Ending their two-day meeting, the Fed (central bank of the US) has once again raised interest rates. The reason for the hike is to control inflation. The United States Congress has given the Fed a dual responsibility – to achieve maximum employment and keep inflation around the rate of 2% over the longer run.
The average consumer in the US has been feeling the burden of rising prices, especially since the start of this year, esp. in gas, housing (including rental), and food prices. The Consumer Price Index, which measures inflation in the US has been at an elevated level for quite some time. In their press release, as of July 13, 2022, the BLS published inflation at 9.1%.
How does the interest rate affect inflation?
Going back to today’s news, let’s understand how the interest rate mechanism works. The FOMC (Federal open markets committee) is responsible for determining the federal funds ratetarget range. This is the rate at which banks borrow from each other. The Fed doesn’t set this rate, but market forces determine it.
The reason this rate is very important to us is through its linkages to other rates. This federal funds rate impacts all the other interest rates such as on credit cards, housing, auto, and education loans.
How much did Fed raise interest rates?
In today’s meeting, the Federal open market committee decided to raise the target range for the federal funds rate from 2.25% to 2.5%. This increase has moved the Federal funds rate to its highest level since December 2018. During their June 13, 2022 meeting, they increased the target range for the Federal funds rate to be 1.25% – 1.75%. You can see the graph of this rate over time here.
So how does the Fed steer the federal funds rate?
It uses “interest on reserves balance” as its main monetary policy tool for that. To understand it better, you can read my article here, which explains this in detail. When the Federal funds rate (borrowing costs of banks) is high, banks will pass on these added costs to their final consumers. These consumers include people like you and me, and businesses.
In a nutshell
The main idea behind this repeated increase in the interest rate is that expensive loans will discourage people from spending. When the cost of borrowing (interest rate) is high, general consumers (households) borrow less for a big purchase such as a car or a house. Similarly, businesses also invest less in the expansion of their plant, inventories, machinery, buildings, etc. All of this will reduce the demand for goods and services these businesses make and they will also hire fewer workers. And when the excess (increased) demand is lower, the prices will eventually start falling, which will control high inflation. Thus, interest rate hikes are the Fed’s main tool to control inflation.
Inflation happens because of strong consumer demand, which supply can’t match. Supply bottlenecks with China during the Covid pandemic, Ukraine war, etc have all contributed to a weaker supply of many essential items we use every day. Since many of the supply chain issues will take a long time to fix, the Fed is trying to control the demand aspect of inflation. By raising interest rates, and making borrowing more expensive, the Fed is hoping to weaken Americans’ willingness to spend money and ultimately bring inflation close to its 2% target level.
Today, I explain some of the most widely used macroeconomic terms relating to a country’s economic performance. These are the terms we often read in the news, so we need to understand what they are and how they affect us. My list is not comprehensive, but I feel it is a good start. In my future posts on Economic Glossary, I will be explaining the meaning of some other important economic terms, so please stay tuned for that. For now, let me explain the ones that are coming to my mind as I type.
Interest rate: Itis the cost of borrowing money or the return we get from saving our money. By changing interest rates, the Fed (central bank) can influence economic growth. Low-interest rates encourage spending and investments and make the economy grow. On the other hand, rising interest makes loans more expensive and lowers investment. This reduces firms’ hiring, employment, and thus total demand in the economy and can lower both inflation and GDP growth.
GDP: It measures the size of the economy. It is the market value of everything (final goods and services) produced in a country, whether it is made by its citizens and companies or by the rest of the world. Market value is how much we pay for something, such as the market price for that bread we eat or the plumbing service we get. The US GDP number is published every quarter to see its trend. Economists at the U.S. Bureau of Economic Analysis estimate GDP by using a lot of data gathered by other federal agencies and private data collectors. As of Q1, 2022, the US Real GDP was $19.7 trillion. The US is the number one economy in the world when measured by real GDP.
GDP Per capita is the GDP divided by the total population. It shows the standard of living of its people and this number is published once a year. Real GDP is the GDP at constant price or base year prices. This measure removes the effect of rising prices on GDP. GDP growth rate is a % measure that calculates real GDP growth as compared to the previous quarter or the previous year. This could be a positive or negative % depending on an increase or decrease in real GDP. To know more about US GDP growth, click here.
Recession: A recession is a significant fall in the economic activity of an economy. It is mostly seen as a decrease in income and employment. During a recession, there is a significant drop in consumer spending. Some businesses can go bankrupt, people out of school don’t find good jobs and people might lose their homes when housing prices fall. If you want the exact definition of recession or expansion in the US, here’s a good source https://www.nber.org/business-cycle-dating-procedure-frequently-asked-questions
Inflation: The inflation rate is a sustained rise in the average price level during a specified period, usually a month or a year. It is calculated as a % increase or decrease in prices from the previous period. Inflation exists when prices increase but our purchasing power reduces over some time. As seen in my post here, demand, supply, and future expectations about inflation affect inflation.
US Government and the Fed both measure and publish inflation numbers every month. They use CPI and PCE respectively for measuring inflation. Sometimes, the CPI can give us misleading information because it includes food and oil/gas prices. These numbers are usually more volatile. The core inflation rate excludes food and energy prices and thus is a better measure of the inflation rate. The Personal Consumption Expenditures price index is another measure of inflation. It includes more business goods and services than the CPI. For example, health care services paid for by health insurance companies are part of PCE and not CPI.
