Wednesday, July 17, 2013

Redistribution of Wealth

The U.S. inflation rate for the month of June was 1.8, 1.4 in May and 1.1 in April.  When it comes to protecting your money you need to get interest above 1.8% for now, whether you get it from stocks or any other type of investment it is up to you.  The inflation rate is not fixed as we can see from rates in the past it can remain low or shoot up pretty high and these unexpected rates can redistribute wealth to the population.  Let's say a college student borrows $30,000 at a 6.8% interest rate and at the time inflation is 1.8% therefore the student will really only owe 5% interest (6.8% - 1.8%) on his loan.  The more the inflation rate increases the cheaper the debt will become for the student at the cost of the creditor's well being since the creditor will receive less valuable dollars.  The student will have his fingers crossed hoping the economy goes through a period of hyperinflation when it comes time to repay the loan meaning that prices and wages will rise so fast that the loan will become less valuable.  In this case the student will win and the creditor will lose.

Now let's see how the student can lose if inflation starts to drop and begins to flirt with deflation.  If the college student would have borrowed $30,000 in 2008 when inflation rates averaged 3.8 his loan still at 6.8% interest would not seem like a problem.  If the student started to pay the loan back in 2009 when inflation averaged -0.4% he would have been shocked to see that his loan would have to be repaid at 7.2% interest (6.8% + 0.4%) the 0.4 needs to be added to his 6.8% interest on his student loan as the U.S. went into deflation territory meaning negative inflation. Just as the student hopes for hyperinflation when it comes time to pay his loan, his creditor will pray that the inflation rates will start to drop making the dollars he will receive much more valuable than when he lent them.  If you anticipate high levels of inflation then this is the most appropriate time to take out a loan if you anticipate inflation will drop you will want to cut down on the amount of money you owe.  When inflation is not easy to predict wealth is redistributed among those who borrow money and those who lend it.  Therefore lending and borrowing money comes with risk especially if the inflation rates starts to move fast in one direction.

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