Inflation and its Effects on Cash Holdings and Investments

Inflation is a sustained rise in overall prices. A moderate rise in inflation means economic growth while high inflation results in an overheated economy. There are certain factors that affect inflation and a couple of theories that are tied to it. So before we proceed it’s very important to know some of the standing factors that influence inflation and how it affects cash holdings and investment.

Inflation can be caused by a number of factors, rising commodities, high-interest rates… etc.

Here are some principles and theories you need to know before we continue.

 Fraction- Reserve Banking

The world currently uses this type of banking system. When someone deposits $1000 in a specific bank, they maintain a claim on that $1000. The bank, however, can lend out those dollars provided they keep a fraction of the money which is regulated by the reserve ratio set by the central bank. So let’s say the reserve ratio is 10%.  The bank can, therefore, lend 90% or $900 out of the $1000 deposit made in the bank while the 10% ($100) stays in the bank.

So as long as the $900 loan is outstanding, there will be two claims having a total of $1900 in the economy. Meaning the money supply has increased from $1000 to $1900. This is merely a simple explanation on how banking grows the money supply.

Quantity Theory of Money

This refers to the supply and demand of money which is a determinant of Inflation. As the money supply grows, prices tend to rise because each individual fraction of the money supply becomes less valuable.

Interest Rates

Interest rates are the prices for holding or loaning money. Banks give out interest rates for saving money which attracts depositors. Banks also receive interest rates for each loan they give out with the deposited money.

Lower interest rates mean a higher demand for loans from businesses and individuals. Each loan increases the money supply as discussed in the Fraction-Reserve banking system and according to the quantity theory of money, (supply and demand), The growth of the money supply will mean an increase in inflation (higher money supply= increase inflation). So this means that lower interest rates will increase inflation and inversely, higher interest rates will equal to lower inflation.

So as result Interest rates have an inverse effect on inflation and therefore can directly affect other aspects like investment and cash holdings. Now let’s dive right into cash holdings.

Cash holdings

Cash holdings are defined as “money that a person or company keeps available to spend rather than investing.”  So for individuals, inflation has a great effect when it comes to consumer spending. Higher prices for commodities means more money is needed to spend whereas for companies, at the macro level, firms are inclined to adjust and optimize their cash-holding strategies in response to changes in purchasing power due to inflation.

Investments

Inflation can pose a real threat to investors as it chips away at real savings and investment returns. Most investors want to increase their long-term purchasing power, but inflation puts this at risk as their investment returns must keep up with the rising inflation to increase their purchasing power. Let’s say you have an investment that returns 4% before inflation. In an environment of 3% inflation you will only have 1% return when adjusted for inflation but in an environment of 5%, inflation will actually produce a negative return (−1%).

Current Interest Changes

After its meeting in March 2018, the Federal Reserve decided to hike its federal funds’ rate target range by a quarter point to 1.5%-1.75%. So as we discussed, rising interest rates have a great effect on consumers and businesses. Consumers will pay more for the capital required to make purchases and businesses will face higher costs tied to expanding their operations and funding payrolls when the Federal Reserve increases the target rate.

This rise in the Fed fund rate will definitely have a great effect on the borrowing costs for consumers and businesses that want to access credit based on the U.S. dollar. This will increase the Prime rate or the lowest rate of interest at which money may be borrowed commercially. Credit card rates, savings, and the U.S. National debt will also increase due to the rise in interest rates.

Conclusion

The rise of Inflation due to the recent changes the Fed made in Interest rates will have an adverse effect on inflation and consequently affect cash holdings and investments of investors and businesses alike. But these changes will fight the rise of inflation and therefore, help consumers and investors in different aspects of business and spending plus assist them through higher savings interest rates. On the downside, higher interest rates mean higher prime rates, credit card rates and increase in the U.S. national debt.

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