5 Economy

Before rates of growth may be applied to actual investments, one should consider the origins of percent change in value over time—in other words, why might a certain asset be worth more interest over time?  What value does cash bring to a bank temporarily controlling it?  At the heart of these questions is a fundamental concept known as the economy, which describes the behavior of a population with regard to their resources.  In reality, the word “economy” is often used interchangeably with various metrics that try to describe performance of various businesses, types of production, personal spending habits, and much more; but, most importantly, economies are made up of people, which means that economic behavior is a form of personal behavior en masse.

In some cases, the flow of cash can prove as a marker of an economy, as a means of describing where value lies and where resources are moving.  On the individual scale: a person working for a company is paid a wage; this wage is used to pay for necessities like food and shelter, and then the excess is stored for later or spent at the worker’s discretion.  The companies on whom the worker spends their discretionary money use that income to pay their costs, including wages to their own workers, who can then in turn pay for necessities and other expenses.  When one link in this chain changes and cash flows more or less readily, other parts of the economy tend to react.  In the United States, the Federal Reserve System (the Fed) is responsible for maintaining fiduciary stability and ensuring that folks still have money and that money can still buy what they need; this is accomplished using a vast network of resources and data, but some of the most important tools the Fed has at its disposal are control over the amount of currency in circulation and control over interest rates charged to major institutional lenders.

When the Fed increases the amount of currency in circulation, each piece of currency is intrinsically worth a bit less compared to the total amount of goods and services in the economy.  This tends to lead to a general increase in the cost of goods and services and an increase in the overall cost of living, which is called inflation.  When the amount of currency in circulation decreases, each piece of currency represents a larger portion of the total currency available and is therefore worth more.  When the amount of currency available decreases compared against the total amount of goods and services in an economy, the result can be a decrease in the price of these goods and services, which is known as deflation.  More commonly, goods tend to cost a little more each year (inflation); but periods in which the rate of inflation slows but stays positive are experiencing disinflation.  By changing the interest rates the Fed charges institutional lenders, those lenders can have more or less access to cash to lend out to other companies and individuals, which also effectively encourages or restricts the amount of currency in circulation.

If something costs $250 today and $260 next year, the price could have been subject to inflation.  If the following year that same item costs $261, then the sector was subject to disinflation (wherein the price still increased, but not by as much).  If the cost decreased from $260 to $240, then it could have been subject to deflation (a broad decrease in the price of goods and services)—or it was on sale!

Deflation can be dangerous—when companies have to charge less for goods and services, they bring in less money and in some cases need to reduce the amount of workers they employ, which can lead to large-scale unemployment; unemployed workers are less able to contribute to a healthy economy, which can lead to more unemployment.  Historically, a small amount of inflation has helped keep companies growing, which allows for workers to demand and earn higher wages.

The Consumer Price Index (CPI) measures the cost of goods and services across many sectors of the economy, with weighting determined by spending habits of consumers and attained through vast amounts of data.  As such, CPI functions as a barometer for inflation, and can also provide economists with insight about the status of the market as a whole: low, steady inflation and growth in the Gross Domestic Product (GDP: a measure of the total value of goods and services produced by a nation’s economy), accompanied by an increase in employment marks economic expansion.  When expansion has slowed (but CPI and GDP are not decreasing), the economy has reached a peak. The peak is usually followed by a period of disinflation (slowing growth) and employment decline known as economic contraction. When employment and downward pressure on prices have stabilized, the economy is in a trough.

These four markers represent the economic cycle: a period of expansion is followed by a peak, a contraction (a small contraction could be called a correction, and a large contraction marks the beginning of a recession), and a trough before the next period of expansion.  Even the worst recessions have historically always subsided and given way to economic growth.