13. What is Inflation Video Lecture | Become an Expert: Value Investing - Business Basics

welcome the course to unit 2 lesson 1
what is inflation in this lesson we have
three lesson objectives
the first lesson objective is what is
inflation the second lesson objective is
how and why does the government inflate
the currency unless an objective 3 is
how does inflation affect bonds and
stocks so let's get started so I'm sure
everyone can remember when they sat down
with their grandfather and he said that
he could buy a can of soda for 5 cents
or whatever the case might be and when
you hear those stories this is what
we're talking about when we talk about
inflation so why does the government
inflate the money the Federal Reserve
will tell you that they inflate the
money because it allows them to protect
the country from deep recessions or
depressions but another reason that a
lot of people really don't talk about is
that it serves as an indirect form of
taxation as we get a little bit further
into this lesson you understand how that
is actually a form of taxation but the
main thing that you need to understand
is that inflation occurs because the
federal government increases the supply
of money so let me give you a quick
example let's assume we have a kid here
named David and he loves milk and
because he loves milk he's going to do
some chores so he can get some money and
go buy the milk so david goes and works
for his parents and he takes out the
trash and his trash detail is worth $4
so his parents give him the $4 for
taking out the trash and what you have
to understand is that money is nothing
more than a symbol of work that's been
performed so david performs some work
his parents gave him some money and then
david can trade that money for the work
that somebody else does always remember
that money is nothing more than a symbol
of the work that's been performed
so david takes that symbol of work
performed which was 4 dollars and he
goes to the supermarket and he can buy
milk in the year 2012 which is the year
that he performed that work ok now let's
say that david performed the work he got
the 4 dollars from his parents in 2012
but he waited an entire year until 2013
before he was able to go and buy the
milk
but now the cost the milk is four
dollars and twelve cents he still
performed the same amount of work he
still did the exact same thing and in
one year he could buy the milk but in
the other year he couldn't buy the milk
and that was because of inflation so
what caused the price of the milk to go
from four dollars to four dollars and
twelve cents so as we look over here
let's look at year 2012 and we have four
people and we're going to say that these
four people symbolically represent all
the people across our entire country
okay and let's just say that the federal
government has put $1,000 into this
system of people that are working and
that thousand dollars is what they have
to use to trade amongst each other
because remember that money is just a
symbol with their work since it's a
symbol of their work they can trade it
amongst each other as they continue to
trade the thousand dollars the value of
each dollar is dependent on what that
person might need whether it's food
clothes transportation or whatever so
let's let's take these four people and
let's go ahead and look at the year 2013
and in this scenario let's say that a
change occurred that the federal
government instead of putting a thousand
dollars between these four people they
put one thousand two hundred dollars
between these four people same number of
people different supply of money which
is just that simple of the work that
they're performing so as they're doing
their work and there's more money in
this system the value that they're going
to charge for services or products that
they're creating is going to be higher
because there's more money in that
system so let's say that in 2012
whenever there was a thousand dollars in
the system one of these people could go
buy milk for four dollars but whenever
we put 1200 dollars in the system in
2013 the milk doesn't have to be four
dollars anymore it could go up to maybe
four dollars and 13 cents or whatever
the case might be it's a higher cost
because it's relative to everybody in
the system that didn't change in
population but the money supply did so
that's what the Fed is controlling and
they're just gradually increasing that
amount of money in the system and that's
how the money becomes inflated so how
does the Fed actually control
the amount of money in the system now
there's many different ways they can do
it they can actually physically print
more money but the way that they they
commonly adjust how much money's in the
system is through banks so the Federal
Reserve sets a thing called the reserve
ratio and in this scenario we're going
to say that the reserve ratio is 20
percent so if this man takes a thousand
dollars and he takes it to the bank and
he says hey I want to save this thousand
dollars the bank then puts it in his
account his digital account you would
check on this computer or whatever and
the bank then takes that money and then
they have the ability to lend it to
somebody else which everyone understands
but what a lot of people don't realize
is that the bank based off that reserve
ratio that's how much money they're
allowed to lend out from the one from
the money that they have received so
since the bank received a thousand
dollars from this customer they have to
keep two hundred dollars on hand and
they have the ability to lend out
another eight hundred dollars okay so
let's see what happens when the bank
lends out that $800 so now they lent
this eight hundred dollars to this woman
here and let's say she takes the $800
and she saves it into the bank so based
off of the rules the second bank which
this woman has gone to has to hold 20
percent about eight hundred dollars so
the bank would hold one hundred and
sixty dollars and they have the ability
to lend out five hundred and forty
dollars now remember we only started
with a thousand dollars okay and now
we're already up to another eight
hundred dollars in the system and now
the bank's going to lend out the five
hundred and forty from that bank and so
what you see is that this guy saves five
hundred and forty which means the bank
has to keep 108 on hand and they can
lend 430 to the next person comes along
and the process goes on and on and on
