AFN 221 Personal Finance: Inflation & Money Management (2022) PDF

AFN 221 Personal Finance Lecture Topic: Inflation and Money Management Andreas Milidonis Department of Accounting & Finance University of Cyprus...

AFN 221 Personal Finance Lecture Topic: Inflation and Money Management Andreas Milidonis Department of Accounting & Finance University of Cyprus Email: [email protected] 1 “Concept Map” for the Course Introduction Interest Rates Inflation & Time Money Management Savings Consumer Borrowing (Credit) Review & Midterm Exam Mortgage Insurance & Risk Investing Management Retirement Risk & Return Biases Review & Final Exam 2 2  Inflation and Purchasing Power 3 Rising prices When I was your age, my hard- earned nickel would buy me a trolley ride down town, a ticket to the cinema, and enough ice cream to split with a friend! In most modern economies, prices tend to rise over time. This phenomenon is known as inflation and an introduction to the effects it has on the consumer will be the subject of this part of the lecture. 4 4  Inflation It’s important to understand not only what inflation is, but what it isn’t.  Inflation is a technical term used by economists to describe the increase in the price level over time.  It does not make sense to talk about inflation in the price of a single, specific good, as we buy many goods.  While, over any given time period, the prices of some goods may rise, and others may fall, inflation describes the changes in the average price. If, on average, prices are increasing, inflation is positive. If, on average, prices are decreasing, inflation is negative (this is known as deflation). 5 5 The Consumer Price Index (CPI) in the US The chart below shows annual inflation rates from 1948 to 2016: Immediately following World War II, inflation was very volatile; the late 1970’s was characterized by runaway inflation; and recently inflation has been low and stable around 2-3%, with a short period of deflation following the 2008 financial crises. CPI Inflation (Y/Y) 15.0% 12.5% 10.0% 7.5% 5.0% 2.5% 0.0% -2.5% -5.0% Source: Federal Reserve of Saint Louis Economic Data (FRED) 6 6  CPI CPI prices increase slightly more in the late 1970s (oil price shock) and in the 2000s (commodities boom and higher fuel costs). CPI (Jan. 2000 = 100) CPI 160 140 120 100 80 60 40 20 0 Source: Federal Reserve of Saint Louis Economic Data (FRED) 7 7 The Consumer Price Index in Cyprus The chart below shows annual inflation rates from 1960 to 2019: Immediately following 1974, inflation was very volatile; and after the Euro introduction it has been around 2-3%, with a period of deflation following the 2013 financial crisis. Source: Cyprus Statistical Service 8 8  Inflation and purchasing power The most obvious effect of inflation is that it reduces the purchasing power of a dollar over time. Ex. Today, a consumer spends an average of $150 per week on groceries for his family. If the inflation rate is 3% (per year), how much will it cost this consumer to purchase the same amount of groceries in 5 years? Ans. Because prices are increasing by 3% per year, after five years, $150 worth of groceries today will cost: $150 ∗ 1.03 = $173.89 (Note that this assumes that the price of groceries changes with the average price level. Of course, the change in the price of groceries might differ from inflation due to supply and demand factors for groceries.) 9 9 Inflation and purchasing power When there is inflation, as time passes, it costs more money to purchase the same amount of goods. In general, the future price of a basket of goods can be found using the following formula: 𝑃 =𝑃 1+𝑖 Where P0 is the price of the goods today, i is the inflation rate, T is the number of years that pass, and PT is the price of the basket of goods T years in the future. 10 10  Inflation and purchasing power As a corollary, as time passes, the same amount of money will buy less goods. Ex. If the inflation rate is 3% and the consumer described above continues to spend $150 per week on groceries, in five years will he be able to purchase more, less, or the same amount of groceries each week? Ans. Because groceries are now more expensive, the consumer is not able to afford the same amount of groceries with the same amount of spending, and so he can only purchase less groceries per week with the same $150. Using the inflation formula, we can see that: 𝑃 1 1 𝑃 =𝑃 1+𝑖 → = = = 0.86 𝑃 1+𝑖 1.03 So, the same $150 in five years will buy 14% less groceries in five years. 