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Tag: understand economics

  • How does the Central bank control inflation?

    You may have heard in the news in the last year, that the Fed has been raising the interest rate. In this post, I will be explaining which is the “interest rate” and how the central bank of the U.S. (the Federal Reserve) does that to control inflation.

    After Jan 2022, there has been a steady rise in prices of many items, esp. fuel, housing rent, and food prices. If you want to understand what inflation is and how it is calculated, you can read my detailed article on inflation here.

    Inflation always happens when there is more demand than supply and when there is an expectation of inflation to continue. Producers raise the price of the goods and services in demand, to make more profit from them.

    The central bank of a country (the Federal Reserve in the US) intervenes when inflation is out of control or is significantly high compared to the target level. As this blog mostly focuses on the US Federal Reserve monetary tools, I use the terms the Fed and central bank interchangeably. However, central banks in other countries also use similar monetary tools.

    Is inflation always bad?

    In the US and many advanced countries, the target average rate of inflation is around 2% every year. This little bit of inflation rate is considered desirable, as it helps borrowers pay off their debt. When there is some inflation, borrowers will have to pay slightly less in purchasing power terms because their money is now worth less to the lenders, exactly by the rate of inflation.

    Additionally, it also motivates people to spend their money on goods and services instead of holding on to them, as their money will lose its value next year by the rate of inflation. So, we get our normal production and consumption, and the economy continues to run smoothly.

    What are the two goals of a central bank and how does it achieve it?

    The central bank uses monetary policy to keep inflation low and promote maximum employment. By maximum employment, we mean the highest level of employment that an economy can sustain while maintaining a stable inflation rate. In the US, these goals are referred to as the Fed’s dual mandate.

    You may ask how the Fed achieves its dual goals. Essentially, the Fed uses its monetary policy tools to start a chain reaction in the economy, each causing one another. In the US, the Fed’s chief body for monetary policymaking is called the Federal Open Market Commission (FOMC). FOMC meets eight times a year and looks at data on current economic conditions, like what is going up and what is going down and how the economy is likely to do in the future based on the data. Based on that information the FOMC makes monetary policy decisions.

    When inflation is high for a long period and unemployment is at a very low level, we call it an overheating economy. The central banks try to raise the interest rates to slow down the overheating economy. This is called contractionary or tight monetary policy.

    Tools of Monetary Policy

    Now, let’s look at the tools the Fed can use to bring inflation down to the stable 2% average rate. This is done in two steps:

    First, the Federal Open Market Committee (FOMC) will raise the target range for the Federal funds rate. This is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. This rate is not set by the Fed, instead, it is determined by the market forces of demand and supply between commercial banks.

    On any given date, there are many different transactions in the federal funds market and they settle at slightly different rates, the effective federal funds rate measures the median rate of these transactions.

    FOMC sets a target range for the federal funds rate. In other words, the majority of the banks’ transactions should fall within the target range. Banks with deficits can borrow money from other commercial banks. The next day those banks return the money with a little bit of interest.

    Now, the main task for the Fed is to use its monetary tools so that this federal funds rate goes up because this is the driving force for all the other interest rates in an economy.

    Interest on reserve balance is the main tool

    So, to steer the federal funds rate in the target range set by FOMC, the Fed uses interest on reserve balance as its primary monetary policy tool. The interest on reserve balances rate is the interest received by commercial banks on deposits that banks hold in their reserve balance account at a regional Federal Reserve Bank. This interest rate is a risk-free investment option for commercial banks. This, the interest on reserve balances rate is set by the Fed and is, therefore, an “administered rate,”.

    Interest on reserve balance: Banks can deposit the excess reserve with the Fed risk-free overnight, and earn interest just like you can do with a savings account.

    When the Fed sees the economy is overheating with high inflation and a tight labor market, it tries to slow down the economy by raising the interest on the reserve balance. With that, the banks will be more willing to deposit their reserves with the Fed, rather than lending to other banks in the federal funds market.

    A key point to note here is that the interest on reserve balances rate serves as a reservation rate or the floor rate for banks. This is the minimum interest banks would be willing to accept in order to lend to each other, rather than keeping it with the Fed. If the Fed raises this interest on the reserve balance, commercial banks must raise the Federal funds rate in order to attract other banks to lend to them.

