User's blog

Tag: economic concepts

  • Some ways to save money and cut expenses

    Who doesn’t like to see some extra money in their savings without having to sacrifice their living standard?

    Saving is the money left after subtracting all our expenses from all our income. This is, after all, the money you can ultimately invest and grow. Well, there are two ways to save money.

    Yes, you guessed it right, either you increase your income or reduce your expenses. In this post, I will focus on the latter.

    I will share some easy ways for you to reduce your monthly expenditures, without even feeling it. While some of these may seem common sense, it is still good to read this article. Maybe, you will find one particular option, which I am going to list below.


    I am combining personal finance and human psychology with my favorite economics knowledge to come up with some doable changes we all can implement. So without further ado, let’s get into it!

    Cut Down on Streaming services

    To start with, please cancel any unnecessary online streaming subscriptions. Many times, we take too many streaming services that we don’t even use much. Honestly, on average, if you are working or studying full time, how much TV do you get to watch every day? Maybe a couple of hours, max?

    So, yes most people do not get the time to watch that much TV and we often end up paying too much for each service. So you should consider how many of these you can’t live without. Even though their monthly fees don’t seem that much individually, together they all add up.

    Is Gym membership worth it?

    Think about marginal benefit vs. marginal cost of Gym membership

    Unless you use the gym 4-5 times a week, paying $20 or so per month isn’t worth it. We get tempted by their deals and may use them for some time in the beginning, but most of us are not able to continue for whatever reason.

    I am totally in favor of exercising and maintaining a healthy lifestyle. And there are free resources for that. You can always start with walking or jogging outside or jump roping. You can also do yoga and make use of many free online exercise videos or free cardio classes. These will all give you the same results if done 3-4 times a week for 30 minutes a day.

    Do you still use Cable TV?

    How to cut your expenses without affecting your living standards?

    In a world where there are so many streaming services, I honestly think we don’t need cable TV anymore.

    I find that a lot of time is taken by the ads shown, and we don’t have the option to skip ads, in cable TV. Honestly, most people just flip between channels waiting for the ads to finish. What a waste of time!

    Consume less electricity during peak hours

    For most places, peak hours are between 4 to 9 PM. This is when you get charged the most. So try not to use your dishwashers and washers during this time if you can. Also, Having an app like Nest will help you monitor how much your AC is running and how to control it. I found some additional ways to reduce your electricity bill in this post in case you are interested.

    Refinance your loans

    If you follow my posts and the news, you must be aware that the Fed has (indirectly) raised all the interest rates that affect us. This includes our home loans as well. The Fed has clearly stated that to fight inflation, it will further raise interest rates. So there is still time for you to refinance some of your loans for a lower rate.

    So anytime, you find interest rates lower than usual, don’t miss the opportunity to refinance your mortgage.

    Eat out less

    Well, this goes without saying, right? I understand everyone can’t have a home-cooked meal every single day. We also need a break and eating out provides us with that happy feeling. But if you can, try to slowly decrease the number of times you go out to eat. For example, start by reducing it by 25% and gradually increase it.

    There will be two advantages to it. Not only you will save money on restaurant bills, but you will also be able to have a healthier life. To get to this, you will certainly need better meal planning (esp. since we all live very busy lives). Nevertheless, it is doable if you incorporate simple and healthy options to cook. One way to do it, which I sometimes do is to make extra servings of the food in an instant pot and use my freezer to save it for the future.


    Avoid instant online shopping temptations

    When we pay with credit card or debit card, often times we don’t know how much money we have spent. We easily fall prey to online shopping deals and offers. Studies have found that the pleasures of online shopping release dopamine, a happy hormone.

    Oftentimes, we just want to buy something because we see others using it. Here, we need to stop and think if we really need it. Is this really adding value to our life?

    An additional tip is while buying clothes, shoes, and accessories, try not to do too many one-time-use purchases. Buy something that you can use more often. We all need a few party wear and special occasions outfits but just choose the number wisely. We work hard for the money and we need to use our judgment while making any purchase.

    Most of the time the pleasure we get by making any purchase is very short-lived. We suffer from something called “shiny object syndrome”. So always think before giving to this instant online need to splurge. One tip is to leave the item in a shopping cart for a few days and then decide if you still need to buy it.

    Return options

    Many of the companies we buy from these days, offer return services, some up to 90 days or more with a receipt. We procrastinate returning because of this long window and may forget to return the item. I am sure it has happened to some of you. So either set up reminders or do it as quickly as you can to avoid sitting with that item.

