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Economic History, Part VII: A Lesson in Inflation and Monetary Policy



The above chart tracks the United States’ inflation rate since January of 2000 through February of 2011 taking monthly averages. The deflation experienced between 2009 and January of 2010 is believed by many to be explained by the Phillips Curve, which “represents the relationship between the rate of inflation and the unemployment rate” (Source A).

But what exactly is inflation?

According to Investopedia, inflation is the rate at which general level of prices for goods and services is rising and purchasing power is falling. Central banks attempt to stop severe inflation as well as severe deflation in an attempt to keep the excessive growth of prices to a minimum (Source B).

So, as you can tell by the chart, it looks like the inflation rate is relatively low with respect to 2006-2008 levels. With rising prices and an increasing need for consumers to cut back at home or search for substitutes, many are clamoring for lower prices. There are several different economic policies a government can enact to reduce inflation:

  1. Monetary Policy – Increase interest rates.
    1. Raises the costs of borrowing which leads to reduced spending.
    2. Increased interest rates makes saving a more appealing prospect.
  2. Supply Side Policies – Privatization and deregulation.
    1. Make firms more competitive and more productive to keep costs low.
    2. Works in the long run and won’t necessarily bring prices down today.
  3. Fiscal Policy – Tax policies.
    1. Increasing taxes and reducing government spending will reduce aggregate demand.

Naturally, there are many other policy options to be considered as everything seems almost inextricably linked in economics, but these will do for our purposes.

But what if the U.S. government decided to simply reduce the value of our money by 20% overnight? To put this in perspective, imagine that your $1 bills were now worth 80¢, your $5s worth $4, your $20s a mere $16 and so on and so forth. Well, this is essentially what happened in 18th century France.

Granted, the monetary regime in place at the time is not the same as ours today. In 1726 France, when these events took place, the government was using a variety of gold and silver coins which didn’t indicate a specific value, like our alternate fiat money. The intent behind the French government’s actions was to lower general price levels, which they thought were too high.

What the government didn’t anticipate, however, were the adverse effects it would have due to expectations. Once the value of their specie dropped, the people lost faith in the coins and held their wares as collateral against the expectation of further diminution. Goods were worth more than the money if there were further decreases in the value of the coins. Business owners had stocked up their inventory based off of yesterday’s prices, so selling them without increasing prices would, in fact, be counterproductive and harmful to their own well-beings.

A local official in Marseille described the situation from a more personal perspective, “the diminution has suspended all business and increased the prices of foodstuffs and merchandise. We never doubted that the first diminution would have this effect…all sensible people are convinced that the third diminution will begin to have some effect and progressively things will return into balance with specie, as long as all are convinced of the King’s firm and serious intention not to increase after the diminutions, It is up to the Court to see how it can persuade foreigners and the King’s subjects that this intent is serious, firm, and unwavering.”

This graph essentially describes what took place in France. First, the government reduced the value of the money. Output and commerce suffered significant setbacks and the aggregate demand curve shifted to the left to reach point B for a significantly longer period of time than was expected by the government. This was due to a combination of expectations that the value of the money was going to continue to fall and because of the contracts which hadn’t yet been renegotiated.

To support his proposition that a law be passed reducing all leases passed since January 1720, the mayor of Nantes said, “In vain would one ask merchants to cut the prices of their wares by a third if one does not reduce by a third the leases on their shops.”

Only after the government finally came out and set an official price did France undergo market clearing and the economy reach point C on the long run aggregate supply curve, as indicated by the arrows.

So inflation, it turns out, has a great deal to do with expectations. Business owners might, for example, anticipate that transportation costs are going to increase due to rising oil prices and bring up their prices. Before you know it, all costs and prices might go on the rise, all due to expectations. Something to be careful of, however, is that history shows that prices are much easier to increase than they are to bring down.

Sources:

Source A: http://www.econlib.org/library/Enc/PhillipsCurve.html

Source B: http://www.investopedia.com/terms/i/inflation.asp

Source C: http://www.econtalk.org/archives/2009/02/meltzer_on_infl.html (podcast)

Source D: Chart Source http://www.tradingeconomics.com/economics/inflation-cpi.aspx?Symbol=USD

Source E: http://www.frbsf.org/publications/economics/letter/2009/el2009-12.html – philips curve

Source F: Policy http://www.economicshelp.org/blog/inflation/economic-policies-to-reduce-inflation/

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Posted by on April 12, 2011 in Economic History

 

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Mutual Funds 101: Demystifying Investment

Definition: Mutual funds are an investment strategy which pools money from many, many different investors to construct a portfolio of stocks, bonds, real estate, and/or other securities, depending on its charter. Each investor in the fund gets a slice of the total pie.

