Understanding Economics And Analysis
Economics, put simply, is the study of shortages – supply vs. demand. As the demand for a product or service rises, the price of those goods or services will tend to rise. Alternatively, if the provider of those goods or services tries to flood the market with those goods or services, the price will tend to decline as the supply outpaces the demand. The supply and demand model works for all goods and services including stocks, bonds, real estate, and money. Series 65 candidates can expect to see 10 to 15 questions on economics.
Gross Domestic Product
A country’s Gross Domestic Product or GDP measures the overall health of a nation’s economy. The Gross Domestic Product is defined as the value of all goods and services produced in a country including consumption, investments, government spending, and exports minus imports during a given year.
Economists chart the health of the economy by measuring the country’s GDP and by monitoring supply and demand models, along with the nation’s business cycle. A country’s economy is always in flux. Periods of increasing output are always followed by periods of falling output. The business cycle has four distinct stages:
An economy, during an expansionary phase, will see an increase in overall business activity and output. Corporate sales, manufacturing output, wages and savings will all increase while the economy is expanding or growing. An economy cannot continue to grow indefinitely and GDP will top out at the peak in the business cycle. An economic expansion is characterized by:
- Increasing GDP
- Rising consumer demand
- Rising stock market
- Rising production
- Rising real estate prices
As the economy tops out, the GDP reaches its maximum output for this cycle as wages, manufacturing and savings all peak.
During a contraction, GDP falls, along with productivity, wages and savings. Unemployment begins to rise, the stock market begins to fall, and corporate profits decline as inventories rise.
The economy bottoms out in the trough as GDP hits its lowest level for the cycle. As GDP bottoms out, unemployment reaches its highest level, wages bottom out, and savings bottom out. The economy is now poised to enter a new expansionary phase and start the cycle all over again.
A recession is defined as a period of declining GDP, which lasts at least six months or two quarters.
A depression is characterized by a decline in GDP, which lasts at least 18 months or six consecutive quarters.
There are various economic activities that one can look at to try to identify where the economy is in the business cycle. An individual can also use these economic indicators as a way to try and predict the direction of the economy in the future. The 3 types of economic indicators are:
- Leading indicators
- Coincident indicators
- Lagging indicators
Leading indicators are business conditions that change prior to a change in the overall economy. These indicators can be used as a gauge for the future direction of the economy. Leading indicators include:
- Building permits
- Stock market prices
- Money supply (M2)
- New orders for consumer goods
- Average weekly initial claims in unemployment
- Changes in raw material prices
- Changes in consumer or business borrowing
- Average work week for manufacturing
- Changes in inventories of durable goods
Changes in the economy cause an immediate change in the activity level of coincident indicators. As the business cycle changes, the level of activity in coincident indicators can confirm where the economy is. Coincident indicators include:
- Industrial production
- Personal income
- Average number of hours worked
- Manufacturing and trade sales
- Non agricultural employment
Lagging indicators will only change after the state of the economy has changed direction. Lagging indicators can be used to confirm the new direction of the economy. Lagging indicators include:
- Average Duration of Unemployment
- Corporate profits
- Labor costs
- Consumer debt levels
- Commercial and industrial loans
- Business loans
The government has two tools that it can use to try to influence the direction of the economy. Monetary policy, which is controlled by the Federal Reserve Board, determines the nation’s money supply, while fiscal policy is controlled by the President and Congress and determines government spending and taxation.
Tools of The Federal Reserve Board
The Federal Reserve Board will try to steer the economy through the business cycle by adjusting the level of money supply and interest rates. The Fed may:
- Change the reserve requirement for member banks
- Change the discount rate charged to member banks
- Set target rates for federal fund loans
- Buy and sell US Government securities through open market operations
- Change the amount of money in circulation
- Use moral suasion
Member banks must keep a percentage of their depositor’s assets in an account with the Federal Reserve. This is known as the reserve requirement. The reserve requirement is intended to ensure that all banks maintain a certain level of liquidity. Banks are in business to earn a profit by lending money. As the bank accepts accounts from depositors, it pays them interest on their money. The bank, in turn, takes the depositors’ money and loans it out at higher rates, earning the difference. If the Fed wanted to stimulate the economy, they might reduce the reserve requirement for the banks, which would allow the banks to lend more. By making more money available to borrowers interest rates will fall and, therefore, demand will increase, helping to stimulate the economy. If the Fed wanted to slow down the economy it might increase the reserve requirement. The increased requirement would make less money available to borrowers. Interest rates would rise as a result and the demand for goods and services would slow down. Changing the reserve requirement is the least used Fed tool.