11 11 Inflation and purchasing power The more time passes, the further inflation erodes the purchasing power of a dollar: Future Purchasing Power of $100 with 3% Inflation $100 $86.26 $80 $74.41 $60 $40 $22.81 $20 $5.20 $0 0 1 2 3 4 5.. 10 … 50 … 100 Years from Today 12 12  Holding cash Inflation is a tax on cash  Holding cash over time is costly: the value of cash will decrease overtime  Cash is not a “secure” investment, there is an inflation risk  Cash cannot be “indexed” to inflation; when there is inflation, the return to cash is negative 13 13 Nominal and Real Prices 14  Real versus nominal prices To control for the effects of the changing purchasing power of the dollar on prices over time, economists distinguish between real and nominal prices.  The nominal price of a good is the actual number of dollars that good costs (i.e., the sticker price). Because of inflation, this will change over time.  The real price of a good is adjusted for inflation, and is indexed to the value of a dollar at some specified point in time. The real price of a good will not change with inflation (but may change due to supply and demand for that good). The distinction between nominal and real prices is more easily demonstrated using an example… 15 15 Real versus nominal prices So while the nominal value of $100 may stay the same, its real value declines with inflation: Real vs. Nominal Value of $100 with 3% Inflation Nominal Value Real Value $100 $80 $60 $40 $20 $0 0 10 20 30 40 50 60 70 80 90 100 Years from Today 16 16  Real versus nominal prices Ex. A business man buys a new suit of the same brand and style every five years. In 1995, this suit cost the business man $400. In 2000, it cost him $440. In 2005, it cost him $525. Inflation has been steady at 2% each year over this time period. What is the nominal and real price of this suit in 1995, 2000, and 2005? Ans. The nominal price of the suit is simply the sticker price and was $400, $440, and $525 in 1995, 2000, and 2005, respectively. The nominal price of the suit increased over this time period. The real price of the suit can be found by adjusting the prices for inflation in terms of some index year. Taking the index year to be 1995, the suit in 2000 still cost the business man about $400 in 1995 dollars: 𝑃𝑟𝑖𝑐𝑒 $440 𝑃𝑟𝑖𝑐𝑒 ,$ = = = $399 1+𝑖 1.02 Thus, the real price of the suit did not increase between 1995 and 2000. 17 17 Real versus nominal prices Ans. (continued) Again taking the index year to be 1995, the suit in 2005 cost the business man $431 in 1995 dollars: 𝑃𝑟𝑖𝑐𝑒 $525 𝑃𝑟𝑖𝑐𝑒 ,$ = = = $431 1+𝑖 1.02 Thus, the real price of the suit increased between 1995 and 2005. In other words, the price of the suit increased at a rate faster than inflation over this time period. The rate of in the price of the suit over those ten years was about 2.8%: $525 − 1 = 2.8% 18 $400 18  Inflation and Wages 19 Inflation and wages When I was your age, it took me a full day’s work to mow three lawns and paint one side of a fence, and all I got was a quarter! Prices may increase over time, but so do wages. So while inflation may reduce the purchasing power of a dollar over time, the purchasing power of a day’s work may not be effected… 20 20  Real wages Generally, wages increase over time, and often do so more rapidly than inflation. As a result, real wages tend to increase over time (because of improved productivity), though there are periods of time where this is not the case… U.S. Real Median Household Income $60,000 $58,000 $56,000 $54,000 $53,657 $52,000 $50,000 $48,665 $48,000 $46,000 $44,000 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Federal Reserve of Saint Louis Economic Data (FRED) 21 21 Inflation and Savings 22  Real versus nominal interest rates Because of inflation, real interest rates are generally lower than nominal rates (and sometimes negative!): T-Bill Returns (1953-2015) Source: Nominal rates from Federal Reserve Bank of St. Louis (FRED). Real rates from Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy,15 (1981): 151-200: 151-200. 