okay so as you can see based off that
reserve ratio as that process continues
on 1,000 dollars initially saved in the
system actually turns into $5,000 so you
can see that supply of money if we were
talking about actual dollars in the
system it's actually if you take one
divided by that reserve ratio that's
going to give you the actual amount that
you got to multiply the base amount of
money by so let's take one divided by
the the point two which is 20% that
gives you a five and you'd multiply five
times a thousand and that gives you the
5000 that's how that's calculated so
what happens when that ratio changes so
what would happen if the reserve ratio
is 10% so if we went through that whole
scenario again and and when this person
by person $1,000 at a 10% reserve ratio
would actually turn into $10,000 okay
because when we take 1 divided by 0.1
that gives us 10 and we'd multiply 10 by
a thousand so you can see the federal
government when they adjust that reserve
ratio from 20% to 10% they just created
another $5,000 in the system if there
was only a base thousand dollars in
there so they can quickly adjust how
much money is in the system just by
adjusting that reserve ratio so this is
just one way that the Fed can adjust the
amount of money in the financial system
but what we need to know as investors is
how inflation or the devaluation of
money affects your investments that's
what really matters here is when the Fed
adjust these rates and they inflate the
money more how does that affect your
bonds and how does that affect your
stocks and that's the question that
we've really got to understand and an
answer so let's start with bonds how
does inflation of impact your bonds so
let's take this scenario we have Dan on
the left and he's going to lend $1,000
to Amy and Amy is basically selling down
a bond for $1,000 and the coupon on that
bond is 5% we're just going to assume
that this bond is a 1-year bond so that
we can kind of see how the inflation
impacts it
okay so thousand dollars to Amy Amy's
gonna have to give that thousand dollars
back after one year and she's gonna have
to pay 5% on it so let's assume that
during that year from 2012 to 2013 5%
inflation occurs during that time frame
so 2013 comes along and amy has to
return Dan's thousand dollars so she
gives
thousand dollars back to him and she
also has to pay a $50 coupon which was
the five percent interest on that
thousand dollars therefore Dan has one
thousand and fifty dollars in 2013 but
due to the five percent inflation the
thousand dollars in 2012 money is
actually equal to a thousand fifty
dollars in the 2013 money so those two
numbers are equal so even though Dan
might think he made fifty dollars Dan
actually made no money because the his
buying power is exactly the same in 2013
as it was back in 2012 so how does
inflation impact bonds well it
drastically impact bonds in order to see
what the actual yield is you have to
take the bond deal and you have to
subtract the inflation rate and that
will give you the actual bond yield so
in that last scenario the bond yield was
five percent but the inflation rate was
also five percent so the actual bond
yield was zero percent now a caveat to
this and I don't really get into it too
much here but you can do more research
on it is something called tips and
that's a Treasury inflated protected
security so how does inflation impact
stocks so we know that with bonds it's
not good so let's see what happens with
the stocks so let's say Dan buys
ownership of Apple which we're just
going to say that he buys a thousand
dollars worth of shares for Apple which
is probably gonna get them about one and
a quarter share at this point but let's
just say it goes and buys a thousand
dollars worth of Apple okay and that
happened in 2012 during his ownership
from 2012 to 2013 the same 5% inflation
occurs so let's look at this from
Apple's standpoint in 2012 apples cost
of materials was $100 their sales price
which is the price that they're going to
sell their product for is $200 and these
are just numbers that I'm coming up with
to really make all the math really
simple so if it cost them $100 to make
the product they sell for 200 their net
income is going to be $100 so as we look
to year 2013 because of the 5% inflation
the cost their materials went up by 5%
and it cost them now one hundred and
five dollars to buy their materials but
the
because of that increase in cost they
are now able to go ahead and sell their
their product at a higher price because
there's more money in the system and
people can afford that because there's
more money in the system they translate
that cost of those materials over to
their customers instead of themselves
and so their sales price is now two
hundred and ten dollars opposed to two
hundred dollars which is also a five
percent increase so when we subtract the
price from the materials then that
income is a hundred and five dollars
which is a five percent increase so what
Apple did from 2012 to 2013 is they
automatically adjusted because the cost
for them to do business was increased by
five percent so they then translated
that cost over to their customer which
was their price was raised by five
percent and then their net income was
raised by five percent
so if Dan was going to back in 2012 Dan
was buying ownership of Apple one and it
was trading in a multiple of the
earnings which the net income was a
hundred dollars and so he purchased his
shares for ten ten times the earnings
which would be a thousand as we look at
the 2013 numbers if the multiple was
exactly the same Dan shares are now
worth $1,050
so his shares automatically kept in in
step with the inflation because then
that income increased to one hundred and
five dollars
so how does inflation impact stocks as a
result stocks with no debt are generally
unaffected so here's a here the quick
caveat to that if the inflation moves
the price point to of the product
outside of the markets desire inflation
will absolutely impact the stocks
performance but generally speaking
stocks are not really affected all that
much by inflation like bonds are so this
concludes course to unit 2 lesson 1 what
is inflation we learned about what
inflation was we learn how and why the
government inflates the currency and we
learned how does inflation affect bonds
and stocks so I hope the lesson was
helpful and I hope to see you guys in
the next lesson