    Be cautious of free trial magazines and other services

    Sometimes, we take a service, which is free for a trial period. Usually, these services require us to give the payment information even though they don’t charge for the trial period. They also give the option to cancel the service anytime during the trial period. But life happens and we may forget to cancel it.

    Then unknowingly, we get charged for a whole year. Be cautious of these. I would suggest not falling for these offers unless you are very disciplined and can keep track of all your free trial subscriptions. One way to avoid getting charged is to set reminders on your phone to cancel before the free trial period ends.

    So, these were some of my tips for reducing your expenses without substantially affecting your lifestyle. I am sure there are many more, so feel free to share those in the comments section below. In my other post, I will also cover some ways to increase your income.

    I hope you learned something from this personal finance post series. Please leave your comments on what type of posts you would like to read, it will help me connect with my readers more. I hope you are having an amazing day and I will be back soon with another topic. Thank you for reading till the end!

     

  • The jobs market in the US is still going strong

    Two days ago, President Joe Biden proudly posted that the unemployment rate in the US was 3.5% in July. This matched the lowest rate in the last 50 years. He also said that since he started, 10 million jobs have been created in the US economy.

    Praising the fastest-growing job market, Biden mentioned that 528,000 jobs were added in the US in July itself. “Today, we also matched the lowest unemployment rate in America in the last 50 years: 3.5%,” he said.

    The Bureau of Labor Statistics (BLS) in the US publishes data for the unemployment and labor force statistics every month. These are based on the data collected from household surveys and establishment surveys on sample-based estimates of employment.

    I got this Civilian unemployment rate graph from the BLS. You can see that the US unemployment rate is now at its lowest level at 3.5%. This had happened three times before in Sep 2019, Jan 2020, and Feb 2020, when it hit 3.5%.

    But have you ever wondered what is the unemployment rate anyway?

    Well, the unemployment rate is the percentage of people who don’t have a job but can work and have actively looked for a job in the past 4 weeks. This is relative to people in the labor force.

    According to the BLS, The labor force is the sum of employed and unemployed people ages 16 and older at a given period.

    Their recent report about July’s unemployment rate was contrary to what many people would have expected. People were expecting a somewhat slowdown in the job market, but clearly, this hasn’t happened yet. The Fed has been raising interest rates to control inflation. The Fed’s policy aims to cool the overheated economy by reducing overall spending by individuals and businesses.

    So what does a low unemployment rate mean for you?

    If you are looking for work or want a change of job, right now could still be a good time for that. There’s a huge likelihood of you finding it sooner than later and as per your terms. With many employers paying higher salaries, it is a good time to ask for a raise if you think you deserve it.

    When the effects of tightening monetary policy start showing up and we see a reduction in jobs created, it might be a little late to negotiate.

    As always, if you enjoyed reading my post and learned something, please feel free to write your views in the comment section below. Thank you, till we meet again next time!

  • Why did Fed raise interest rates again, making borrowing more expensive?

    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 rate target 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.

  • Commonly used macroeconomic terms that you should know

    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: It is 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.

    1. Seven Board of governors guide the entire monetary policy and set the discount rates for member banks
    2. 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.
    3. 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!

  • What role do models and graphs play in economics?

    Our economies are complex, but by making some simple assumptions, we can focus on what is most relevant in explaining something. For this reason, economists use models to give us logical and precise reasoning behind many questions that come to our minds. Sorry, if you thought of this model as the one who walks on the ramp or does an ad on TV. Unfortunately, here we are talking about a little bit boring, economic models. Unlike attractive human models, these models generally consist of a set of mathematical equations, which are a simplified depiction of the real world. So, even if they are not pretty looking, they serve a very important role in economics. They try to precisely (like theories in science) describe how and why, we, as economic agents, act and are likely to act in future.

    One of the most important models in economics is the demand and supply model, together they explain how the price of anything gets determined.

    Economists use models for a variety of reasons, some of these include:

    • To assist in academic research that supports a proposed economic theory
    • To make economic forecasts so that we can understand the conclusions based on the assumptions made
    • To influence policy making relating to larger economic activities or at macro level
    • To explain and influence company strategies for businesses
    • To explain the growth pattern among countries
    • To understand banking, investment and saving behavior
    • To explain decision making at household level

    And many more…

    Even though, no economic model is a perfect description of reality, the process of making, testing, and revising these models forces economists and policymakers to think logically when trying to propose something. With the help of these mathematical models, they try to accurately depict how the economy works, and what drives economic behavior in people at large. This in turn helps them answer what they should or should not do when proposing a particular policy.

