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INTRODUCTION
Inflation is the rise in prices of goods ands services over time and is measured by
the annual percentage change called the inflation rate. The inflation rate is one indicator
of the overall strength of the economy and directly affects the purchasing power of the
dollar. (“What Is Inflation?”) It also plays a role in whether a country’s economy is
doing well in the global market and provides feedback on the performance of the
domestic market. As of March 2008, the annualized inflation rate in the United States
was 3.89%. This comes at a time of slowing economic growth when many economists
are predicting a future recession. This compares with an annualized inflation rate of
1.48% in March, 2002, when the U.S. economy was strong. (Financial Trend Forecaster)
Observing and analyzing trends in the rate of inflation can facilitate predictions
pertaining to the growth and general health of the national economy. This paper will
discuss how inflation rates can have an affect on credit cards, exchange rates and the
purchasing power of money abroad. It will also discuss the Federal Reserve’s role in the
economy.
CREDIT CARDS
Credit cards are small plastic cards that are used to borrow money from a
company to complete transactions quickly and efficiently. Credit card issuers offer low
introductory interest rates to attract new credit card users. A consumer is more likely to
use the credit card and build a debt balance because of the low initial interest rate. Credit
card companies offer low initial rates because a consumer that goes into debt provides
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significant profit for the credit card issuer, especially after the low introductory rate
expires and the higher normal monthly rates commence.
Unsecured debt is a loan that is not secured by an asset. Typical credit cards are a
type of unsecured debt because a person does not have to pledge an asset as collateral for
the credit card balance. This allows the cardholder to purchase goods and services
without regard to whether the individual has the assets to pay for them. (“Unsecured
Debt”) However, there are also ‘secured’ credit cards in which the cardholder deposits
money equal to the card’s credit limit with the card issuer. (Curry)
Credit cards can carry either a fixed interest rate or a variable interest rate,
referred to as Annual Percentage Rates (APRs) on unpaid balances. A fixed APR does
not change. A variable APR, on the other hand, can change and is usually calculated by
adding a certain disclosed percentage rate to a published interest index such as the Prime
Rate or the Treasury Bill Rate. (“Credit Card Terms and Fees”).
Many credit cards have a grace period. The grace period is the number of days
that a credit card holder has to pay the current balance of the credit card without incurring
a finance charge. Grace periods are usually between twenty and thirty days. After the
grace period is over, the interest rate is applied to any unpaid balance plus any purchases
the cardholder has made since the prior statement. However, if the entire billed balance is
paid off by the end of the grace period, there will be no interest rate applied on the either
the billed purchases or the new purchases made since the previous billing. (Bankrate)
Three things that determine a credit card’s credit limit are the applicant’s FICO
credit score, the applicant’s monthly income, and the credit standards employed by the
lender. A FICO credit score is a number between 375 and 850 and is determined by
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statistically analyzing a number of factors including an individual’s payment history and
outstanding debt. (myFICO) Also, if a cardholder exceeds the assigned credit limit, an
additional fee can be assessed. (Bankrate)
Although a credit card and debit card can appear identical, they are quite
different. While a credit card deals with borrowing money, debit cards immediately
remove money from the user’s bank account or checking account. (“Debit Card”)
INFLATION
Inflation affects the economy in many ways and its affects on prices, values, and
credit cards are no exception. It is currently considered the nation’s top economic
problem. In a recent poll conducted by CNN/Opinion Research Corp, over ninety
percent of Americans are concerned with increasing prices in the economy. (Goldman)
Whenever an item is purchased, it has a price. The “price of an item” is the
nominal value of a good or service that is charged to a buyer. This “nominal value” of
the item is the value of that item expressed in today’s dollars. The “real value”, on the
other hand, is the value of the item expressed in purchasing power at a given time and is
calculated by dividing the nominal value by the price index in decimal form. ("Deflating
Nominal Values to Real Values")
Inflation is the general upward movement of the average price of goods and
services in an economy. Note that this definition covers only the increase of average
prices. An increase in the average price of goods and services in the economy is does not
necessarily mean that all prices are rising (Graf). Even in an inflationary environment,
technology advancements and productivity increases can drive down the cost of some
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items. In general, in an inflationary environment, the opportunity cost of buying an item
in the future is greater than it is buying it in the present. However, for items such as
televisions, stereos, and computers, the opportunity cost of buying an item in the future is
less than buying it in the present. This is because new technology and productivity
advancements make products easier to manufacture and drives down components costs.
