Tuesday, March 18, 2008

Macro economics is interesting!

As you've probably noticed, I've started to post less and less in the blog. Why? I've simply got less and less time. Actually, there's nothing much to talk about from the daily fluctuations of the market anyway. I've been reading intensely (as always, since the start of this year) and I've learnt a lot of things. I'm just wondering why I didn't start this intensive reading program of mine earlier, so I can compound the knowledge sooner

I started reading this excellent book, titled the 'Concise guide to Macro Economics' by David A. Moss. The slick black colour attracts me to at first, and after browsing through a couple of pages, I thought this is a must read for everyone who don't have a background in economics.

It's pretty short, hence the title concise. It skipped all the maths/equation parts about economics and zoomed in right to the principle and general understanding of it. It really opened up my eyes. I wondered how I lived my life so far without knowing what's the different between nominal, real GDP, the components of GDP, how depreciating USD to SGD doesn't always mean USD goods are cheaper etc.

Frankly, I've not read through the whole book but the knowledge I got from it already widened my worldview. For example, just now when I was cashing out my ERS, I noticed the dividend rate is given as 3% plus real GDP. Haha, my eyes opened up when I saw 'real GDP'. Books always gave me this feeling that my mental eye can roam further and see deeper.

Of the most important things I've read so far, I realised that the FED isn't the only one who can increase money supply. Banks can do that too. Assume that the bank's reserve ratio is 10%. If I deposited $100 into the bank, based on the reserve ratio, the bank can lend out $90 and have to keep $10 in the bank. Well, if I still have my $100 and someone had $90, then money supply had increased from $100 to $190, an increase of $90. Well, of course, it doesn't just end there. If that someone used it to buy some goods and the person sold the goods for $90 also deposit it into the bank, then the bank can lend out another $81 out, increasing the money supply further.

Okay, this bit is from my knowledge of geometric progression (GP). The amount of money forms a GP with first term as 100 and ratio as 0.90:

100...90...81...72.9...65.61...59.049... and so on ad infinitum

If we assume that everyone downstream puts the money into the same bank and the bank reserve ratio do not change, then taking the sum to infinity of the GP will lead us to $1000. I found that this is exactly the same as the formula quoted:

Money multiplier = 1/(proportion of leakage)

If the reserve ratio is 10%, then leakage is 10%.

Since initially I deposited $100 and the money multiplier is 10, the money supply increased to $1000 (100 x 10), exactly the same as what is calculated by my sum to infinity of a GP. Hence, we can see that banks can also 'print' money by taking deposits and lending out. What is amazing is that this supposedly highly leveraged position is the core business of banks, since they charge interest for the money loaned out. Can you imagine how much interest my $100 can generate for the bank?

If there is no credibility in the bank, people will start to withdraw their money all at once, causing bank runs. This is where other banks or the central banks have to lend money to this particular bank, in order for them to pay the extra $900 generated from my initial $100. If nobody wants to lend to this bank, the bank goes bankrupt.

Besides being amazed by the potential lucrative business in running a bank, I start to see the whole picture of Fed's action. This is no doubt helped by Stupid's excellent insight into L&S behaviour. By printing and injecting more money into the money supply, by making open market purchase into private financial institutions, by lowering the discount rate that FED lends to banks...they are employing all the tools of monetary policy. What's their aim? Definitely not to control inflation. This huge inflow of money will lower short term interest rate, possibly increase long term rates and in turn increase short term rates when inflation sets in. As Stupid mentioned, this inflationary environment is planned so as the assets being writedown will not go down so fast, creating an illusion that the situation is under control. This can happen since the assets are marked down to market value, and thus nominal and not real.

All this from reading just a concise guide to macro economics. Can you imagine how much insight I'll gleam from reading a not so concise guide? As they say, knowledge is power.