of your house gets cheaper and cheaper every year?
So in reality, inflation shall always happen, its just good news for the economy. Bad news for having to fork out more to eat a plate of chicken rice, but remember, it also mean that the prices of your property will rise too! (Well, assuming all other factors stay the same)
So how does the Government play an active role in this? The central bank does. In our case, our central bank is MAS. It is their job to ensure that money supply is managed till the point where inflation doesn't get out of hand. How does MAS do it? They just do it by changing the interest rates. Because a minor change in interest rates affect everything monetary.
So this is really how money supply, interest rates and inflation come in together. Now in case you are wondering what do I really meant by money supply, it simply means money that are circulating outside MAS.
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