    These economic models use a lot of mathematics, as one of the key contribution of economics to mankind is how to think on the margin. That means calculating the additional benefit, and the additional cost of any particular action. Knowledge of calculus comes in handy in finding these solutions. So, if you or someone you know are planning to study economics in college, make sure they are good at calculus and algebra.

    Economists also use a lot of graphs, as these are a good visual representation of these economic models. The charts and graphs are relatively easier for people to understand as compared to mathematical models. So for my blogs, I will stick to graphs only. 🙂

  • How price of anything is set?

    The answer to this complex question is simpler than you might think.

    Do you think a business can charge whatever price it wants, to get the highest possible profit? But consumers who demand those products would like to buy them at the cheapest price, so how do they come to a consensus? In markets that are highly competitive (see footnote)*, meaning there are many producers and consumers of a specific good or service, the price of that product or service gets determined by the interaction of supply and demand forces. These forces work together in the same manner as the blades of the scissors cutting the paper.

    Wait, but what are these supply and demand forces?

    First, let’s understand them individually, and later we will see how they interact to set the “right” price.

    Demand

    In economics, we assume that people buy more of something when its price is lower. This negative or inverse relationship between price and quantity demanded is called the law of demand. This means the higher the price, the lower the demand is, and the lower the price, the higher the demand is for any normal good or service. Undeniably, a change in people’s tastes, income, and preferences can affect the demand for something, but we will assume that these other factors don’t change, so we can only focus on the relationship between price and quantity demanded.

    Let me explain this with a simple example of the demand for bread. The prices are shown on the Y-axis and the quantity that people are demanding is on the X-axis. You can see this inverse relationship in the graph below that slopes downward.

    If the price of one loaf of bread is $10 there is going to be very less demand for it, let’s say only 10 loaves of bread will be demanded. Once the price is lowered to $6, a few more people will be willing to buy it, so the quantity demanded increases to 20. And if the price is further lowered to $2, more people would be willing to buy it, as more can afford it, so the quantity demanded now is 40.

    Supply

    Now let’s look at the supply pattern. For a producer, if he gets a higher price for bread, he will be willing to make more bread and supply more of it. A higher price or reward encourages producers to supply more, and you can see this positive relation in the graph below as an upward-sloping supply curve. So, the law of supply states that there is a positive relationship between the price of a good and quantity supplied. This means the higher the price, the more businesses or producers are willing to supply, and the lower the price, the less they would like to supply. In the graph below, we can see at $2, producers are only willing to supply 10 loaves of bread, at $4, 20 loaves, and at $10, 40 loaves of bread will be supplied.

    Now when we plot both of them together in one graph, we will see there is one price, where both these curves meet. In economics, we call it an equilibrium point, where the price is just right for the producer/seller and the consumers. In the graph below, this happens at point A, where demand and supply meet or cross each other. The price is set at $4 and the quantity demanded and supplied is 25 loaves of bread. Thus, we saw no one individually impacted the price, but producers’ supply and consumers’ demand worked together to set the price that makes everybody happy.

    You understood how prices can influence how much people want to buy and produce. Now, let’s understand also, how it works the other way round, meaning how much people demand and businesses supply can influence the prices as well.

    If there’s more demand than supply for something (such as point B above), this will send a signal to the producers to increase the price from $2 to $6, because they understand that people are prepared to pay more to receive that good or service. In this case, there is an incentive for the producers to increase the price. If the price goes up to $6, some consumers will drop out as they won’t be able to afford bread at price $6.

    On the other hand, if there is more supply than demand (shown as point C above), this is a signal to the producers to lower the price from $6 to $2, because the price at $6 was too high and there is a very limited number of people who are willing to buy it. Now some producers, might drop out and can’t lower the price to $2, because they can’t cover their cost of production.

    Over time the price will keep moving upwards or downwards until it reaches a point where demand is equal to the supply, at point A ($4).

    Today, you learned two fundamental concepts in economics: the law of demand and the law of supply.

    If you are wondering about whether it is possible to plot these demand and supply curves in real life, the answer is, yes? In economics, a graph is just a simple representation of economic principles or behavior observed. Economists survey people and collect data and plot that data using easy-to-understand graphs. In the demand and supply curves we looked at today, the slope could be steeper or flatter. In order to learn what decides how steep or flat (demand or supply) curve will be, we will have to look into another important principle in economics called elasticity. More on that will be in my future posts. For now, if you just want to know why economists use models and graphs to solve real-world economic problems, please read my post here.