Unemployment rate. Every country sets a target unemployment rate that it seeks to achieve. In most advanced economies it is a lower % compared to developing economies. In the US, The BLS publishes this % every month. The Fed aims to keep the unemployment rate around 4%. The unemployment rate represents the number of unemployed people as a percentage of the labor force. People in the labor force include people 16 years of age and older, who are either employed (have a job) or unemployed (those who have looked for a job in the past 4 weeks but couldn’t get one).
As of June 2022, the unemployment rate in the US was 3.6%. The total number of unemployed persons was 5.9 million.
Monetary policy or the Fed: Federal Reserve is the central bank of the U.S. The Fed performs many important functions such as supervising the nation’s commercial banks, conducting monetary policy and providing financial services to the U.S. government. It also promotes the financial system’s stability by taking measures to prevent crises like recession and bank failures.
The Fed is not just one bank but consists of 3 main components.
Seven Board of governors guide the entire monetary policy and set the discount rates for member banks
12 regional federal reserve banks are located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St, Louis, and San Francisco.
FOMC, the Federal open market committee. It meets eight times a year and makes decisions that help promote the health of the U.S. economy and the stability of the U.S. financial system.
The Fed is an independent entity and is not affected by U.S. politics. Congress has given Fed a dual mandate of stable inflation and maximum employment. The Fed tries to keep prices stable with a long-term 2% inflation target and also promotes maximum employment. Please see my detailed post on how Fed in the US uses its monetary policy tools to keep inflation in the target range.
Fiscal policy : Fiscal policy is the term used to describe the spending and taxation decisions of a government that can influence an economy. For example, the government can lower taxes and raise spending to boost the economy when needed. Governments often spend on infrastructure projects to create jobs and grow income to take the economy out of a recession.
Similarly, the Fed increases business investment and spending by lowering interest rates. In a boom situation, when the economy is overheating with high inflation and very low unemployment, they do the opposite. The government reduces its spending and raises taxes. Alternatively or in addition, the Fed raises the federal funds rate which in turn increases all the other interest rates in an economy and thereby puts a break on overall economic activity. Thus, either fiscal or monetary policy or both can be used to expand or contract the economy.
If you like my posts or think I can do better, please provide your feedback in the comment section below. I will be happy to research and write about any topics you might be interested in learning more about. Thank you!
By definition, money is anything that is accepted as a medium of exchange. When we use the term “medium of exchange,” we mean we can use it to buy or sell anything (good or service) and that the other person will easily accept and use it for his/her transactions. Money is also a measure of value, which means a product’s worth (value) can be measured in the monetary unit. Just like gold and precious metals, money is also a store of value* (see note below), and a standard of deferred (future) payment, which means you can use the money to pay someone in the future and it will be acceptable by that person.
How did money come into being?
Long time ago, when coins and currency were not there, people used to exchange goods for goods. That system was called a barter exchange system. But there were several problems with it. The most important was the lack of double coincidence of wants. Let’s understand this with an example. If, person A is growing rice and has extra rice than he needs, he has an option to trade it with someone who wants rice in return for something he wants. Now let’s assume person A actually wants wheat, he will have to find a person who has extra wheat and at the same time that other person (person B), must want rice in return for this trade to happen. But if person B doesn’t want rice instead wants something else, then there is going to be a problem in doing this commodity to commodity exchange.
This Barter exchange system became very difficult to continue as the population grew, because searching for the “right” person to exchange one’s extra produce was not easy.
Another problem with the barter system was that it didn’t have a store of value. Perishable items like milk, meat, and vegetables that people wanted to trade couldn’t be stored for a long time and would lose their value once they went bad. Nonperishable items may have a store of value but, were not always easily convertible into other things with universal acceptability.
This lack of store of value also made this barter system very difficult to carry on. Also, the barter system could not make future payments.
People needed something intermediary, something that both parties could accept to help the exchange of goods and services. Thus, all of these problems were eliminated by the introduction of money. As I mentioned in the first paragraph, there were various advantages of having money. The most important being its universal acceptability of being a medium of exchange and a measure of value. It also is a store of value and can be used for future payments. Though when inflation is really high (above the target level), money can lose its capacity to act as a store of value.
The currency and digital money that everyone is using nowadays only came a few decades ago. Money had evolved over time into different types, and various items were used as money at different periods in history.
In the past, people had used cows, salt, and stone wheels as money, as they were widely accepted as a medium of exchange for goods and services. The central bank of Brazil published this article about the origin and evolution of money. However, there was always the risk of diseases and death with cows, and people wanted something easier to carry.
Then, there was commodity money like gold and silver coins, which people could use in exchange for goods and services and they also had their own intrinsic value as well. By intrinsic value, I mean gold and silver always have had worth to people because of their uses for jewelry, etc. The minting of gold and silver coins prevailed for many centuries.
Then came the representative money which was a paper certificate that you could exchange for gold in a bank for the underlying commodity. As people started trusting these paper certificates same as much as gold, it led to the creation of modern money which is also known as the Fiat money.
