[philosophy of economics]Absolute reserve and relavtive reserve

Absolute Reserve and Relative Reserve

The failure of consumerism has already been exposed when the global financial tsunami came about last September, which quakes the whole system of the world economy, both Developing and Developed countries. Obviously consumerism, suggesting an economic growth should be forced by the increasing of consumption, is a stupid idea created by those fat American businessmen, especially those bankers who lend money to those poor but greedy guys. When their consumers, or debtors, spend much more than their income without an ability of paying back, they bankrupt. Being bankrupt, debtors become bad debts of the bank. So how can we avoid such a serious financial problem? The answer is that: we need to save an appropriate reserve so as to face with any financial challenges. Reserve means a supply of something that is available to be used in the future when it is needed, according to the explanation from OALD. But what is "appropriate reserve"?

Thus I come up with a calculation of the relationship between income and consumption, which is very easy. There are two approaches: absolute approach and relative approach. For the absolute approach, here is the formula:

I - C = A (Income - Consumption = Amount of reserve)

The reserve left via this calculation called as Absolute Reserve. For the relative approach, here is the formula:

I ? C = P (Income ? Consumption = Proposition of reserve)

The reserve left via this calculation called as Relative Reserve.

According to our basic mathematical knowledge, immediately we can infer that:

If I>C, then A>0 and P>1;
If I=C, then A=0 and P=1;
If I<C, then A<0 and 0<p<1.

Remember, I and C are always more or equivalent to zero, since they are counted by money. Negative number is meaningless for money. Of course only the first situation is what we wish we would achieve. The reason for saving a reserve is to prevent sudden accident, for example when you lose your job suddenly. Chinese, Hong Kongers and Taiwanese are good at saving money while American seldom think of the term "reserve". That's why the crisis spread out from USA.

But don't be happy too early, my fellow Hong Kongers. Even A>0 and P>1, problems still appeared. Let look at this case: Frederick, a doctor, income HK$40,000 and consumption HK$12,000 (note: 1USD = 7.8HKS, 1 euro = 10 HKS, 1 pound = 12 HKS), while Dennis, a small restaurant manager, income HK$15,000 and consumption HK$14,000. Although both of them achieve the principle of A>0 and P>1, neither of them is okay. Frederick's reserve is HK$28,000, which is too much. Since reserve is an amount of money that you seldom change its amount unless you put in or take out some of them, it doesn't include investments, for their price changes a lot. Only banking is included since the rate of interest seldom changes and the interest is very low usually. Too much reserve lead to the reduction of flexibility in using and investing money. You will lose your chance in having and enjoying a better quality of living. However, too less reserve is a problem, too. Dennis' reserve is just HK$1,000. When he is fired suddenly, he only got 1,000 to spend, an amount of money that even cannot hire a room for living in Hong Kong.

But looking the amount of A is not accurate. if Frederick's reserve is HK$6,000 while Dennis' reserve is HK$6,000 at the same time, does it mean that their situation is totally the same? No! We have to consider about P (proposition), since their income is different. That's the importance of calculating the Relative Reserve.

For P>1, I will categorize it into three situation: 1<P≦1.5, 1.5<P≦3 and P>3. If 1<P≦1.5, it is not good since the percentage of reserve is too low. If p=1.5, the percentage of reserve would be (1.5-1) ? (1.5+1) ? 100% = 20%. In another word, you spend 80% of your income. Don't you think it is very crazy?

If 1.5<P≦3, it is the most appropriate for the percentage of reserve is the most reasonable. If P=3, the percentage of reserve would be (3-1) ? (3+1) ? 100% = 50%. Maybe you think that if the percentage is 21%, 22%, or so on, is a bit too low, but we should consider realistically. Of course those who have got higher income can achieve the target of 50% reserve easier, but it would be difficult for those having lower income. If the consumption A and consumption B is the same, but income A is more than income B, reserve A must be more than reserve B. For those having lower income but higher consumption, such as a person having many children to be raised up, consumption is difficult to be reduced a lot. But at least they should remain the reserve above 20% for long term consideration.

If P>3, it is not good since the percentage of reserve is too high. If p=4, for example, the percentage would be (4-1) ? (4+1) ? 100% = 60%, meaning your consumption would be only 40%. As I have said, not all consumption is bad. Some money you have to spend, such as paying your children's school fee, paying bills for seeing doctors, should never be reduced. And some appropriate consumptions of entertainment is necessary, since the fundamental reason for us to gain money is to have a better quality of living.

To apply the calculation, we can do some case studies. Let's do some exercises now.

Let there are six persons: saleswomen Amy, Travel agent Margaret, Economics teacher Diana, Pastor Agnes, Professor Christina and CEO Gladys. Here is their income and consumption per month (calculated by HKS):


(Per month)
Amy
Margaret
Diana
Agnes
Christina
Gladys
Income
14,000
18,000
25,000
22,000
80,000
120,000
Less: Consumption
10,000
6,000
12,200
17,000
40,000
26,000
Absolute Reserve
4,000
12,000
12,800
5,000
40,000
94,000
Relative Reserve
1.4
3
2.04918
1.294118
2
4.615385


Only Diana and Christina achieved the target of 1.5<P≦3. Amy and Agnes left too less reserve while Gladys and Margaret left too much reserve. And you can find out that it is simpler than calculating their percentage of reserve one by one.

To conclude, we should control our income to be more than consumption so as to save a reserve. But more importantly, we should be balance. Too neither less income nor too much income is appropriate. The former makes us loss the opportunity for investment and affect our quality of living, while the latter makes us loss the ability of dealing with sudden financial problem. Therefore, calculating the Relative Reserve is even more important than the Absolute Reserve. We should always remain our reserve into 1.5<P≦3. Not too much but not too less, just take the middle course. For applied strategies, you can:

Firstly, make a plan for spending money every month. Make sure your reserve is appropriate.

Secondly, remain the flexibility of using money. Don't become Mr. Scrooge. Money is produced for using. Spending for entertainment is okay, unless it costs too much. Prices of stocks, foreign exchange and bonds change everyday and you have to be ready for changing your investment.

Thirdly, put your reserve in a save place. Don't put them under your bed. Saving money in a trustworthy bank is good enough. Buying insurance can be treated as a reserve also.

The same idea can be applied in national economy. The government should remain their national reserve within 1.5<P≦3 for the same reason. The logic is simple, but application is another serious problem.

Andrew Tam
22nd June, 2009

Note:

1. You may cast doubt on why the range of 1.5<P≦3 forms a range of percentage of reserve that is 20%<x≦50%. Why it is too much when x>50% but okay when 20%<x≦50%? Such a range is due to a common phenomenon of finance: reserve ≦ consumption (I would call it as the law of reserve). The law of reserve is valid due to the demand for consumption is always more than the demand of reserve. Consumption can satisfy your demand directly but reserve can only satisfy your demand in future indirectly (unless you spend your reserve, your demand cannot be satisfied). Simply speaking, Demand of reserve ≦ Demand of consumption, thus reserve ≦ consumption. When reserve > consumption, it is unusual and unnatural (therefore a mean person like Scrooge is obviously mad).

2. What is the relationship between A and P? In order to check your calculation, a formula of the relationship between A and P is provided for you below:

C(P - 1) = A
Proof:
1. I - C = A, I ? C = P (Given)
2. ∵I ? C = P
∴I = CP
3. CP - C = A
C(P - 1) = A
Q.E.D.

If your P and A doesn't match the formula above, your may calculate wrongly. This formula is also appropriate for calculating A or C without the information of I, especially in calculating national reserve (since data of gross national income may be difficult to find out sometimes).