    *In non-competitive markets, like monopolies, where one company controls the market, it gets more control in setting the price. The demand and supply forces don’t work very well here. Producers want to get the maximum profits by setting the price higher and can do that as well. In the absence of other competing businesses, consumers who want to buy their product or use their service, don’t get other options. Hence, they end up paying a higher price than they would have paid if more companies were in the market for that product or service. Usually, to prevent businesses from exploiting consumers, some government intervention is required so these monopolies don’t create artificial barriers to entry.  

    It is worth noting that, some monopolies can happen naturally and not all monopolies are bad. We will look at this more in detail with real-world examples in another post.

  • What are our real earnings when we deposit money in our savings accounts?

    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.

  • What are the different types of economies in the world and where does the US rank in terms of economic freedom?

    We know economics is all about putting resources to their best use, so we get the most out of it. Economists use a fancy term called “allocative efficiency” to describe it. By resources, we mean land, labor, capital, entrepreneurial ability, and time.

    Now, you may ask could there be different types of economies or economic systems to make the best use of limited (scarce) resources? Yes, indeed. These economic systems help to answer the three essential economic questions of what to produce, how to produce, and for whom to produce?

    Let’s take a quick look at the three most common economic systems around the world: they are 1. free market, also called the market economy, 2. centrally planned economy also called the command economy, and 3. mixed economy or Keynesian economy

    I don’t want to bore you with lots of text, so briefly I will explain these. But before you leave, make sure to scroll down to check an interesting chart comparing different countries in 2022. I know we all like visuals to better understand something.

    So here are the three famous systems:

    Market economy: In this type of economy, goods and services exchange freely through market supply and demand forces. In economics, it’s called Laizzes Faire, which means a policy of letting things happen their way, without interference. So, in this system consumers and firms interact freely and maximize their incentives without government intervention. Now, you as a consumer should typically act to satisfy your utility by demanding products you want or need. Similarly, all consumers will do the same. So, consumers signal the producers in the market about what to make and what not to make based on their demand. This helps to answer the question of what goods and services to produce.

    Firms act to satisfy their profit motives by producing products at a minimal cost. Because businesses want to get maximum profits, they will adjust the production process to minimize costs so there’s less wastage of resources. This helps to answer the question of how to produce goods and services. Also, no single producer is required to know all the information in terms how many competing producers are there, and what is alternative use of his resources. Prices set by demand of consumers, and supply of every other producer can give him that signal to produce in the best possible way. Because if he charges more than others or don’t make the products people demand, people will not buy his product and go to the one next to him, given the other producer is local and they sell identical products. This has become easier with so many online shops now a days. Thus, the invisible hand or natural market forces will answer the question for whom goods and services are produced.

    Let’s take an example, if more people demand more of a specific good, like iPhone, its price tends to rise as well. This happens because we as consumers are willing to pay more for that good. Acting in response, producers wanting more profit, will increase production to satisfy the demand of people. As a result, a market economy tends to naturally balance itself.

    Whenever we see a rise in prices in one sector of an industry due to high demand, the scarce resources, such as land, labor, capital, and entrepreneurship shift to those areas where they’re needed the most. In the free market economy., the role of the government is only limited to protecting property rights, this way there is a guarantee of fair competition in the marketplace. People can protect their ideas through patents and copyrights, and this encourages innovation. Thus, a free-market economy is the one with the least amount of government intervention.

    Command economy: On the opposite spectrum is the command economy, where the entire price set up and distribution of goods and services are controlled by a central planner or the government. All economic and political decisions are taken by the government or a central committee of very limited people. They decide how to allocate the country’s limited resources. North Korea is one example of this type of economic system. This type of economy is commonly seen in communist countries. Natural market forces of supply and demand can’t decide the price and quantity of goods and services produced and consumed.

    Generally, people living in these countries don’t have a high standard of living and don’t enjoy economic freedom. By “economic freedom” we mean the ability to choose to produce something or consume something based on your ability and need. Since the government fails to collect all the information correctly about what to produce and how to produce, a lot of wastage happens. People who advocate a command economy think this system is more equitable because everybody gets an equal share. But at the core of economics is the belief that people want to act for their self-interest. As a result, there is less incentive for businesses to work hard and employ better production techniques to maximize profits. Because if someone doesn’t get to keep the extra share, why work hard for it?

    There are flaws in both pure market economy and command economy

    Let’s investigate, why both these economic systems are not perfect. We just discussed why the command economy is not a great system, but we also need to know what the limitations of a free-market economy are as well.