In an inflationary environment, debtors benefit at the expense of creditors. The
upward trend in prices that occurs during inflation creates a “weak dollar.” That is to say,
the “real purchasing power”, which is “the value of the money as measured by the
quantity and quality of products and services it can buy”, of any amount of money
decreases in an inflationary environment. (“Purchasing Power”) Therefore, every dollar
that a debtor owes to a creditor is worth slightly less than it was when the loan was taken
out.
Although currently it appears that inflation is having a negative affect on the
majority of Americans (Stewart), the United States has recently experienced consistently
low rates of inflation (TABLE A) as compared to many other world countries. For
example, in 2007, Zimbabwe had an inflation increase of 1033.5%, while five other
countries experienced inflation rates in excess of twenty percent. (TABLE B) (“What are
the Inflation Rates…”)
EXCHANGE RATE
Inflation plays a strong role in determining foreign exchange rates. A weak dollar
is inflationary because it directly affects the cost of foreign imports. As the Unites States’
dollar falls in value compared to other currencies, foreign goods and service become
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more expensive. Due to the relatively higher prices of foreign goods, American made
goods and services become more desirable. They are now relatively less expensive
causing an increase in the aggregate demand for domestic goods and services. The
increase in aggregate demand causes a rise of prices, output, and employment for
American companies. (Rosenbush) If the dollar depreciates against the Euro, the price of
the Euro rises in dollar terms. Previously, when the dollar and the Euro were equivalent, a
good that would have cost a 1 Euro could have been purchased for $1. With the
weakening of the U.S. dollar, a good that costs 1 Euro will cost more than $1.
As the U.S. dollar depreciates in value compared to other currencies, foreign
imports become more expensive. This means that a bottle of French wine will become
more expensive as the U.S. dollar depreciates in value against the Euro. Because
American’s want to purchase foreign goods, there becomes a “Derived Demand” for
foreign currency, in this case the Euro. (Deardorff) Since the Euro has a higher value
than the U.S. dollar, more U.S. dollars will have to be spent to become equivalent to the
price of the wine in Euros. An internationally weak currency is perceived as a good thing
for domestic producers because there is a higher incentive for domestic consumers to buy
domestic products over imported products. Also, an internationally weak dollar
encourages higher American exports to foreign countries, because goods become cheaper
in local currency for foreign consumers. (Rosenbush) An internationally weak currency
is bad for domestic consumers because both imports and domestically produced goods
become more expensive.
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THE FED
The Federal Reserve System which consists of twelve Federal Reserved Banks
and is referred to as ‘The Fed’ is the central bank of the United States. ("Frequently
Asked Questions - Federal Reserve System”) The Fed’s three long term goals are price
stability, economic growth, and full employment. (“Price Stability is Fed’s…”) When
the Fed conducts open market operations it purchases U.S. government securities off the
public market.
In turn, the banks lend out the new money obtained from the Fed, increasing the money
supply. When the Fed purchases public bonds, M1 shifts to the right and the price of
goods and services drops. (“Neutrality of Money”)
One of the ways the Fed affects the prime rate is by setting the federal funds rate,
which is the interest rate banks lend balances at the Federal Reserve to each other. Fed
decisions to change the federal funds rate will result in a change in the prime rate. When
the federal funds rate decreases, inter-bank borrowing costs decline. Banks are able to
charge their clients lower rates, thus lowering the banks prime lending rate to their best
cost. (Bankrate.com, “Prime Rate…”) Most adjustable 30 year mortgage rates are
affected by the prime rate which is derived from the federal funds rate. If the prime rate
goes up, the mortgage rate will go up and if the prime rate goes down so will the
mortgage rate.
Money neutrality refers to the idea that when the Fed adjusts money supply, there
is only a direct effect on nominal variables. These include prices and wages. The Fed’s
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adjustments or change in the money supply does not have a direct effect on real variables
including unemployment rates.