23 23 Measuring knowledge of inflation Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account? a) More than today b) Exactly the same c) Less than today d) I do not know e) Refuse to answer Source: 2015 National Financial Capability Study 24 24  National Financial Capability Study Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account? a) More than today b) Exactly the same c) Less than today d) I do not know e) Refuse to answer 64% answered correctly. Source: 2015 National Financial Capability Study 25 25 Chapter 3 Money Management Strategy: Financial Statements and Budgeting 26  Chapter 3 Learning Objectives LO3-1 Recognize relationships among financial documents and money management activities. LO3-2 Develop a personal balance sheet and cash flow statement. LO3-3 Create and implement a budget. LO3-4 Relate money management and savings activities to achieving financial goals. 27 27 Successful Money Management LO3-1: Recognize relationships among financial documents and money management activities. Daily spending and saving decisions are the main element of financial planning. Decisions must be coordinated with needs, goals, and personal situations. MONEY MANAGEMENT is the day-to-day financial activities necessary to manage current personal economic resources while working toward long-term financial security. 28 28  Opportunity Cost and Money Management Spending for current living expenses reduces the amount you can save and invest. Saving and investing for the future reduces the amount you can spend now. Buying on credit ties up future income. Using savings for purchases results in lost interest earnings and depletes savings. Comparison shopping can save money but takes valuable time. 29 29 Exhibit 3-1: Money Management Activities 30 30  A Personal Financial Records System An Organized System of Financial Records provides a basis for: – Handling daily business affairs, such as paying bills – Planning and measuring financial progress – Completing required tax reports – Making effective investment decisions – Determining available resources for current and future spending Home file, safe deposit box, computer, cloud storage 31 31 Personal Financial Statements LO3-2: Develop a personal balance sheet and cash flow statement. MAIN PURPOSES OF PERSONAL FINANCIAL STATEMENTS – Report your current financial position in relation to the value of the items you own and the amounts you owe. – Measure your progress toward financial goals. – Maintain information on your financial activities. – Provide data you can use when preparing tax forms or applying for credit. 32 32  Personal Balance Sheet: Step 1 PERSONAL BALANCE SHEET: WHERE ARE YOU NOW? – Also called the Net Worth Statement or Statement of Financial Position – Preparation requires using three steps STEP 1: LIST ITEMS OF VALUE - Assets: what you own  Liquid assets  Real estate  Personal possessions  Investment assets 33 33 Personal Balance Sheet: Step 2 and 3 STEP 2: DETERMINE AMOUNTS OWED - Liabilities: what you owe  Current liabilities (less than 1 year)  Long-term liabilities STEP 3: COMPUTE NET WORTH - Net Worth = Assets − Liabilities - Assets = Liabilities + Net Worth - Insolvency is the inability to pay debts when they are due 34 34  Net Worth Net Worth is an indication of your current financial position on a given date Items of value − (what you own) - Amounts owed = (what you owe) = Net worth (your wealth) Ways to increase Net Worth - Increasing your savings - Reducing spending - Increasing the value of investments and other possessions - Reducing the amounts you owe 35 35 Net Worth Calculation Example If a household has $193,000 of assets and liabilities of $88,000, then the net worth would be $105,000. Assets − Liabilities = Net Worth $193,000 − $88,000 = $105,000 36 36  The Cash Flow Statement WHERE DID YOUR MONEY GO? – Cash Flow is the actual inflow and outflow of cash for a given time period – Also called a Personal Income and Expenditure Statement – Process for preparing a cash flow statement: Total cash Cash outflows Cash surplus or received during during the time the time period − period = deficit 37 37 The Cash Flow Statement: Step 1 Preparation requires using three steps STEP 1: RECORD INCOME - Wages, salaries, and commissions - Self-employment business income - Savings and investment income - Gifts, grants, and scholarships - Government payments, such as Social Security, public assistance, and unemployment benefits - Amounts received from pension and retirement programs - Alimony and child support payments 38 38  The Cash Flow Statement: Steps 2 and 3 STEP 2: RECORD CASH OUTFLOWS - Fixed expenses - Variable