Fiat money does not have any value of its own, (just a piece of paper or metal) but it has a guarantee from the government of the issuing country.
It is declared as the legal tender and is an acceptable form of payment backed by that country’s Central bank. We all know if we have paper currency or coins, we can use them anywhere and they will be accepted as a form of payment. In today’s modern economy, most of the time we don’t even hold currency, as all the payments and receipts can happen online, where the money gets debited or credited directly in your bank account from another person’s bank. A lot of countries have gone virtually cashless because a large number of people use smartphones nowadays and internet access has become much cheaper and wider. This has made the digital transfer of funds between two people just with a click of a button on phone. It is important to note that a credit card is not considered money* (read the section below Supply of money).
Is there a thing called a Money market?
Just like any commodity, money also has a demand and supply, and thus, has a market. The interest rate at which we borrow money is the price of money.
Demand for money
We hold money for two reasons. First is to make transactions, so we can make payments for our various expenditures.The transaction demand part is positively proportional to the real GDP and price level. In other words, people will demand more money when there is inflation and higher real GDP. It is simply because they will need more money to be able to purchase more goods and services (real GDP) and at higher prices (inflation).
The second reason why people demand more money is for speculative reasons. To understand the speculative reason, first, we must understand that when we hold money, there is an opportunity cost for it. Opportunity cost, in economics, means the cost of missing the next best possible use of something. Which in this case is the sacrificed interest that we could have received if we had saved money in a time deposit with a bank instead. When there is extra money in people’s hands (high money supply), they can use it in two ways- spend it or save/invest it.
When banks are charging and paying a higher interest rate, demand for money gets low because of two reasons. First for a borrower, the cost of borrowing money gets high, so he will borrow less and hence demand less money. Second reason is that when interest paid on our deposits are really high, we will expect interest rate to fall in future and want to convert their money in bonds. Bonds pay fixed interest and principal at maturity, and the interest promised at maturity doesn’t change with market interest rates changes. Thus, it becomes safer to invest our extra money in bonds than in a savings or time deposit with the bank. Interest rates are paid on time deposits, which can vary according to the central bank monetary policy tools. In this case, when the interest rates are high, the demand for money is low. With the same logic, when interest rates are very low in the economy, people expect them rise in future and will demand more money compared to bonds. So, speculative demand for money always has a negative relation with interest rates.
So, the total money demand is equal to the money demanded for transactional and speculative purposes.
Supply of Money
The money supply is the total amount of money that the people in an economy are holding at a particular point in time.
Central bank of a country has the authority to issue the currency of any country. This currency issued by the central bank is held by the public and by commercial banks.
In the US, the Fed controls the money supply of the country through various tools by changing interest on reserve balance and thereby controlling the federal funds rate and other interest rates in an economy. You can read about this in more detail in my post here.
The money supply is a stock concept, which means it is measured at a particular point in time and a country’s central bank usually publishes the total amount of money periodically.
Money is a financial asset that we can spend to purchase goods or services. When calculating the money supply, the central bank includes financial assets like currency and deposits. On the contrary, credit card debts are liabilities. With each credit card transaction, a new loan is created for the credit card issuer, which needs to be repaid with a financial asset called money.
The two establishments in any country, the Central bank and commercial banks play an important role in deciding how much money is circulating in an economy at a particular time.
Since different assets can be used as money, the central banks give various categories and definition to keep track of it. In the US, there are two commonly used measures of money, known as M1, M2.
M1 is the most liquid and widely accepted. It includes paper currency and coins held by the public + demand deposits of public at commercial banks, + other highly liquid accounts called other checkable deposits. Prior to April 24, 2020, savings accounts, deposits were not part of M1. Savings are now more liquid and part of “M1 money”. Regulation D by the Fed has made savings deposits as convenient as currency. The Fed published data on M1 and M2 every month, As of April 2022, the United states had $20.6 trillion in M1.
M2 = M1 + small-denomination time deposits of under $100,000 + balances in retail money market funds. As of April 2022, The United States had $21.7 trillion in M2.
If I asked, “What’s the interest on your savings account?” many of you will tell me the interest rate that the bank is stating. However, you need to understand the difference between nominal and real interest rates.
In this post, you will learn about the true return you get by saving your money in a bank.
What is a nominal interest rate?
When you deposit money in your savings account at the bank, you get something called nominal interest. So, if your savings account has a 2.5% interest rate, that is actually a nominal interest rate.
A nominal interest rate is the interest rate banks and financial institutions give to you. It is the actual rate they will pay on your savings balance. This interest rate is not adjusted for inflation.
Before we dig into real interest rates, we need to understand what inflation is and how it impacts the real return on savings.
What is Inflation and how does it affect your actual return?
Inflation is the general increase in the prices of everyday goods and services we use. It is important to note that the price of one item can go up and down, but the increase in any single item won’t qualify for inflation. Inflation happens when price rise for a majority of goods and services we use. In other words, inflation only happens when the average price level is going up. For example, when the prices of food, housing, gas, and other items we use, all rise for a while. I have written a detailed post on inflation in another post if you are interested.
Real interest rate – the one that actually matters!