What are the perks to investing in mutual funds? Diversification, one of the basic rules of investing in general is varying your portfolio. Diversification is a technique that mixes a wide variety of investments within a portfolio. This is meant to yield higher returns for lower risks because while you might take hits in some parts of your portfolio, the positives—if chosen correctly—will offset those.

“Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction.” – Investopedia

Another pro to the mutual funds game are the relatively low minimum investment amounts. Some you can join with just a few hundred dollars, spreading the risk across to more people, allowing investors to make some riskier decisions with higher potential returns.

So, there’s active management and passive management.

Active Management:

Is the actual practice of picking your stocks and market timing to pick securities which will beat out the market. This is the most common type of management. The high volume of trading results in higher expenses.

Passive Management:

These funds do not attempt to meet the market, but to match the risk with the return of the stock market. These usually track a market index such as the S&P 500. Those that follow this index, for example, tend to hold the stocks within the S&P 500.

Advantages:

1. The percentage of fees paid to the company to manage and operate the fund is less in passive funds than in active funds.
2. Lower mutual fund capital gains distributions.

A good analogy I found regarding the difference between active and passive investment management is the distinction between the actions of one individual vs. the actions of the group as a whole. “Active investment is like trying to bet on who will win the Super Bowl, while passive investing would be the ability to profit as all the NFL teams collectively made money on ticket and merchandise sales.”

Now, let’s move on. There are two different types of funds I’d like to talk about today: stock (equity) funds and bond funds.

Equity Funds:

Mutual fund that invests primarily in stocks; equity funds typically have their own distinct styles. Some focus on the different sizes of companies such as the size of businesses (small-cap versus large-cap) and their geography while others might buy shares within particular sectors such as health care or entertainment. These are sometimes referred to as “specialty stocks.”

Bond Funds:

Bond funds come in many different colors as well. There are safe investments with lower yields such as government bond funds, high-risk (and hopefully high-yield) bond funds. These can get extremely complicated, but if this is something you’re interested in, click here to be taken to a page which does an adequate job of explaining what type of things to look for to determine whether or not these bonds will be safe investments.

But don’t forget to pay your taxes. Regardless of whether or not you sell your fund shares, if you’re raking in money, you could be hit by a pretty hefty tax for both your dividends and capital gains. That sounds pretty painful doesn’t it? What if I told you that you’re stuck paying taxes even when your funds have declined in value? Well, the truth of it is that you’re going to end up paying taxes regardless of how your fund performs, but since there’s not much to be done about that, my only advice here is to be aware of this undeniable truth. According to CNN Money, the most tax-efficient funds avoid rapid trading.

CNN Money also advises investors to not chase winners and to look for consistency in the long-term rather than those particular funds which might be ranked highly at this one point in time. Investors are also told to not be too quick to dump underperforming funds as any fund can have an off year. Just make calculated decisions, watch for a pattern, and come up with a few forecasts.

A VERY SUCCINT DISCUSSION OF A FEW DIFFERENT TYPES OF STOCK FUNDS:

1. Value funds: look for cheap stocks. Either big companies/corporations which have been suffering in recent days and are selling shares at lower, discounted prices, or smaller companies which have been beaten out by competition or other investors but could have brighter days ahead.
2. Growth funds: varies depending on how aggressive the investor might be. Tend to favor established names, but look for rapidly growing companies as well. Good for long-term investors who should build around such funds in their portfolios.
3. Sector funds: as I mentioned before, these investors focus on particular sectors such as health care, entertainment, technology, etc. Just be aware that entire sectors are also liable to head south.

