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The Economy
by
Charles Lamson
Our economy is influenced by interaction between government, business, and consumers, as well as world economic conditions. Through specific policy decisions, ideally, the government's goal is to regulate the economy and provide economic stability and high levels of employment. These government decisions have a major impact on the economic and financial planning environment. The federal government's monetary policy, programs for controlling the amount of money in circulation (the money supply), is used to stimulate or contract economic growth. For example, increases in the money supply tend to lower interest rates. This typically leads to a higher level of consumer and business borrowing and spending that increases overall economic activity. The reverse is also true. Reducing the money supply raises interest rates, reducing consumer and business borrowing and spending and slowing economic activity.
The government's other principal tool for managing the economy is fiscal policy, its programs of spending and taxation. Increased spending for social services, education, defense, and other programs stimulates the economy, while decreased spending slows economic activity. Increasing taxes, on the other hand, gives businesses and individuals less to spend and, as a result, negatively effects economic activity. Conversely, decreasing taxes stimulates the economy.
Economic Cycles
Although the government uses monetary and fiscal policy to regulate the economy and provide economic stability, the level of economic activity changes constantly. The upward and downward movement creates economic cycles (also called business cycles). These cycles vary in length and in how high or low the economy moves. An economic cycle typically contains four stages: expansion, recession, depression, and recovery.
The stronger the economy, the higher the levels of employment and production. Eventually, a period of economic expansion will peak and begin to move downward, becoming a recession when the decline lasts more than 6 months. A depression occurs when a recession worsens to the point where economic growth is almost at a standstill. The recovery phase, with increasing levels of employment and production, follows either a recession or a depression. Since then, the government has been reasonably successful in keeping the economy out of a depression, although we have experienced periods of rapid expansion and high inflation followed by periods of deep recession.
After the recession of the early 1990s, the economy went through a very long and drawn out expansion phase. Inflation and interest rates remained generally low, while the stock market soared to record levels. In early 2001, the stock market experienced some significant declines.
Economic growth is measured by changes in the gross domestic product (GDP), the total of all goods and services produced by workers located within the country. The broadest measure of economic activity, GDP is reported quarterly and is used to compare trends in national output. A rising GDP means the economy is growing. The rate of GDP growth is also important. For example, although actual GDP rose year after year for much of the 1990s, the annual rate of GDP growth varied widely.
Another important yardstick of economic health is the unemployment rate. The swings in unemployment from one phase in the cycle to the next can be substantial. For example, during the Great Depression of the 1930s, U.S. unemployment reached a staggering 25 percent of the work force. In contrast, during the expansion in 1968, unemployment rose to over 10 percent. During the expansion that followed and lasted until late 1990, unemployment fell to 5.3 percent before rising to about 7.4 percent during the recessionary period of the early 1990s. By mid-2000, unemployment had dropped to 4.0 percent, from which it rose to 6.4 percent by June 2003. And finally, to it went back down to 3.9 percent in August of 2018 (U.S Bureau of Labor Statistics www.bls.gov).
Unemployment, inflation, interest rates, bank failures, corporate profits, taxes, and government deficits have a direct and profound impact on our financial well being; these factors affect the very heart of our financial plans---our level of income, investment returns, interest earned and paid, taxes paid, and, in general, prices paid for goods and services consumed.
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Smart.sites
How is the U.S. Economy doing this month?
Check out the Bureau of Labor Statistics Web site, www.bls.gov. |
Inflation, Prices, and Planning
Our economy is based on the exchange of goods and services between businesses and their customers---consumers, government, and other businesses---for a medium of exchange called money. The mechanism that facilitates this exchange is a system of prices. Technically speaking, the price of something is the amount of money the seller is willing to accept in exchange for a given quantity of some good or service---for instance, $3 for a pound of meat or $10 for an hour of work. When the general level of prices increases over time, the economy is said to be experiencing a period of inflation. The most common measure of inflation is the consumer price index (CPI), which is based on the changes in the cost of a market basket of consumer goods and services. At times, the rate of inflation has been substantial. In 1980, for instance, prices went up by 13.5 percent. Fortunately, inflation has dropped dramatically in this country, and the annual rate of inflation has remained below 5 percent every year since 1983, except in 1990 when it was 5.4 percent. Today, the rate of inflation is 1.9% (see Table 1).
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Inflation is of vital concern to financial planning. It affects not only what we pay for the various goods and services we consume, but also what we earn in our jobs. Inflation tends to give an illusion of something that does not exist. That is, while we seem to be making more money, we really are not. As prices rise, we need more income because our purchasing power---the amount of goods and services we can buy with our dollars---declines.
Inflation also directly affects interest rates. High rates of inflation drive up the cost of borrowing money as lenders demand compensation for their eroding purchasing power. Higher interest rates mean higher mortgage payments, higher monthly car payments, and so on. High inflation rates also have a detrimental effect on stock and bond prices. Finally, sustained high rates of inflation can have devastating effects on retirement plans and other long-term financial goals. Indeed for many people it can put such goals out of reach. Clearly, low inflation is good for the economy, for interest rates and stock and bond prices, and for financial planning in general.
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Use the inflation calculator at www.bls.gov to check on the buying power of today’s dollar.
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*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 27-30*
END
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