Happy Friday!

You may have noticed that I didn’t post yesterday…due to my upcoming hectic travel schedule (next week I will be in Santiago, Chile, and then in Washington D.C. the following week) I will be cutting down the frequency of Kung Fu Finance emails to Monday, Wednesday, and Friday (and in all honesty, this is probably a permanent change, as I’m working on some ideas to bring more value to you!).

So let’s jump into this week’s questions…tons of great questions, as always!

First, Gilbert asks,

Hi KFG, You’ve talked about debasing our paper money. But I’ve been searching for eternity on how inflation happens. No one can probably explain inflation in such a simple manner as you explained fractional reserve banking. Please enlighten us about this.

Hi Gilbert!
You are so nice; I’m happy to talk about inflation. I actually wrote a post on this awhile back here:

What Happened To Your Money? (Part 2)

But I only talked about the cause of inflation for a few sentences there, so I can definitely spend some more time on it in a full-fledged post.

Basically, inflation is an expansion of the currency supply, just like we saw in our example from Fractional Reserve Banking. Our story started out with you with your 100 coins that you deposited in your bank and your receipt for $100 (assuming $1 per coin). Then the bank issued a second receipt to John for $90, and then a third receipt to Sarah for $81…all backed by the same 100 coins.

This is inflation…an expansion of the currency supply.

Instead of there being only your original $100 “floating around” in the economy chasing goods and services, now there is $271 “floating around” in the economy, chasing the same goods and services.

And if you and John and Sarah each want to buy a belt for $50, which one of you gets to buy the belt? You all have more than enough currency to purchase the belt, so the belt-maker, being a smart guy, raises the price of his belts. So are you or John or Sarah any richer by having more currency? No.

The best description of this I have found is from The Creature from Jekyll Island,

“Let us illustrate the point by imagining that we are playing a game of Monopoly. Each person has been given a starting supply of play money with which to transact business. It doesn’t take long before we all begin to feel the shortage of cash. If we just had more “money”, we could really wheel and deal. Let us suppose further that someone discovers another game-box of Monopoly sitting in the closet and proposes that the currency from that be added to the game under progress. By general agreement, the little bills are distributed equally among all players. What would happen?

The money supply has now been doubled. We all have twice as much money as we did a moment before. But would we be any better off? There is no corresponding increase in the quantity of property, so everyone would bid up the prices of existing pieces until they became twice as expensive. In other words, the law of supply and demand would rapidly seek exactly the same equilibrium as existed with the more limited money supply.

When the quantity of money expands without a corresponding increase in goods, the effect is a reduction in the purchasing power of each monetary unit. In other words, nothing really changes except that the quoted price of everything goes up. But that is merely the quoted price, the price as expressed in terms of the monetary unit. In truth, the real price, in terms of its relationship to all other prices, remains the same. It’s merely that the relative value of the money supply has gone down. This, of course, is the classic mechanism of inflation. Prices do not go up. The value of the money goes down.

If Santa Claus were to visit everyone on Earth next Christmas and leave in our stockings an amount of money exactly equal to the amount we already had, there is no doubt that many would rejoice over the sudden increase in wealth. By New Year’s Day, however, prices would have doubled for everything, and the net result on the world’s standard of living would be exactly zero.” — The Creature from Jekyll Island, p. 142

(I’m probably not supposed to quote quite so liberally from a book, but as I’ve recommended it here highly and repeatedly 🙂 hopefully I’m not violating any copyright laws.)

And if you want to see a hilarious visual representation of this, I encourage you to watch the DuckTales video in the earlier inflation post I wrote! Watch what happens when Hughey, Dewey, and Louie get their hands on a “magical money multiplier machine”….

Hopefully this answers your question, and if not, I’m happy to do another post on inflation—we can spend a lot of time on that topic!

Thank you so much for your nice comment!

Next, Sarah asks,

Happy birthday Kung Fu Girl!
I just started a new job and my company offers a 6% match on my 401(k) contributions. It’s tough to say no to free money from my employer but I’m skeptical of many of the mutual fund options they provide. I did notice one index fund with a much lower expense ratio that the other funds offered (0.04% vs. 1% and higher). What is your opinion of index funds? Any other wisdom to share?

Hi Sarah! Congratulations on your new job!

I would definitely choose a low-expense index fund over an expensive mutual fund every day of the week (if it were me… I’m not allowed to give personal advice but if it were me I would definitely choose the low-expense index fund!).

I wrote about 401(k)’s including how the fund fees eat into your returns in a series of 401k articles here:

Whether or not to invest in a 401(k) is highly personal and dependent on your own unique situation, goals, dreams, plans, discipline, etc. You are very wise to be skeptical of the mutual funds though, particularly those with high expense ratios! Those really do eat into your returns, especially over time.

And you are really stuck as to your investment choices in a 401(k)…if the index fund tracks the S&P 500 (common), then you will do whatever the S&P 500 does. This isn’t necessarily bad, but it’s not necessarily good either—it really depends on your other investments and investing knowledge.

Good luck with your decision! Let me know how it goes!

Next, Willis asks,

What a fantastic post KFG. I’ve heard of this concept numerous times but you nailed this section into my head with the down to earth explanation. One question – does the new currency created using FRB ever contract? Doesn’t the monetary base just keep on expanding if all the banks keep doing FRB, i.e. our currency keeps devaluing.

Hi Willis! Great question, and yes, the new currency created using Fractional Reserve Banking does contract as well as expand. This is probably worthy of its own post, too, but here is a quick run-down of a few ways in which the currency contracts:

  • Whenever someone defaults on a loan: In our example, if John declared bankruptcy and didn’t pay back his loan, that currency would just “disappear” from the economy
  • When the banks reserve requirement increases: In our example, if the bank was required to keep 20% on-hand instead of only 10% so could only lend out $80, and then $64, etc…
  • Bank runs: In our example, if you decided you wanted all 100 of your coins back, the bank would have to call in the loans it made to John and Sarah because it wouldn’t have enough reserves.

This is definitely worthy of its own post, but hopefully that gives you a few ideas of how it works.  Great question!

Kris asks,

Straight up, Kung Fu Girl, Birthday Wishes. Sounds to me as though the entire family will enjoy the celebration.
I look forward to the Q&A columns and especially enjoyed the time management tidbits in this week’s edition.
I use Options in my own portfolio (mostly deep in the money Bull Puts, Covered Calls and Short Puts) and would appreciate knowing more about how you trade options and how and where you gathered your options education? Happy Birthday.

Thanks Kris! Sure, I will definitely write a post on how I use options (although I warn you, it’s probably not too exciting—it’s a small part of my strategy and I would say I’m still learning myself, but I’m happy to share!).
Thank you for the nice birthday wishes!

That’s it for this week…next week starts my crazy travel (and it’s the older Kung Fu Kid’s birthday) but I will work on getting three solid posts out to you!

Until then, have a wonderful weekend!

To your financial success,

—Kung Fu Girl