If there is any inflation in an economy, money loses its value or purchasing power. So, the interest you earn from the bank won’t buy the same amount of things it could before the price rise. Thus, we need to calculate the real interest rate. This is the rate we get after subtracting the inflation rate from the nominal interest rate your bank quoted to you. So, the real interest rate r is
r = nominal interest rate- Inflation rate
This is called Fisher’s equation in economics, named after American economist Irving Fisher. He explained the difference between true or real interest from nominal interest.
Thus, we will only earn interest income on our savings, when the real rate of interest is positive. If this number is positive, we haven’t lost money and actually gained some by keeping it in bank.
Let’s learn this by an example. Think of a big balloon with some air. Here air is the money you deposited in your savings account (balloon). Now, let’s think of the “nominal interest” you earn on your savings as the rate you are blowing air in the balloon to make it bigger. But let’s suppose there is a hole in the balloon, which is making the air come out of it as well. This air coming out of the hole is representing inflation in an economy.
If you’re blowing faster than the air that is coming out of the hole, your balloon will become bigger. And if your balloon is getting bigger, then purchasing power of your money in a savings account will grow over time. This is when you are earning interest in a real sense, and you will be able to buy more things.
But if the hole is bigger, the air will come out faster than the air going in. This will cause your balloon size to decrease, which means your purchasing power will go down.
So even if you are getting a nominal interest on your savings account from the bank, because of inflation, you will only be able to buy fewer things with that money in the future.
So, the real interest rate could be positive, zero, or negative depending on whether the inflation rate is less, equal, or more than the nominal interest rate.
If the real interest rate is zero or positive, then saving your money in a bank is still better than keeping it with you.
When you keep money in your house, it certainly will depreciate by the rate of inflation. The only time keeping money in the house will help is when there is a deflation, which means the general price level is going down.
In the chart below, you can see how inflation affects your true savings return.
Does anyone benefit from stable inflation?
Savers, borrowers, and lenders all benefit when the inflation level is stable and low (around 2%). For borrowers, it helps them pay off their loans because they are paying a little bit less in real terms.
Banks know the target rate of inflation, so they keep their nominal lending rate of interest higher than that. This helps them get some real return on lending money.
Similarly, for depositors, if inflation is stable, they get the real return as the excess of nominal return over the inflation rate.
However, if inflation is more than the normal 2%, then both lenders and depositors will lose money.
To learn about what measures the Fed takes to keep inflation stable at around 2%, please click here.
You might have heard in the news might have heard that the US economy has contracted in the first quarter of 2022. When we talk about economic contraction or expansion, we look at the % change in the most widely used statistic to measure the overall economic health of a country, also known as the GDP. Many were surprised by this decline, and it’s said as the worst quarter since the pandemic started in March 2020. To know more about what GDP is, please click here.
The official source of publishing GDP numbers in the US is the Bureau of Economic Analysis. In their April 28, 2022 press release, they projected an annual 1.4% decline in the real Gross Domestic Product of Q1 2022 vs a growth projection of 6.9% in Q4 2021. If you want to see the details about the calculation, data, and assumptions, you can check this page here. https://www.bea.gov/data/gdp/gross-domestic-product
What were the reasons for this decline?
The main reason that made the GDP growth negative was the trade deficit, meaning imports were far more than our exports, as US domestic supply couldn’t keep up with the domestic demand. In addition to the trade deficit, the GDP was also deflated by the omicron variant of COVID that shut down some businesses, and the government-funded pandemic relief to businesses and households decreased or stopped altogether by the first quarter of 2022.
Should we worry about this slowdown?
Despite the projection, economists are saying that there is no reason to panic yet because this GDP decline happened due to the net export component. In the chart below, data collected from BEA shows the percent shares of each of the four main contributors to the US GDP in the 2022 Q1.
The two major contributors to the US GDP have been consumption and investment, and both remained strong. Consumption, which is the most important driver of the US economy (contributing to almost 70%) increased during the first quarter at a rate of 2.7% annually, compared to 2.5% during the fourth quarter of 2021. Similarly, the business investment such as capital expenditure on factories, equipment, software, etc. remained robust and hence should increase productivity for the remainder of 2022. Firms’ investment had grown at a rate of 9.2% in the first quarter of 2022 which is a significant increase from the 2.9% increase in the last quarter of 2021.
In summary, even though the GDP first quarter fell, it is not indicating a recession coming. A recession is defined as a fall in GDP in two successive quarters. And we may only hope for a better future and some happy news in the economy.
Both gasoline and diesel prices are still up. Drivers across the US and globally are feeling pain when they visit gas stations to pump gas. You can see that both gas and diesel prices have been trending up in each of the regions in the entire US from October 2021, with a steep rise after Russia started the Ukraine war. I got these charts from the US Energy Information Administration, which is the US official source of data for energy information.
And since gasoline and diesel both are needed for the transportation of many goods, the increase in fuel prices has several linkages to other industries as well. In this image, taken from the US EIA website, you can see, that the national average for a gallon of gas in the United States was $4.11 and $5.12 for diesel as of April 2022.
What has caused the continued rise in fuel prices?
In most simple terms, it is the imbalance between the supply and demand of crude oil. There is an increasing oil demand, while there is not enough supply. Gasoline and diesel both are made from crude oil. The petroleum refineries make gasoline and other petroleum products from crude oil.
