Working with Numbers

Simple vs Compound Interest;

Inflation and Deflation; Bonds and Interest Rates;

Monetary vs Fiscal Stimulus; Gold vs the Dollar;

GDP and recession/growth.

Compound interest – lump sump investment

Simple vs Compound Interest

Albert Einstein called Compound Interest “The greatest mathematical discovery of all time.”

Compound interest – described simply – is interest earned on the initial deposit (of cash) PLUS interest on all subsequent interest earned after that. To understand compound interest, it is first important to understand simple interest.

Simple Interest is interest paid on the original deposit only.

So if you deposited $1,000 in a savings account and earned 5% in simple interest each year, then your savings would grow as follows

At the end of year 1, you would have $1050.
At the end of year 2, you would have $1,100 ($1,050 + 5% interest on the original deposit of $1,000)
At the end of year 3, you would have $1,150 (as there would be $50 accrued each year on the original investment of $1,000)
And so on.
After twenty-five years, you’d have $2,250.

However, if you were earning compound interest….you’d have $3,386 – ie over $1,136 more! For doing nothing!

Why? Because you’d earn interest on the interest that you earn each year.

So using compound interest, in Year 1, you’d have 1,050.
In Year 2, you’d have $1,102.50 (as opposed to $1,100 with Simple Interest)
In Year 3, you’d have $1,157 (as opposed to $1,150 with Simple Interest)
As time goes on, the compound interest would “snowball” and at the end of the 25 year period, the difference, as you can see is significant.

So to recap, over a 25 year term with 5% interest per annum, if you’d invested $1,000, at the end you’d have $2,250 with Simple Interest but $3,386 with Compound Interest. You can use our Compound Interest calculator to find out the final amount for different deposits with different interest rates and different saving terms. The formula for Compound Interest is

FV = PV (1+r)^n
Where FV is the “future value”, PV is the “present value”, r is the interest rate and n is the number of periods.

Inflation –inflation is “too much money chasing too few goods!” When too much money is chasing too few goods, the prices of the goods rise because demand is outstripping supply. Inflation is also known as a combination of an increase in prices on a broad range of goods which results in a decrease in the purchasing power of money.

For example:

Imagine that you bought a bottle of wine in 2010 for £100 and the inflation rate was 0%. If the following year, inflation rate was running at 50%, then that means the same bottle of wine would cost 50% more, so you would have to pay £150 for the same bottle of wine! Which would mean that the power of your money is no longer as strong, because you have to pay more money to get exactly the same thing (this is the decrease in purchasing power). In reality, inflation rates are often much lower (in developed countries) running at between 1.2% and 5% in the UK and 1.6 and 2% in the US, over the last two years (2012-2014). However, in Argentina, as of September 2014, inflation was 40%! And in Zimbabwe, although it’s declined significantly in recent months, it was as high as 231,000,000% – yes, 231 million percent!!

There are two types of inflation – the CPI and the RPI (Consumer Price Index and Retail Price Index, respectively).

In the UK, the CPI is based on a basket of the most common goods and services bought such as milk, bread, eggs, clothes, petrol/gas for cars, travelcards, haircuts and even netflix subscriptions.

In the UK, the RPI (Retail Price Index) is different from the CPI (Consumer Price Index) because it includes housing costs such as mortgage rates and council tax, whereas the CPI doesn’t.

In “real life”, many companies will give staff pay rises which are close to the rate of inflation. So, for example, if inflation is running at 3.1%, you might expect a pay rise of around 2.5-3%, that is if your company is actually offering annual pay rises! The reason the annual pay rise is linked to inflation is because the cost of a travel card / rail and bus travel will go up in January each year, some times by much more than the inflation rate, so wages are increased to keep up with this rise in costs.

The Bank of England aims to keep inflation at 2%. If it falls below 1% or rises above 3%, then the governor of the Bank of England has to write a letter to the Chancellor explaining why those levels have been breached. Although the Chancellor will know why eg for 3% likely reasons are rising oil prices, rising cost of goods such as clothes, etc, it is a mandatory task for the Governor to write to the Chancellor explaining why as the Governor is responsible for controlling inflation and would have to raise the interest rate to curb it, and lower the interest rate to avoid deflation.

Someone once said that “inflation is a hole in every saver’s pocket!” This is indeed true, especially if your savings are not earning a return above inflation. So if annual inflation was 2%, and you had a savings account paying only 1%, then the annual return on your savings would be negative – and you’d need to earn a higher level of interest on your savings, which is why people invest in stocks and shares – higher risk, but higher reward!

Deflation, on the other hand, is when prices fall, year on year (YoY). This causes consumers to hold off purchasing goods, as they believe the prices of the goods will fall further in the future, and because demand drops for products, it causes prices to fall even further, creating a self-fulfilling prophecy.

What affects the dollar?

Loose monetary policy, where interest rates are lowered to boost the economy – why and would this affect the dollar? When a country has low interest rates, it makes it less attractive to foreign investors because low interest rates will make the banks in that country offer low interest rates to savers and depositors in that country. This will make the currency of that country less attractive if savers can get higher levels of interest in other countries, which means demand for the currency in the country with low interest rates will decline, which will cause the value of that currency to fall.