    In a free market, sometimes, markets can waste scarce resources by producing products at higher than necessary costs. This usually happens when there is very less competition or if one producer displays a monopoly. Due to a lack of competition, there’s no real pressure to bring down costs as a result, prices are inflated. The second type of market failure happens in the case of public goods. Private businesses don’t want to produce these public goods, even though we all collectively enjoy these, and are very necessary for the safety and well-being of our people. Since these types of investments are usually not profitable for private firms to produce, they don’t do that. Services like infrastructure or military, police services or fire departments, parks, basic k-12 education and healthcare for the poor. So, if we are only left to the free market, the people would go without these goods and services and not have basic needs and wants met. Also, there will be more unequal distribution of income and people may have extreme inequalities. So, to solve this problem, some role of government is vital. This type of system is called a Mixed economy.

    Mixed economy: Thus in the real world, pure market economies rarely exist because there is usually some government regulation or intervention needed for smooth function. In most countries, like the US, public education, security, law and order, nuclear energy, social security benefits, public goods like parks, and defense are provided by the government. The government also provides regulation, so businesses don’t create monopolies and exploit people by charging very high prices. The government also invests in scientific research to develop future businesses and industries. Additionally, when the economy is not behaving optimally, ie. when a lot of people are unemployed (as in a recession) or if the prices are too high (inflation), government intervention is needed to get the economy back to full employment and achieve stable prices.

    How much role the government plays in an economy can vary between countries, but in countries with higher real GDP per capita, there has been less government intervention and more free-market play. In this economic system, the government or the public sector and the free market also known as the private sector, work together to meet social needs. The free-market system is allowed to work independently, but the government intervenes to avoid market failures. Thus, we see this mixed economic system as the most common economic system around the world today.

    Here’s a chart from Heritage Index showing how different countries enjoy economic freedom. In their study, they used twelve economic freedom categories. Within these categories, they graded the freedom of doing it on a scale of 0 to 100. It’s interesting to see the twelve economic freedom indicators, which they use to calculate a country’s overall score. Here is the list, I got from their website. https://www.heritage.org/index/about

    • Rule of Law (property rights, government integrity, judicial effectiveness)
    • Government Size (government spending, tax burden, fiscal health)
    • Regulatory Efficiency (business freedom, labor freedom, monetary freedom)
    • Open Markets (trade freedom, investment freedom, financial freedom)

    The study gives equal weight to each of the above factors.

    Economic systems and economic freedom experienced in countries of the world

    As you can see, countries with the highest score in economic freedom from 80-to 100, are in darker green. Countries with the least economic freedom are in red.
     
    From the chart, you can see China, North Korea, Zimbabwe, Cuba, and Venezuela have the least economic freedom because of a command economy.
     
    On the other hand, Singapore, New Zealand, Ireland, Switzerland, Luxembourg, Taiwan, and Estonia have the most economic freedom. When we look at the real GDP per capita of these countries, the people living there mostly have a higher standard of living. All these countries are highly advanced, free-market economies, mainly because of their open and corruption-free business environment. In all these countries, there is a well-secured property right to stimulate entrepreneurship and innovation. There is also a very high level of transparency and government accountability.
     
    Many other countries, like India, Mexico, Brazil, and Russia show poor to moderate levels of economic freedom. Even though countries like India are opening from their initial planned structure, there is still a lot of bureaucratic red tape that hinders setting up new businesses easily there. In addition, there is a lot of political corruption and scandals. Unfortunately, many of them are not even reported.

    Originally from India, I can’t stop noticing the score India got in this ranking. Unfortunately, it still got very low score in the economic freedom index. Despite considerable liberalization since 1990s, India still has a lot of government controlled sectors and capital market. International participation in many industries is still limited compared to many other countries that rank higher in the economic freedom index. Also, In India, property rights are not very well established, which hinders free enterprise and technological innovation. Reservation system based on cast, instead of socio economic status is another deterrent in its economic performance. All of this combined has caused the infamous brain-drain, where a lot of highly skilled class move to other countries for a better lifestyle. Unless all these changes are made, India is still has a long way to catch up in the economic freedom score.
     
    The US and the UK and many advanced countries are mixed economies. They are under the “mostly free category” denoted in the light green color. According to their report, the US economic freedom score is 72.1, which makes it the 25th freest country in the world to do business in. The US private property rights are secured, and contracts are protected and enforced.
     
    It’s interesting to note that countries with higher economic freedom also have higher GDP per capita and higher happiness indexes. So, we can conclude that, overall, less government intervention (only limited to areas where the market fails), is needed for countries to do better economically.

  • We hear this word so much in news, but what exactly is an economy?

    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.

  • What is causing the prices to rise the world over? Understanding inflation and its causes

    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.

    If you are interested, you can check the detailed report here with relative weights and price changes by category. https://www.bls.gov/news.release/pdf/cpi.pdf

    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.