ANALYSIS
The Phillips Curve proposes that there is an inverse relationship between the inflation
rate and the unemployment rate (Hoover) (SEE APPENDIX, Figure 1). The Phillips
curve postulates that an unexpected increase in aggregate demand (AD) in the short run
causes price levels to rise and unemployment to decline. This means that a greater than
unexpected increase in AD will cause higher inflation rates in the short run and a lower
unemployment rate. The Phillips curve was rejected at one point because economists
believed that inflating the economy would soon be included into economic predictions
and forecasts. That way the Phillips effect would diminish over time.
Economists are worried about stagflation today because input costs, like the
increasing price of oil, shifts the SRAS curve to the left (SEE APPENDIX, Figure 2).
The higher costs of production, caused by the increasing oil prices, eventually causes a
cut back in production by certain firms. Higher costs also impact the labor market. The
rise in price level takes down the real wage rate and unemployment also rises.
CONCLUSION
Inflation has corrosive impacts on everyone in the world. Whether it is rising gas
prices or the slowly changing price of milk, inflation is everywhere. Inflation has been
relatively tame over the last decade as new technologies and low cost country product
sourcing have helped to hold down production costs and prices. Lately, however,
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inflation rates have been at a fifteen year high (Historical US Inflation Rate 1914Present). It has not been since 1991 that inflation rates have soared over 4% for long
periods of time. By glancing at the inflation rates for the past twenty years, it becomes
quite clear that the inflation rate is slowly getting higher and higher and at this pace we
could be headed back over 5%. Growth of developing economies such as China, India,
and Brasil are likely to cause increasing demand of scarce commodities going forward.
This mismatch of supply and demand in the short run will continue to flow through the
world economy pushing up input costs. The Fed’s recent actions to lower short term
interest rates will also stimulate the US economy which has historically added to
inflation.
Normally an increase in inflation will cause creditors to raise interest rates which
will also increase the interest rates on credit cards (“High or Low Inflation- Which is
better?”). Creditors raise interest rates for new loans because when they loan out money
before inflation occurs its real value is higher. However, after inflation occurs, the real
value of the borrowed money is lower, resulting in the creditors earning less money.
With an increase in interest rates, they can make up for the difference inflation makes and
earn the return they desire.
The exchange rate of the dollar versus most Reserve currencies has been falling
because of high relative inflation rates and low interest rates in the US. As the value of
the dollar declines, foreign purchasers will demand more dollars for each unit of their
domestic currency, driving down the dollar exchange rate.
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APPENDIX
Part 1:
Real Wages/Nominal Wages Over Time
$65,000
$60,000
Wages
$55,000
Real Wages
Nominal Wages
$50,000
$45,000
$40,000
1998-07-24 1999-12-06 2001-04-19 2002-09-01 2004-01-14 2005-05-28 2006-10-10 2008-02-22 2009-07-06
Date
Part 2:
FEDFUNDS, MPRIME, MORTG
10.00
9.00
8.00
Percent Change
7.00
6.00
MPrime
FedFunds
MORTG
5.00
4.00
3.00
2.00
1.00
0.00
1998-07-24
1999-12-06
2001-04-19
2002-09-01
2004-01-14
Date
2005-05-28
2006-10-10
2008-02-22
2009-07-06
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Part 3:
CPIAUCNS, UNRATE, GDP
7.0
6.0
5.0
Percent Change
4.0
3.0
CPIAUCNS
UNRATE
GDP
2.0
1.0
0.0
1998-07-24
1999-12-06
2001-04-19
2002-09-01
2004-01-14
-1.0
-2.0
Date
Part 4:
2005-05-28
2006-10-10
2008-02-22
2009-07-06
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TABLE A
U.S. Historical Inflation by Month – 2000-2008
Year
Jan
Feb
Mar
2008 4.28% 4.03% 3.98%
Apr
NA
May
NA
Jun
NA
Jul
NA
Aug
NA
Sep
NA
Oct
NA
Nov
NA
Dec
NA
Ave
NA
2007 2.08% 2.42% 2.78% 2.57% 2.69% 2.69% 2.36% 1.97% 2.76% 3.54% 4.31% 4.08% 2.85%
2006 3.99% 3.60% 3.36% 3.55% 4.17% 4.32% 4.15% 3.82% 2.06% 1.31% 1.97% 2.54% 3.24%
2005 2.97% 3.01% 3.15% 3.51% 2.80% 2.53% 3.17% 3.64% 4.69% 4.35% 3.46% 3.42% 3.39%
2004 1.93% 1.69% 1.74% 2.29% 3.05% 3.27% 2.99% 2.65% 2.54% 3.19% 3.52% 3.26% 2.68%
2003 2.60% 2.98% 3.02% 2.22% 2.06% 2.11% 2.11% 2.16% 2.32% 2.04% 1.77% 1.88% 2.27%
2002 1.14% 1.14% 1.48% 1.64% 1.18% 1.07% 1.46% 1.80% 1.51% 2.03% 2.20% 2.38% 1.59%
2001 3.73% 3.53% 2.92% 3.27% 3.62% 3.25% 2.72% 2.72% 2.65% 2.13% 1.90% 1.55% 2.83%
2000 2.74% 3.22% 3.76% 3.07% 3.19% 3.73% 3.66% 3.41% 3.45% 3.45% 3.45% 3.39% 3.38%