You might ask why the gas price is high in the US when it only imports a very small percent of crude oil from Russia. The answer to this lies in the fact that crude oil prices are set in the global market.
In this chart, you can see the supply and demand imbalance.
On the x-axis, we have the quantity of crude oil demanded and supplied and on the y-axis is the price of crude oil. For any commodity, an equilibrium price is set, where the upward-sloping supply curve and the downward-sloping demand curve intersect. That is the quantity that the producers are willing to supply and the quantity the consumers are willing to buy at a price that works for both.
If the producers supply more than what consumers demand, then the price of that commodity will fall because there is excess supply. On the other hand, if demand for a commodity is more than what the producers can supply, it causes price to increase because there is excess demand and consumers are willing to pay more. In the case of oil price hike, the latter has happened. This has led to both a rise in price of crude oil and a lower equilibrium quantity of crude oil consumed and supplied. The above chart shows that as Q1 and P1.
The economic sanctions put on Russia by the United States and the European Union in response to Russia’s invasion of Ukraine have had a shattering effect on the Russian oil supply to the world. Many countries have cut trade ties with Russia, leading to a lower supply from Russia. Even though, US has become the largest producer of crude oil. Russia is still one of the biggest crude oil producers in the world, so it has a significant influence on the total industry output in the global oil market.
When Russian oil is not available to its full capacity, the world supply of crude oil has dramatically decreased. This has caused crude oil prices to rise significantly. During the early part of 2020, when the demand for transportation dropped significantly due to the lockdown, crude oil was at an average price of $39 a barrel. This was its lowest price since 2003.
However, as the lockdown eased and economies returned to normal, there has been an increasing demand for crude oil. With people commuting to work again, traveling on vacation, and going out more, the demand for gasoline has resumed. While the suppliers are not able to increase the supply of crude oil, there is an increasing demand. The price of crude oil in the international market exploded to $139 before settling at $123 a barrel. Much of the inflation is due to a rapid rise in crude oil.
Crude oil is used to produce gasoline, so fuel refining companies like Exxon, Chevron and others are passing the higher costs of production on to consumers by raising prices at the pump. This is the inflation caused by supply factors.
Million dollar question in everyone’s mind is when will the fuel prices go back to normal?
The sad news is that Economists don’t expect gas prices to fall anytime soon, unless war in Ukraine comes to an end and and some sort of order is restored in Europe. Until then, the world oil market will continue to struggle to provide an adequate supply to meet worldwide demand meaning that crude oil prices will remain high. This of course will keep prices inflated at the pump and drivers will struggle to fill their tanks.
Additionally, as summer approaches, the demand for travel will continue to rise and the average cost of a gallon of gas might peak at $5. Many economists believe that even if supply issues are fixed and prices start to decline in the coming months, the average is still expected to remain over $4 nationally until at least November, as the adjustments take time.
Going forward the best strategy for countries will be to keep extra reserves when the crude oil price is low. Investment in alternative energy sources will be the strategy for the future to withstand such supply shocks.
If you want to know more about it, you can also refer to CNN’s article on June 1. Is it just a coincidence that a famous news channel published this article a few days after I did? It is not. This is just what everyone wants to know. https://www.cnn.com/2022/06/01/energy/record-gas-price-causes/index.html
Has it ever happened to you while listening to the news that there is some big scary vague thing called the economy that’s just out there? You might think you have no control over it, as most of it is based on business and government decisions. You are wrong here!
You are also a very important player in the economic game. The economy is just all of us together, acting in our own individual best interests, deciding how to use the limited resources we have, to get the maximum happiness. By pursuing our selfish interests, we indirectly contribute to the growth of society, by the magic of some invisible hand.
We all are in the economy as everyday people, who are going about everyday tasks and decisions. The main point is that we’re all actors in the economy rather than spectators. So, we are not passively looking at this thing called economy but taking an active part in the economy all the time.
In other words, an economy is a large set of interconnected production, consumption, and trade of goods and services that help in determining how scarce resources are allocated. I know in economics some fancy words are often used, such as “scarce”. By scarce we mean limited, something that we don’t have an infinite amount of.
It is true that in the news, macroeconomic indicators are discussed more often, like inflation, GDP, unemployment, etc. But believe it or not, a lot of times, the decision-makers behind these big indicators are millions of small entities like you and me. In microeconomics, we look at how people can make the best decision they can to make their lives better by making good choices.
We apply an essential economic tool called “thinking on the margin” in our daily lives. It essentially means evaluating the benefit of one extra unit of something vs. the cost of one extra unit of the same thing.
For example, should I spend one more hour studying? Should I eat one more pizza slice? Small decisions like that are also economic decisions. Households, businesses, and governments all think about tradeoffs and marginal cost vs marginal benefit analysis while taking many decisions in life.
For an individual, it is a personal decision like should I spend a few additional minutes reading this article or should I switch to some other activity that may give me more marginal benefit? Similarly, firms must decide whether to hire additional labor to increase production and by how much? Will the extra revenue generated from hiring that extra labor to be enough to cover his cost of wages?
Lastly, on a macro (aggregate) level, governments make the monetary and fiscal policies to make more significant decisions by doing the same marginal analysis. Should they build an extra park or use the money on healthcare? We need to remember that the principles of economics can provide guidance across all sectors, be it at the micro-level or macro level.
