The secondary options and derivative markets spread the risk (and profits) around to a greater number of players; the main mechanism for a bank to compensate for increased inflation is to raise interest rates. Any time a bank offers a loan to a customer at a certain rate of interest, the rate has at least two components 1) the anticipated inflation over the term of the loan and 2) the profit margin above inflation. What I noticed is that the standard formula for calculating a loan amortization schedule assumes that the borrower's income will not increase over the course of the loan since the monthly payment is fixed. In other words, while the bank gets to compensate for expected inflation over the course of the loan, the borrower does not; an assumption that becomes more lopsided the higher inflation and interest rates go.
What I realized is that it's this lopsided response of banks to inflation that makes the increase in interest rates so devastating to the economy. If a bank thinks inflation is going to be x percent per year over the course of a loan, it should also allow for the borrower's income to increase by x percent per year. Keeping the payment fixed means the cost of a loan vs. incomes goes up quickly and hence, a big reason the economy slows down when the Fed starts raising interest rates.
Some examples using the conventional and new formulas show the effect.
If one assumes an i=12% and g=9% the monthly payment is $423.55, or $1.30 more per month with a 6% increase in the interest rate using the new formula. Using the old formula, the payment increases to $1028.61 per month with i=12% (assume P=$100,000 both times.)
The Fed would not be happy to see this new formula used because they would quickly realize that it would undermine their attempts to slow the economy for the purpose of holding wages in check. If a law were passed mandating the use of this new formula by banks, the immediate effect would be a rapid increase in the prices of homes, followed by an increase in the supply of homes as builders saw their profits rise.
The effect of people cashing in their equity would hit the economy with a tsunami of demand for goods and services, causing unemployment to drop substantially, causing wages to go through the roof.
My point is that a progressive government could use this formula to put a check on central banks like the Fed here in the US. If a different government agency set the g in the formula, it could have a ready mechanism to stimulate the economy and undermine central bank decisions to slow the economy. Something I would like to see.
Chuck
> Don't banks already compensate for inflation in the tertiary, swaps
> and derivatives markets?
>
> I like the idea, though, in that instead of just offering
> adjustable-rate mortgages, you can offer inflation-adjusted mortgages.
>
> But I don't really see how it brings more money into the economy, per se.
>
>
> boddi
>
>
> On 12/3/05, lbo at hvgreens.org <lbo at hvgreens.org> wrote:
>> For an idea on how to stimulate the economy for the purpose of achieving
>> full employment (and also undermining the Fed's ability to throw the
>> economy into a recession) check this out:
>>
>> http://www.sinceslicedbread.com/idea/14155
>>
>> Chuck,
>> Ann Arbor, HVGreens
>> (Sorry for the typos in the previous post, it's been a long day!)
>>
>> ---------------------------------------------------------------------------
>>
>> Flawed Mortgage Formula
>>
>> THE PROBLEM: the formula used to calculate mortgages harms the economy.
>> HOW MY IDEA FIXES IT: Stepping the monthly payment amount on a mortgage
>> by
>> the expected annual inflation rate will keep housing more affordable but
>> more importantly, stimulate the economy.
>> HOW FIXING IT BENEFITS WORKING FAMILIES: Mortgage affordability will
>> remain constant regardless of inflation which will also stimulate the
>> economy.
>>
>> Background: the standard mortgage formula is:
>>
>> A = P(i)[(1+i)**N]/[(1+i)**N-1],
>>
>> where A = the payment per month, P = amount borrowed, i = interest rate
>> per month, N = number of months and (1+i)**N is the quantity (1+i)
>> raised
>> to the Nth power. The formula should be changed to:
>>
>> A = P(i-g)[(1+i)**N]/[(1+i)**N - (1+g)**N)],
>>
>> where g is the rate of increase in monthly payments and everything else
>> is
>> the same as above. Using i = 6% = 0.005, g = 3% = 0.0025, P = 100,000
>> and
>> N = 360, the standard monthy payment is $599.55 while with the new
>> formula, the monthly payment is $422.25 to start, increasing by 0.25%
>> per
>> month.
>>
>>
>> ________________
>>
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>>
>
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