***Source:: "Current Inflation."
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TABLE B
Countries with Highest 2007 Inflation Rates
Ranking
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Country
Inflation Rate
Zimbabwe
Iraq
Guinea
San Tome and Principe
Yemen
Burma
Uzbekistan
Congo, Democratic Republic of the
Afghanistan
Serbia
Source: "What Are The Inflation Rates Of Other Countries Worldwide?".
1,033.5%
53.2%
30.0%
23.1%
20.8%
20.0%
19.8%
18.2%
16.3%
15.5%
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BIBLIOGRAPHY
*** Indicates Required Reading List
Bankrate.com. Bankrate.com. 8 Apr 2008 <http://www.bankrate.com/>. ***
Bankrate.com, "15 Must-Know Credit Card Terms". Bankrate, Inc.. 15 Apr 2008
<http://www.bankrate.com/brm/news/cc/20020906a.asp>.
Bankrate.com, "Prime Rate, Fed Funds, COFI". Bankrate, Inc.. 15 Apr 2008
<http://www.bankrate.com/brm/ratewatch/leading-rates.asp>.
Clarke, Warren. "How to Read Your Credit Score". Edmunds Inc.. 18 Apr 2008
<http://www.edmunds.com/advice/finance/articles/47274/article.html>
.
"Choose the Credit Card that Fits You Perfectly". FIA Card Services, Inc.. 8 Apr 2008
<http://www.mycardchoices.com/>. ***
"Credit Card Terms and Fees". BCSalliance.com. 15 Apr 2008
<http://www.bcsalliance.com/credit_cards02.html>.
"Current Inflation." InflationData.com. Financial Trend Forcaster. 19 Apr 2008
<http://inflationdata.com/inflation/Inflation_Rate/CurrentInflation.asp>.
Curry, Pat. "10 Questions Before Getting a Secured Credit Card". Bankrate, Inc.. 15 Apr
2008 <http://www.bankrate.com/brm/news/cc/19990823.asp>.
Deardorff, Alan V.. "Deardorff's Glossary of International Economics". 15 Apr 2008
<http://www-personal.umich.edu/~alandear/glossary/d.html>.
"Debit Card". Investopedia ULC. 18 Apr 2008
<http://www.investopedia.com/terms/d/debitcard.asp>
"Deflating Nominal Values to Real Values." Economic Data. Federal Reserve Bank of
Dallas. 19 Apr 2008
<http://inflationdata.com/inflation/Inflation_Rate/CurrentInflation.asp>.
"Economic Data - FRED." Economic Research. Federal Reserve Bank of St. Louis.
10 Apr 2008 <http://research.stlouisfed.org/fred2/>. ***
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BIBLIOGRAPHY (con’t.)
*** Indicates Required Reading List
"Frequently Asked Questions - Federal Reserve System ." The Federal Reserve Board. 7
Mar 2007. The Federal Reserve Board. 16 Apr 2008
<http://www.federalreserve.gov/generalinfo/faq/faqfrs.htm>.