A VERY SUCCINT DISCUSSION OF A FEW DIFFERENT TYPES OF BOND FUNDS:

1. U.S. government bond funds: bonds issued by the U.S. Treasury or federal government agencies. Seen as extremely safe, so you shouldn’t expect extremely high returns with these. The longer you hold on to the bonds, the higher your yield. So if you’re comfortable with sitting on them—they fluctuate with the interest rate—then you probably might as well be in it for the long run.
2. Corporate bond funds: bonds issued by corporations. Each corporation has a credit quality issued to them, the highest being AAA. The longer the average maturity, the greater the volatility.
3. High-yield bond funds: focus on smaller and/or riskier companies. Expect a few defaults here and there. Shouldn’t be a huge proportion of your portfolio unless you’re comfortable taking risks for the chance of seeing higher returns.
4. Municipal bond funds: issued by cities, states, and other government localities. Are tax-exempt. Don’t have much more to say about these myself, so just click through the link if you’re interested in safe, low-yield prospects.

Now that we’ve hopefully demystified mutual funds (or at least opened a few doors for you) you might be wondering why exactly some active funds underperform. The costs of research, administration, management salaries, and other expenses are borne by the shareholders.

If you’re new to the game and want to try to get your own slice of the market, explore U.S. Securities and Exchange Commissions’ page to get started. Look for more posts on the subject of investing in the days and weeks to come!

Sources:CNN Money, Investopedia & About.com

 
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Posted by on March 23, 2011 in Business/Technology

 

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Small Business 101: Part I, Business Structures

If you haven’t already, please read the introduction to this series!

Now, I realize that covering business structures might seem an unorthodox place to begin, but you’re just going to have to trust that there’s a method to my madness. Before you jump into writing business plans, designing business cards, and taking out ads on Facebook, you’re going to want to think about a few things. The following is a list of the different types of business structures you will want to decide between to get you jumpstarted on your brainstorming.

So you have an idea for a business and want to make it official. Or maybe you’re just a little low on self-esteem and feel that tacking “Founder and CEO of Urban Watermelon Innovations” or “Director of Kerblunking at Yachtswoman Industries,” onto your resume might just do the trick and impress some important people. Either way, it’s probably time to start filling out that paper work, right?

Wrong.

Before we go all Rambo on our paperwork, we should probably decide on the right business structure for you. This is important because the business entity you establish determines which income tax return form you have to file, though that’s only where the distinctions begin. So, what are your options?

If you recall from my introduction, I’m going to approach this as if I intend to start my own consulting firm in entertainment and technology. Let’s say, for examples sake, that I plan on entering into this with several friends and we all want to share in the responsibility, profits, and losses. While we shouldn’t make any rash decisions now without a decent business plan, I can rule out a sole proprietorship.

As you can see in the above, incorporating your business has a lot of benefits, but since my business is not already established and with any structure or any foreseeable revenue stream, the disadvantages seem to definitely outweigh the pros.

If you already have a small business which you want to incorporate, talk to a lawyer and consider receiving counsel from an accountant as well.

I don’t see my future company as having shareholders anytime soon, so we’ll tentatively keep an LLC in mind as we continue towards the next step: writing an effective business plan, the topic of my next post.

Thanks for reading and feel free to comment with any feedback or questions you might have from what we’ve covered thus far.

 
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Posted by on January 12, 2011 in Small Business 101

 

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Small Business 101: Introduction

Today begins part 1 of a series of posts dedicated towards helping you start your own business: Small Business 101. Just the thought of starting your own business can be overwhelming. Well I’m glad you’re reading this because I can tell you right now that it doesn’t have to be like that. I will break up the steps for your reading convenience; go at your own pace.

I predict that this will span beyond 8 posts, with each entry covering a new step or topic. While I recommend you go through them in the sequence I have myself ordered, feel free to browse through the titles and content and decide where you might need some help and throw out whatever doesn’t apply to you.

As an example, I will approach the series as though I am considering starting a consulting firm in entertainment and technology.

And I almost forgot to mention: even if you have no intention of starting your own business any time soon, I highly recommend you keep up with the series. Who knows, you might change your mind—and a little bit of learning never hurt anyone (disclaimer!).

I’ll be updating the below list with every new post, just click on the link to be taken to that page:

Table of Contents

  1. Part I, Business Structures
  2. Part II, Writing an Effective Business Plan
 
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Posted by on January 12, 2011 in Small Business 101

 

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Virtualization 101

I received an email from Microsoft this morning telling me to register on their Free Virtualization Event in San Francisco, or TechNet Events Presents: Virtualization 101. It just happens that I’m sitting inside a Starbucks in San Francisco near a rainy Fisherman’s Wharf as I type this. I took this as a sign to post an entry on the subject.