expenses STEP 3: DETERMINE NET CASH FLOW - The difference between income and outflows can either be positive (surplus) or negative (deficit) - Cash flow statement provides the foundation for preparing and implementing a spending, saving, and investment plan 39 39 Budgeting for Skilled Money Management LO3-3: Create and implement a budget. A budget is a spending plan The main purposes of a budget are to help you: – Live within your income – Spend your money wisely – Reach your financial goals – Prepare for financial emergencies – Develop wise financial management habits 40 40  Exhibit 3-5: Creating and Implementing a Budget 41 41 The Budgeting Process Step 1: Set Financial Goals Step 2: Estimate Income Step 3: Budget An Emergency Fund and Savings Step 4: Budget Fixed Expenses Step 5: Budget Variable Expenses Step 6: Record Spending Amounts Step 7: Review Spending and Saving Patterns Review Your Financial Progress Revise Your Goals and Budget Allocations 42 42  Characteristics of Successful Budgeting A budget will work only if you follow it. Experts advise that a successful budget should be: – Well planned / Realistic / Flexible / Clearly communicated Which one works for you? Types of budgets – Mental budget – Physical budget – Written budget or computerized budget (excel) – Online budget: use bank or financial institution website – Budgeting app: use cell phone or tablet 43 43 Personal Budget in Cyprus (1/7) Taxes and Contributions – Social insurance – General Health System (GHS) – Income Tax – Special contribution for defense – Personal Expenses 44 44  Personal Budget in Cyprus (2/7) Social Insurance Social Insurance contribution varies: For employees: 21.5%, of which – 8.3% is paid by the employee, – 8.3% by the employer and – 4.9% by the Republic. For employees covered by an occupational pension scheme without the employee contributing to it: 21.5%, of which – 4.2% is paid by the employee, – 12.4% by the employer and – 4.9% by the Republic. 45 45 Personal Budget in Cyprus (3/7) Social Insurance For self-employed workers: 20.5%, of which – 15.6% is paid by employee and 4.9% by the Republic. For optional domestic insured persons: 18.4%, of which – 14% is paid by the insured person and 4.4% by the Republic. For optionally insured abroad: 21.5%, of which 16.6% is paid by the insured person himself and 4.9% by the Fixed Fund of the Republic. -Note that the rates above apply for the contribution years 2019 to 2023. 46 46  Personal Budget in Cyprus (4/7) GHS Annual (personal) taxable income for GHS purposes: € 180,000. If person not a tax resident of Cyprus, contributions calculated only on the income, earnings, and pensions that derive from the Republic of Cyprus, excluding dividends and interest. Employers’ contributions and employees’ deductions are calculated on the gross salary and will be paid through Social Insurances From 1 March 2020 contributions are : Employees and pensioners: 2.65% of their income / on their pension Employers: 2.9% on the salary of every person employed The state: 4.7% on the salary of employees, remuneration of self-employed, officials and on pensions Self-employed people: 4% on their remuneration => Contributions are income-tax deductible (up to 20% of income) 47 47 Personal Budget in Cyprus (5/7) Income Tax An individual is tax resident in Cyprus if (s)he spends in Cyprus more than 183 days in any one calendar year. Tax exemptions apply. https://taxsummaries.pwc.com/cyprus/individual/taxes-on-personal-income 48 48  Personal Budget in Cyprus (6/7) Special Defence Contribution (SDC) The SDC tax applies only for income earned from – Dividends – Interest earned – Renting out properties – For both tax and non-tax residents More information here: https://www.mof.gov.cy/mof/TAX/taxdep.nsf/All/BFA1B33F3C95FFB9 C22582280036FEC3?OpenDocument 49 49 Personal Budget in Cyprus (7/7) Personal Expenses Loan payments Utilities (electricity, water, phone, internet etc.) Daily supermarket Car expenses Children’s budget (!) Entertainment Summer holidays 50 50  Summary Explained the concept of inflation Separated Nominal and Real interest rates Explained the impact of inflation on savings. Observed historical trends on the above. We then explained the concept of money management through personal ― Cash flow statement ― Balance sheet ― Budget ― Goal setting and achieving ― Also gave the “Cyprus budget” big picture 51 51