Financial Trend Forecaster, “Current Inflation Rates.” InflationData.com. 2008. Capital
Professional Services. 17 Apr 2008
<http://www.inflationdata.com/inflation/inflation_rate/CurrentInflation.asp>
Goldman, David. "Inflation is Americans' Top Economic Concern." CNNMoney.com. 18
Mar 2007. Cable News Network. A Time Warner Company. 19 Apr 2008
<http://money.cnn.com/2008/03/18/news/economy/cnn_poll_inflation/index.htm?
section=money_topstories>.
Graf, Paul. "Macroeconomics." 100 Thomas, University Park, PA.
"Historical US Inflation Rate 1914-Present". Financial Trend Forecaster. 16 Apr 2008
<http://inflationdata.com/inflation/Inflation_Rate/HistoricalInflation.aspx?dsInflation_
currentPage=0>.
“High or Low Inflation- Which is better?". Financial Trend Forecaster. 16 Apr 2008
<http://inflationdata.com/inflation/Inflation_Articles/HighOrLow.asp>.
Hoover, Kevin D.. "Phillips Curve". The Library of Economics and Liberty. 16 Apr 2008
<http://www.econlib.org/library/Enc/PhillipsCurve.html>.
Miller, Roger Leroy. Economics Today: The Micro View . Fourteenth Edition.
Boston: Pearson, 2008.
Moffatt, Mike. “What is Inflation? Your Inflation Questions Answered”. About Inc.
17 Apr 2008
<http://economics.about.com/od/helpforeconomicsstudents/f/inflation.htm> ***
myFICO, "What's in Your FICO Score". Fair Isaac Corporation. 17 Apr 2008
<http://www.myfico.com/CreditEducation/>. ***
"Neutrality Of Money". Investopedia ULC. 15 Apr 2008
<http://www.investopedia.com/terms/n/neutrality_of_money.asp>
"Price Stablity is Fed's Long-term Goal -Fed's Kohn". Thomson Reuters. 15 Apr 2008
<http://uk.reuters.com/article/marketsNewsUS/idUKWBT00845320080226>.
16
BIBLIOGRAPHY (con’t.)
*** Indicates Required Reading List
"Purchasing Power". WebFinance Incorporated. 15 Apr 2008
<http://www.investorwords.com/3959/purchasing_power.html>.
Rosenbush, Steve. "The Pros and Cons of a Week Dollar". The McGraw Hill Companies
Inc.. 15 Apr 2008
<http://www.businessweek.com/bwdaily/dnflash/nov2004/nf20041112_3507_db039 .
htm>.
Stewart, Hale "Bonddad". "For Most Americans Inflation Is Getting Worse, Not Better."
The Huffington Post. 17 OCT 2007. The HuffingtonPost.com, Inc.. 19 Apr 2008
<http://www.huffingtonpost.com/hale-stewart/for-most-americansinflat_b_68781.html>.
"Unsecured Debt". Fairlex Inc.. 15 Apr 2008 <http://financialdictionary.thefreedictionary.com/Unsecured+debt>.
"What Are The Inflation Rates Of Other Countries Worldwide?". My Two Dollars. 15
Apr 2008 <http://www.mytwodollars.com/2008/01/25/what-are-the-inflation-rates-ofother-countries-worldwide/>.
17
DIVISION OF LABOR
COVER PAGE
Dan Fimbianti/P.J. Harley
INTRODUCTION
Matt Donachy: Research and Writing
EXCERPT
Matt Donachy: Introductory and Differences between Debit Card and Credit Card and
Typing
Lauren Shuman: Differences between Variable and Fixed Rates, Unsecured Debt
Dan Fimbianti: Grace Period
P.J. Harley: 3 Determinants of credit limit
INFLATION
Dan Fimbianti: Research and writing
EXCHANGE RATES
Lauren Shuman: Research and writing
FED
Lauren Shuman: Research and writing
ANALYSIS
Matt Donachy: Research and writing
CONCLUSION
P.J. Harley: Writing and research
APPENDIX
P.J. Harley: Research and graph making
Dan Fimbianti: Graph making
ASSEMBLY AND EDITING
Dan Fimbianti