Monday, October 5, 2009

Client Questions on Credit Union Safety, Interest Rate Rises, Inflation

Two Client Questions

Q1: how does a large credit union compare with a savings and loan association with regard to overall safety and vulnerability to failure?

A:Generally, there is little difference. Both lend out money obtained via demand deposits and are therefor basically illiquid.

Q2: What causes interest rates to rise?

A: interest rates rise when the demand to borrow money is greater than the supply of funds available for loan.

In my opinion, a number of things may cause this situation:

1]An increase in the general markets expectations for inflation

2] Changes in tax laws that increase the tax -saving value of interest deductions- causing many to favor borrowing ahead of saving money.

3] Sales of treasury bills or bonds by the Federal Reserve system - which "tightens" the money supply. this causes less money to become available for lending, a shortage of liquidity and an unexpected slowing of business, leading more people to want to borrow money.

Reader Question on Inflation [from a forum]:

Q: "Ok I get inflation raises prices due to the devaluing of currency...and I get that prices are set by subjective premises of individuals but how do these two come together? How do prices fluctuate due to inflation yet also do to subjective value?"

A: I have always liked Austrian economist Ludwig Von Mises' explanation, as found in his book "The Theory of Money and Credit" , because it is so simple, and makes so much sense.

He points out that money [ i.e.paper money, " fiat currencies", " fiduciary media" etc.] is merely a commodity, albeit one with a negligible , close to zero cost of production.

Just like any other commodity it is therefor subject to the laws of supply and demand [a.k.a . the subjective valuations of individuals]; therefor its actual value at any point in time [i.e real world, market value, as opposed to the denomination printed on it- $1, $5, $100 etc.], just like any other commodity, is always ultimately set by the final outcome of the interplay of the two factors, supply, and the demand for that supply.

[Nov.2010 update/clarification: the term "demand for money" on this site refers specifically to the individuals demand to hold on to $'s, or whatever fiat currency being used, and to _not _ spend them.

The desire to hold on to more, or to spend more of a currency is an ever changing factor mostly accounted for by psychological factors that are both unpredictable and individually unique - however the end result will still be a general tendency to hold on to to more, or hold on to less currency units than previously felt necessary.]

"Inflation" is the term for a result, the end result of the supply/demand equation wherein the broad mass of individuals have [individually and subjectively] decided that the paper money produced is worth less to each of them than the broad mass of other goods /commodities available to them, so they decide to hold less $'s .

"Deflation" is the opposite; the broad mass of individuals have [individually/ subjectively] increased their (e)valuation of paper currency relative to other goods/commodities [for whatever reason], and desire to hold on to more [$'s] than they did [collectively] previously.

N.B. increasing the Money supply Does not Necessarily Cause Inflation!

Although increasing the money supply may cause inflation, it is not a foregone conclusion simply because demand for that supply can never be anticipated.

For example, if demand for money consistently outpaces the increased supply [of newly created money] , deflation [i.e increased consumer valuation of paper money] , will still result.

Conversely, if the money supply is decreased [less issued], but the demand for that decreasing supply drops even faster, inflation [i.e decreased consumer valuation of each $], would still result.

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