The ABCs of the economy

Gross domestic product (GDP)

How do we know if the economy is expanding or contracting? One way is to monitor the evolution of gross domestic product (GDP). If a country’s GDP increases by say 4%, this usually means the economy has grown by 4%. If it falls by that same amount, it means the economy has pulled back.

GDP is a measure of the goods and services produced within a country’s borders over time and can be calculated using either the income approach, expenditure approach, or production approach. Nominal GDP doesn’t incorporate the effects of rising prices while real GDP is adjusted for inflation so that it provides a more realistic picture of how it’s trending over time.. 

Gross national product (GNP)

Gross national product (GNP) is another way of gauging the overall health of the economy. While the GDP calculation includes all goods and services produced within a country’s borders, GNP goes one step further to include all goods and services produced by a country’s citizens (corporations or individuals) both domestically and abroad.

Consumer price index (CPI)

How can we monitor the prices of goods and services? The Consumer Price Index (CPI) tracks the cost of a basket of goods and services bought by consumers over a period of time. The CPI is used to track changes in consumer prices and is widely used to measure inflation.

To make sure it’s representative of the most common goods and services bought by consumers, this basket is updated on a periodic basis. For instance, if rent usually represents a greater portion of consumers’ overall expenditures, a 10% increase in rental prices will have a greater impact on CPI than say a 10% increase in bubble gum. 

Inflation

Inflation is an overall increase in the prices of goods and services in an economy. While some inflation is healthy and can be a sign of robust economic growth, when it goes beyond the central bank’s target (often around 2%), it becomes a problem, as higher prices have a negative effect on consumers’ purchasing power.

When inflation spirals out of control, policymakers can intervene in a number of ways to help keep price pressures in check. Usually this is done by raising interest rates, which discourages borrowing, limits consumer spending, and alleviates price pressures over time. 

Deflation

Deflation is the opposite of inflation—it’s an overall decrease in the prices of goods and services in an economy. This can happen due to an excess amount of goods and services produced, a decline in overall demand, or a decrease in money supply or credit.

While deflation might seem like a good thing for consumers (since prices are dropping), it’s actually very dangerous for an economy as it can discourage consumer spending—one of the biggest contributors to an economy—in the long run.

Disinflation

Disinflation is a slowdown in the pace of the inflation rate. Disinflation doesn’t imply falling prices and typically isn’t viewed as a negative catalyst. Disinflation could happen in either good or bad economic times.

Purchasing Managers’ Index (PMI)

The Purchasing Managers’ Index (PMI) examines trends in manufacturing and is based on a survey of managers across hundreds of companies in various industries. A PMI reading of 50 indicates no change in manufacturing activity compared to the previous month while a reading over 50 represents an uptick and signals an expansion. In contrast, a reading under 50 indicates a contraction.

Consumer confidence

Consumer confidence refers to how consumers feel about the current state of the economy and its direction. For instance, consumers may be wary about the impact inflation and rising interest rates will have on their wallets. As a result, they may choose to spend less and save more.

Examples of consumer confidence measures include the Consumer Confidence Index (CCI). The CCI is a U.S.-based survey that measures how optimistic or pessimistic consumers are regarding their finances. Moves in excess of 5% can indicate a change in the economy’s direction. Economists often use consumer confidence measures to predict trends in consumer spending, which accounts for a significant part of the economy.

Money supply

The money supply refers to the amount of cash and liquid assets circulating in an economy at a given time. When money supply increases, this typically lowers the general level of interest rates since money is widely available. In contrast, when it decreases, the general level of interest rates tends to rise due to the lack of money at consumers’ disposal.

Unemployment rate and jobless claims

The unemployment rate represents individuals in the labour force who are actively looking for work but can’t find a job. The unemployment rate is an important measure of the overall health of the economy. If economic growth is robust and jobs are abundant, the unemployment rate will tend to trend lower. If the economy is contracting and there’s a shortage of jobs, the unemployment rate will rise.

Jobless claims pertains to the number of individuals filing for unemployment insurance benefits at a given point in time. Initial jobless claims refers to individuals who are applying for these benefits for the first time, while continuing jobless claims refers to those who’ve already begun receiving benefits.

Recession

A recession is often defined as two consecutive quarters of shrinking GDP. But more simply, it’s a sustained contraction in economic activity. Dwindling production and consumption, as well as higher unemployment or lower prices, are tell-tale signs the economy has made its way into recession territory.

In recessionary times, unemployment may rise, people may save more, and manufacturing can decline sharply. Overall prices can also decrease; liquidity can dry up and deficits can increase.

Depression

A depression is similar to a recession but it lasts for a longer period of time. Rather than the economy contracting for several quarters, a depression tends to last for years. While the average recession since the 1940s has lasted for 10 months, a depression has only occurred once (the Great Depression). The effects are far worse than a recession.

Exchange rates

One currency is exchanged for another at a rate called the exchange rate. Currencies’ values are determined in a number of ways. They’re either allowed to float or are pegged to other currencies. In the case where they’re allowed to float freely, their values will largely depend on supply and demand in the foreign exchange markets. In the case of a currency peg, governments will typically set a fixed exchange rate with another currency or basket of currencies, which limits fluctuations and encourages trade between countries.

Central banks

Supply and demand irregularities, high unemployment, price instability, and uneven growth, are just some of the ways an economy can stray off course. Each country’s central bank (or each region, as is the case with the European Central Bank) oversees the banking system and has the responsibility of addressing some of these economic challenges through monetary policy.

By making sure of price stability (controlling inflation), setting the goal of full employment, and managing a nation’s currency, the actions of central banks promote a healthy economy.

Monetary policy

Monetary policy revolves around the management of a nation’s money supply. When economic growth needs to be cooled down, policymakers will typically cut the money supply and raise interest rates. This is called contractionary monetary policy. Contrarily, when the economy needs a kick-start, money supply is increased and interest rates are decreased. This is called expansionary monetary policy.

Fiscal policy

Unlike monetary policy, which is the responsibility of a nation’s central bank, fiscal policy is the responsibility of the government. Fiscal policy refers to the use of taxes and government spending to control the economy’s direction. For instance, tax increases and public spending cuts are ways for the government to slow the pace of economic growth and help keep inflation in check. In contrast, the government can issue tax breaks and increase public spending to spur economic growth.

Economic cycle

A healthy economy regularly transitions from expansion to contraction phases and back again. The economic cycle is a series of phases that an economy usually goes through. The phases include expansion, peak, contraction, and trough.

Expansion

In the expansion phase, the economy is experiencing robust growth, usually driven by low interest rates. Employment, wages, production, prices, and corporate profits all tend to rise in this phase.

Peak

In this stage, the economy tends to overheat, growth hits a peak, and indicators may begin to stabilize. At this point, the economy may begin to slow and revert to the downside.

Contraction

The contraction stage is characterized by a period of slower growth and rising unemployment. It’s the time span between the peak and the trough. Demand tends to fall and oversupply issues may arise, leading to falling prices.

Trough

This is the point where the economy stops contracting and bottoms out. With time, the economy begins to recover, and the economic cycle starts all over again.