The most talked-about topic affecting everyone for now almost a year is inflation. Your money loses its purchasing power, you need more money to buy the same amount of goods and services you purchase or use. If you are hiding a lot of money under your mattress or in a safe place at home, trust me it’s a bad idea. You will only be able to buy fewer items with that in the future than now.
The easiest way to define inflation to a layman is the sustained increase in the average prices of a basket of goods and services that we buy over a specific period. So, when there is inflation, the cost of living goes up. This becomes a real problem if your income doesn’t rise as quickly as inflation, then with your current income, you will only be able to buy less same stuff than before.
The inflation rate is expressed as a percent change from the previous period. Below is the actual inflation rate in the US in the last 6 years. So if the annual inflation is 6%, it means on average, prices have risen 6% from the last year. As you can see, the inflation slope became steeper in 2020, after the pandemic hit the global economy.
So, what causes inflation?
This can happen in two ways: either through demand-pull factors or through cost-push factors.
The quantity theory of money explains inflation caused by demand-pull factors.
Demand-pull inflation
This occurs when people have too much money and they want to buy more, whereas there is not enough supply to meet that demand. Or in other words, too much money is chasing too few goods. This usually happens when the economy is at (or very close to) full employment/full capacity. By full employment, we mean people who are looking for jobs can find one. Also, in this situation, the country’s GDP grows at a rate faster than its long-run trend rate. This happens when there is too much money in circulation. If the bank interest rates are too low, people, both households and businesses can borrow easily and as a result, can buy more goods and services than what the firms can supply. We call this phenomenon “too much money chasing too fewer goods”. Producers increase prices and profit because they can’t increase supply in the short run.
Using the demand and supply curves, I explain this idea. You see that the demand curve always slopes downwards, meaning people always want to buy more items at a lower price, Also, note that the supply curve faces upward, which means the firms producing those goods would like to supply more at higher prices, With the same assumption that is everything else staying the same. Equilibrium price and quantity are established at P and Q where the supply and the demand curve meet. We call them P and Q.
To explain this graphically, let’s look at the demand and supply model. On y axis, we denote the general price level, since inflation reflects general price level rise. On x asis we will show the real quantity of goods and services or real GDP. In the graph below, demand will be aggregate demand as this is represents demand from the whole economy. This demand is also downward sloping curve, as the demand for any normal item will be. It shows people overall demand lower quantities when the prices are high and demand more quantities when the prices are low. With the same assumption that nothing else is affecting the demand and everything else stays constant. The aggregate supply curve always is upward sloping meaning producers are willing to supply more at higher prices, so they can get more profits and vice versa. With the assumption that everything else is staying the same, the price level and quantity are set where aggregate demand meets aggregate supply at e. This is the price level consumers are willing to pay and producers are willing to accept and is denoted by P. And the corresponding quantity supplied and demanded is denoted by real production of goods and services or real GDP at Q. Economist call this equilibrium price level and quantity.
If there is excess money in circulation in the economy, people can afford to buy more, so for each price level, there is an increased demand. Or in other words, too much money is chasing fewer goods.
In our graph, you will see the aggregate demand shifting to the right or upwards. Now we get the new equilibrium e1, where the new demand and supply meet, and you can see that the new price and the quantity both have increased to P1 and Q1. This happens in the short run when producers don’t increase the supply of goods and services but instead, charge more prices because of increased demand.
Over time when producers can increase their production, the supply will be increased. In the graph below, this will mean the supply curve shifts to the right. So we can see at the new equilibrium, the prices will fall back. How much the prices fall, will depend on how much adjustment (increase) in supply is made in the long run. If the supply is adjusted enough to meet the increasing demand, then the prices will back to level P and the quantity demanded and supplied will be even higher, as shown at Q2. And the increase in the general price level is controlled.
Cost-push inflation
When the supply of the good is reduced due to an increase in the price of inputs in making that good or service. Supply shocks can cause cost-push inflation. Supply can fall due to a variety of reasons, such as if the cost of inputs for production goes up or if there is a natural calamity. Most recently after the pandemic, lockdown jams in major ports have contributed to a slowdown in the supply of a lot of items.
In the graph above, supply shock has pushed the price up to P1, and Quantity is reduced to Q1.
How to calculate the inflation rate?
Inflation is expressed as a % change in the price level of a market basket of goods and services over a period. To understand how inflation is calculated, let’s start with a very simple economy, where people only bought and consumed 3 items – bread, internet, clothing, and a house. You spend 30% of your yearly income on bread, 10% on clothing, 10% on the internet and 50% on renting an apartment. Then let’s assume the price of bread in year 1 is $2 and the price of internet is $45, price of clothing is $10, and rent is $25000. The price of bread in the year 2022 goes up to $2.5, price of internet becomes $60, price of clothing increases to $15 and rent in year 2 is $30000. We also, in the table below, list the proportion of income or weight they spend on all these items. The sum of these weights needs to add to 100%.