If you don’t already have an idea of what virtualization is, you’ve come to the right place. Whether you’re a college undergrad studying business, computer science, engineering, etc., already in the workforce, or whatever other category you might fall under, virtualization is not a trend you cannot afford to be unaware of.

The idea behind virtualization is, as the term itself might imply, the virtual creation of something that might otherwise have been a physical reality.

The initial intentions behind virtualization—in the tech world—were to migrate physical servers to virtual servers (a.k.a. server consolidation) in an attempt to save energy, utilize space, and reduce the amount of administration on those servers thereby increasing IT efficiency, high availability, and “enable business agility,” according to Edwin Yuen, a Senior Product Manager within Microsoft.

I understand how abstract all of this sounds if you have never before worked with computers enough to be exposed to the concept, so here’s my attempt at simplifying the concept:

  1. Virtualization software emulates your hardware such that you can have multiple operating systems (OS) running on a single physical computer.
  2. Each guest OS runs as if it has available all the resources of the host computer, including processing power, memoiry, applications, etc.
  3. The reality of things is, however, that all of the above mentioned resources are being allocated ONLY AS NEEDED in a way that the virtual machines do not impede each other in any way.

Now, go back and reread the 3rd bullet point please because that part is probably most applicable to you as a user. This concept is huge! Computers, like the human brain, are largely inefficient and suck much more energy than is required by their tasks. Virtualization is a solution which allows for users to use several different applications as if each application has its own operating system.

Think of virtualization as a commercial plane. Imagine a reality where we each had our own private jets to take us where we wanted to go and consider how inefficient that would be. Virtualization, in this metaphor, is basically the commercial plane. Each has its own specific destination but has the capacity to take x amount of people there, and a result, is much more efficient than the alternative.

That was an imperfect metaphor, but I hope it gets the idea across just the same.

According to a survey considering environments containing more than 50 virtual machines (which rules out most small businesses anyways), it was discovered that the primary problem with virtualization is insufficient server RAM.

But wait, doesn’t that mean we should wait until exploring this option and applying it to our businesses until this problem is resolved?

Hell no!

Imagine all the money you could be saving with these virtual servers (assuming you have a decent amount of tasks you’re performing with different applications). According to the same survey, each physical computer is equivalent to more than 10 operating systems!

It doesn’t take an industry genius to see that virtualization has a huge future ahead of it. My advice is that you at the very least consider this opportunity to scale your performance and do some of your own research.

Try the Windows Azure free trial and take the Cloud Power Assessment to get a custom report for your business.

Open your eyes and invest in the cloud.

Sources:

 
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Posted by on December 17, 2010 in Business/Technology

 

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Let’s Laugh Through Our Misery

You know your audience consists primarily of college kids when your view count drops to single digits during finals week.

But check out these cartoons on your study break for a few laughs 🙂

If you’re a computer programmer, check out these jokes.

If you still haven’t heard about Ireland’s newest declaration of war, click here!

 
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Posted by on December 5, 2010 in Recreational

 

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Signs of a Failing Economy

Got this forwarded to me a long time ago. Just saw it again a couple minutes ago and thought I’d share 🙂

The Economy is so bad that:

-I got a pre-declined credit card in the mail.

-I ordered a burger at McDonald’s and the kid behind the counter asked, “Can you afford fries with that?”

-CEO’s are now playing miniature golf.

-If the bank returns your check marked Insufficient Funds,” you call them and ask if they meant you or them.

-Hot Wheels and Matchbox stocks are trading higher than GM.

-McDonald’s is selling the 1/4 ouncer.

-Parents in Beverly Hills fired their nannies and learned their children’s names.

-A truckload of Americans was caught sneaking into Mexico .

-Motel Six won’t leave the light on anymore.

The Mafia is laying off judges.

-Exxon-Mobil laid off 25 Congressmen.

-Congress says they are looking into this Bernard Madoff scandal. Oh Great!! The guy who made $50 Billion disappear is being investigated by the people who made $1.5 Trillion disappear!

 
-And, finally

I was so depressed last night thinking about the economy, wars, jobs, my savings, Social Security, retirement funds, etc., I called the Suicide Lifeline. I got a call center in Pakistan , and when I told them I was suicidal, they got all excited, and asked if I could drive a truck!

 

 
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Posted by on December 1, 2010 in Recreational

 

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