Quantitative easing, also known as money printing can also cause the value of a currency to fall, as much more money is available in the country’s system.

What affects the price of oil? The most recent event has been the threat of an attack on Syria by the West. Oil affects the price of everything. Literally everything!!! as whatever you buy, whether it’s milk, jam, juice, a pair of jeans, sunglasses, even a bikini! They’re all affected by the price of oil, because they have to be transported from whether they were produced or manufactured (whether that be a farm or factory) to the destination where you will buy them (ie a supermarket or shop) or your house if you’re ordering them online. This will involve the use of petrol in a car or fuel of some kind to transport the goods, and the fuel will contain oil – one of the most precious commodities in the world!

Another event that caused the oil price to surge in 2013 was when the President of Egypt was deposed by the military. Prior to his resignation, it was feared that attacks on the Suez Canal (which is used to transport oil from Africa to other countries) would cause disrupt and therefore the supply of oil to be affected, whilst demand would remain the same, resulting in a price rise.

Airlines’ shares usually fall when the price of oil rises.

Difference between Fiscal and Monetary stimulus
Fiscal stimulus – concerns the ‘pumping of money’ into the economy. This would be achieved by the Central Bank ie the Bank of England in the UK, buying corporate and government bonds. By doing this, they would be giving money to companies who may otherwise not have received the cash, as well as giving more money to the government which can then spend the money on things like schools, infrastructure, etc.
In modern day language, this has been termed ‘QE’ or ‘Quantitative Easing’ because Central Banks agreed to buy billions of pounds a month in bonds in order to ‘stimulate’ the economy, as they would indirectly be giving cash to companies that need it, as well as the government.
Monetary stimulus – this concerns the lowering of interest rates. The Central Bank, ie the Bank of England in England or The Federal Reserve in the US, would lower the base rate – the rate at which rates for many different products, including mortgages in particular, would be set. If the base rate is lowered, then this would reduce the amount of money people pay on their mortgages where they have a ‘variable rate’ mortgage ie one that depends on the base rate (and this would happen if their lender/bank in turn decides to lower the rate that they are charging customers for their mortgage). How is this a stimulus? Well, if the interest on their mortgage was lowered, then their monthly outgoings on the mortgage would be lower and give them more disposable income which they could spend on goods and services, which would boost the economy. To give a crude example, if the base rate before a recession was 10% and someone was paying the base rate + 5% on an ‘interest-only’ mortgage ie 15% on a property worth £300,000 ie 15% x £300,000 = £45,000/25 years (the length of the mortgage) = £1,800 a month, and the base rate was lowered to 1%, then the following could happen.
The interest on their mortgage could come down to 1% base rate + 5% = 6%. 6% of £300,000 = £18,000. £18,000/25 = £720 a month.
So the customer would save £1,800 – £720 = £1,080 a month in interest on their monthly payments. This would mean that they have a lot more disposable income than they had previously, and they could go and spend their money on goods and services eg shoes, clothes, financial advice, etc, which would in turn boost (or stimulate) the economy, as consumer spending would increase.
As at the 27th of June 2013, the Federal Reserve in America has been purchasing $85bn a month worth of mortgage assets in order to stimulate the economy.

Corporate Calendar – you may have heard journalists on Bloomberg or the BBC mention the “Corporate Calendar” or you may have read the phrase in the Financial Times. Well, the Corporate Calendar simply refers to a period in time when public companies report on their results. Public companies are those that are listed on the stock market and they usually have to report their results every quarter (or 3 months) as it is an obligation they have to fulfil so that investors (as well as city commentators and other people) know how the companies are doing in terms of sales and profits. There will always be expectations on how companies have done and if they exceed expectations, this can help to move the stock market UP. Whereas, if their earnings (profits) are below expectations, then this can move the stock market down! On the other hand, if expectations were that a company would make a loss of $500m, for example, but it actually lost $100m for a given quarter, the share in that company can actually rise, as the results are not as bad as investors feared.

Budget Deficit – this is when a government is spending more money than it is earning. Eg if a government may be spending money on building hospitals, schools, roads and paying benefits, but it’s income (through corporate and individual taxes) is lower than the amount it is spending.

Budget Surplus – this is the opposite ie when a government is getting more money than it is spending. This happened in the USA in December 2013, then it brought it $53.2 billion more in revenue than it spent in that month! Nice!! It was the first time since 2007 that it had a budget surplus.

gdp and recession/growth

GDP – GDP or Gross Domestic Product is the sum of all the goods and services that a country produces. So you basically add up the total value of the sale of fish and chips, ice creams, aftershaves, chocolate bars, legal fees, accountancy fees, consultancy fees, and other transactions that have been carried out in a country. If GDP is increasing, then a country’s economy is deemed to be growing. If it is falling, then it is deem to be shrinking. GDP is usually measured quarterly, and if there are two consecutive quarters of negative growth, then a country is deemed to be in a recession. That is the technical definition for a recession – 2 consecutive quarters of negative growth. If the GDP is above 0%, then the economy of that country is considered to be growing, which is what all countries want.