Inflation from year 1 to year 2 is calculated as (CPI2 – CPI1)/ CPI1 * 100 where CPI1 is the price level in year 1 and CPI2 is the price level in year 2. CPI is a weighted average price of many day-to-day goods and services that a typical American person living in a city buys at a particular time. Don’t be frightened by the term “weighted average”. Weight here refers to the importance of spending on a particular item compared to total expenditure. It simply means more weight is given to goods and services where you spend more money of your income. This could be because you buy that thing more often like, daily or you spend a lot of money buying it.
If we change the weight of some things from table 1, even with the same absolute increase in price, the inflation % will change. As you can see in table 2, it became 20.02%.
If the change in prices is more compared to that from table 1, even with the same % of weight, the inflation % will be greater.
BLS calculates and publishes inflation in the US
However, our consumption is not just restricted to these four items. In fact, a typical American urban consumer consumes a wide variety of goods, known as the market basket of goods.
In the US, the Bureau of Labor Statistics calculates something called the CPI (consumer price index). To collect the monthly price data, BLS-trained representatives make personal visits, phone calls, and get online surveys to collect data on what goods and services American people are buying.
The price and weight info are essentially based on a survey of people of what proportion of their income people spend on a given good or service. BLS tries to calculate the prices of the same basket of goods and services. Now, here some people will argue that what if people don’t consume the same things after some years? That is a subject of further investigation, but the general idea is that the BLS tries to calculate the prices of the same goods and services consumed by the average person over a period for which it is calculating the inflation rate.
Since CPI is a sample of retail prices and does not cover the complete universe of all prices, it is subject to some errors. However, that sampling error is not statistically significant to change the calculation by a lot. You will have to get into statistics class to understand the more technical aspects of what is considered a significant error or not, but for now, you can understand the error possibility is very small, so it is a reliable indicator of how the prices are behaving in general.
But when do we need to worry about inflation?
Well, some inflation is not bad and is considered healthy for the economy. Since our salary/wages have also increased over time and in most cases, some general rise in price level doesn’t hurt our purchasing power.
The BLS calculates this measure at 1-month, 3 months, 6 months, and 1-year intervals, and publishes that data. Over the last 40 years, we have seen this inflation % on average staying close to 2% annually. That means the same basket of items that you buy is 2% more expensive from 1 year to the next. The goal of monetary policy is to keep the inflation number close to this target-rate.
But in some countries like Zimbabwe and Venezuela, the prices had risen to a level making it very difficult for people to hold on to their currency. That situation where general prices rise at a rate of 50% per month is called hyperinflation. People know that they won’t be able to buy the same set of goods with that amount of money, even the very next day, so they demand more wages to cope with it. This, in turn, causes firms to pass this burden by increasing the prices of goods and services they provide. This, in turn, causes an increased demand for higher wages and the spiral continues. This is called the wage-price spiral. This can cause a severe crisis in any country.
To know more about how the Fed uses monetary policy to control inflation, click here.
Economists have some simple key models to understand our complex economies. One such model is the circular flow model. This model comes handy when we understand why GDP from income method and expenditure method should equal.
There are two main ways of calculating nominal GDP and will discuss these in detail later in this article. These methods are known as the expenditure method and the income method.
But first, we should understand the relationship between the income method and expenditure method of calculating GDP in a circular flow model. The circular flow model shows the linkages between two groups of economic decision makers, households and businesses. It also tells us that there are two types of economic markets, the resource or factor market, and the product market for goods and services. Once we understand this simple circular flow model, it will be useful to understand the complex economy and the GDP computation. In order to learn more about what GDP is, please click here.
The model begins by assuming a simple economy with two markets:
Factor or resource market: a market for factors of production that the firms demand.
Product market: a market for goods and services that the households demand.
By household, we mean people living in a house. Businesses are privately owned entities producing goods and services to sell in exchange for money. It is important to understand that the households and businesses are both buyers and sellers.
Households are sellers in the factor market. They sell land (including any natural resource like trees), labor, capital, and entrepreneurial ability in exchange for money. Households are buyers in the market for goods and services. Households give money to businesses for goods and services.
Businesses are sellers in the market for goods and services. Businesses sell goods and services in exchange for money, which they call revenue. At the same time, businesses are buyers in the market for resources. Businesses exchange the revenue earned in the market for goods and services to buy factors of production i.e., land, labor, capital and entrepreneurial ability in the resource market. Here, the money they spend is called the cost of production.
Let’s understand it better with a simple example.
When you go to your local pizzeria to eat your favorite pizza, you give your money to the owner for the pizza you buy from him. When you pay your bill, you are buying goods and services. But the money doesn’t remain with the pizzeria owner for long. The pizzeria owner uses part of this money to buy resources such as wheat flour from a farmer. He also pays wage/salary to the server who took your order and also might spend money to purchase a new equipment for his pizzeria. For the pizzeria owner, all these expenditures are costs of production. After he pays his costs of production, the remaining income is his profit. This is the money he earns as being an entrepreneur owning and operating his business with his skills. Now let’s say your money went to the farmer and that for her, is her income. But that money won’t remain with her for long as well. She will spend it too on other things she wants to buy, and the entire cycle will start again.
Thus, this circular flow keeps going on and on. Here’s an animation explaining the model, you can see the circular flow between the product market and factor market. You will also see the flow of money between the two. Money flows in one direction while goods and services and resources flow in the other direction. Through this model, we can see the relationship between households and businesses and how these different decision-makers fit together in our big economy.
In reality, our economy is more complex and has more elements, like, government, foreign trade etc. and we can expand the model to include all these players. But the basic idea won’t change.
I hope this made sense. Let’s go back to the two ways of calculating GDP and we can see why these two methods will yield similar results.
Expenditure method: Since GDP is the market value of all final goods and services produced in a country at a given period, if we add the total spending done by all the people in a country, we can get a number close to nominal GDP. We usually categorize these total expenditures done by these four sectors:
Household spending includes any new good or service we buy, big or small. So, we will add all our expenditures be it on buying an apple or a new house, in a given period, to get the private consumption component of GDP. We can denote it with C.
Spending by firms/businesses on capital and inventory, which we call investment or I. Investment here refers to investment by a firm in machinery, research& development, inventory, etc. We only include investments done by businesses in real assets in the calculation of GDP. We don’t include any financial investments, like buying a company’s stock or bond or a financial asset.
Government, like us, spends money on various things. These include big expenditures on building infrastructure, public parks, public-funded education, hospital, nuclear energy, defense, salaries paid to government officials and small expenditures on office supplies, and many more. All of those will be part of the G component of GDP. But we won’t include government spending on any transfer payments, such as pensions to retired people or on welfare programs and subsidies. Those payments are not counted in GDP because no good is produced or service is exchanged against these payments.
Spending by the rest of the world (Exports – Imports or net exports). We denote it with NX. Sometimes, a country produces some goods more efficiently than other countries and can sell them to other countries for profit. Those are called Exports. Similarly, the things a country has a comparative disadvantage in making, it can buy from other countries, which can make it relatively cheap.Since GDP, includes only goods produced “within the boundaries of a country.” we will include foreign people’s expenditure on things made in our country or our exports. At the same time, we won’t include us buying any foreign-made goods or our imports.
So, GDP = C + I + G+ NX
Let’s look at the second approach of calculating the GDP.
Income method: Here we add the total income earned by all the people living within the boundaries of a country. Economists classify income earners into four broad categories. Labor, land, capital, and entrepreneurship. These are called factors of production- the inputs used in the production of goods and services. Thus, we sum up all the income earned in a given year by these four factors of production using this formula.
Wages/salary (earned by labor) + Profits (earned by an entrepreneur) + Rent (earned by landowners) + Interest income (earned on capital equipment).
There is another method, which is less frequently used and is called the value-added method.
Value-added Method: In this method, we add up all the value-added at various stages of production. For example, to make a dress, we will calculate the value of the raw material that a fabric company sells to the dress manufacturer ($10), which he combines with his skill and capital ($40) to make a dress worth $50.
So, these were all the ways of calculating the nominal GDP. To learn more about US GDP, please click here.
IMF projects lower global GDP growth of 3.6% for the next two years
IMF’s World Economic Outlook report published on April 19, 2022 has predicted a drop in the GDP growth of the world economies in the years 2022 and 2023 to 3.6%. This downward revision is from their previous estimate of 6.1%, largely because of the war in Ukraine. IMF publishes this report twice every year.
Below is the chart from IMF showing these growth projections by region. These projections are for real GDP growth and not nominal GDP growth. As changes in real GDP are the most popular indicator of a country’s overall economic condition. If you want to know more about the US GDP and its components, please click here.
Countries, like the United States, the EU, Japan, the UK, Canada, and other advanced countries are projected to grow on an average of 3.3% in 2022 and only 2.4% in 2023.
The emerging market and developing countries such as India are projected to grow at 8.2% in 2022 and 6.9% in 2023. Whereas because of the lockdown in Shanghai, China, the projected growth is slightly lower at 4.4% in 2022 and it is expected to be 5.1% in 2023, as the lockdowns are eased.
As expected, there is a severe double-digit drop (-35%) in GDP projection for Ukraine in 2022. They also project a contraction for Russia due to sanctions and European countries’ decisions to reduce energy imports. The war has also severely impacted emerging and developing Europe, which shares proximity to the war area with an expected fall of 2.9% in their real GDP in 2022. There is a hope of some recovery in 2023 with GDP growth returning to 1.3%. Russia will see a GDP growth of -8.5% in 2022 and -2.3% in 2023.
The two charts below show the GDP growth comparison in some major countries of the world after the start of the global pandemic. The first chart shows the performance in the years 2020 and 21.
The second chart shows the projections by IMF for the years 2022 and 2023.
Sadly, the war just doesn’t affect the countries directly involved, its economic costs and implications are widespread. Through commodity markets, trade, and to some extent financial interlinkages of the countries, the war can indirectly affect so many more countries.
Globally we are seeing rise in fuel and food prices since late 2021. The fear of War is aggravating high inflation problem even further. Unfortunately, the world’s poor population, particularly in low-income countries is getting the most impacted by this. To know more about inflation, please click here.
Many leading economists propose mutual efforts by countries to respond to the war crisis and prevent further economic fragmentation. At the same time, it is important to manage the debt problem, tackle climate change and end the pandemic to bring back economic growth.
Fighting inflation without slowing down the economy is the toughest challenge many central banks are facing currently. To know more about monetary policy and the role of a central bank, in controlling inflation, please click here.