    Another key concept that ensures that the federal funds rate does not fall far below the interest on reserve balances rate is called arbitrage. Arbitrage means simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price.

    So, for example, if we assume the federal funds rate is 1.75 percent and the interest on reserve balances rate is slightly higher at 2.25 percent, banks will see that they can borrow funds in the federal funds market at a lower rate and earn higher interest by depositing those funds at the Fed. They will keep doing that until with the forces of demand and supply, the increase in demand for funds in the federal funds market will cause the federal funds rate to rise. It will keep rising until it reaches the interest on reserve balances rate so that banks no longer see the opportunity to profit by borrowing in the federal funds market and depositing it with the Fed. 

    As the Fed sets the interest on reserve balances rate directly, the Fed can steer the federal funds rate up or down by raising or lowering the level of the interest on reserve balances rate. In fact, this phenomenon of arbitrage makes interest on reserve balances a very effective tool for steering the federal funds rate direction.

    There are two other tools that the Fed can use to guide the federal funds rate

    1. By setting a floor with an overnight reverse repurchase rate,

    2. and by setting the ceiling using a discount window

    Let’s understand both of them.

    The Fed has an overnight reverse repurchase facility that is open to a broader set of financial institutions, as interest on reserve balances is available only to banks and a few other institutions. This facility allows these financial institutions to deposit their funds at a Federal Reserve Bank and earn the overnight reverse repurchase agreement rate offered by the Fed.

    Thus, the overnight reverse repurchase agreement rate does the same thing as the interest on reserve balances rate does by acting as a reservation rate for these financial institutions. If this rate is higher than the federal funds rate, then by pressure of demand and supply, the Federal funds rate starts going up until there is no profit from arbitrage. The overnight reverse repurchase agreement facility is a supplementary tool because the rate the Fed sets for it helps set a floor for the federal funds rate.

    So when it raises the overnight reverse repurchase rate, the Federal funds rate tends to move up as well.

    The discount rate is the rate banks have to pay to the Fed for borrowing money from the Fed through the Fed’s discount window. Banks are more likely to borrow from each other (at the federal funds rate) only if it is lower or equal to the discount rate that they have to pay to borrow from the Fed. Thus, the discount rate acts as a ceiling for the federal funds rate. Also, it is set higher than the interest on reserve balances rate and the overnight reverse repurchase agreement rate.

    Lastly, there is another tool that used to be the Fed’s primary tool to control the money supply in the economy before the 2008 financial crisis. This is called open market operations where the Fed would buy or sell t-bonds. Now, with ample reserves in the banking system, the Fed only uses this as a supplemental tool to help maintain ample levels of reserves. The Fed can buy or sell government securities in the open market to increase or decrease these reserves in the banks account with the Fed.

    In a nutshell, when the Fed wants to control inflation, it would set a higher range for the Federal funds rate. To achieve this target, it would increase the interest on reserve balances rate as the main monetary policy tool. It can also use additional tools by raising overnight reverse repurchase agreement rate, and discount rate. All this will ensure the federal funds rate stays within the high target range set by the FOMC.

    Why does the Federal fund rate matter?

    Since the federal funds rate affects all the other interest rates in the economy, all the other interest rates go up as well. At high interest rates, households will borrow less money to buy big-ticket items they want. This will cause a reduction in spending by households. This will cause overall savings to increase because now they are getting higher interest rate to save money in a bank.

    Once household demand is reduced, firms will reduce their investments. They will also reduce their workforce and demand fewer workers. This will reduce employment levels also and cause the inflated prices to return to the target of 2%.

    The now-raised federal fund rate would cause other market interest rates like mortgage, auto, and other interest rates that banks charge from households and businesses to rise as well. The increased cost of borrowing will reduce spending across all sectors of the economy, lowering excess demand and bringing prices back to normal.

    The Fed will do the exact reverse of this process when the economy is in a recession when the inflation is below the 2% target rate and there is high unemployment. It will lower the Federal funds rate target range by lowering interest on the reserve balance. It can also use additional help from lowering interest on overnight reverse repurchase agreement rates, and discount rates to give a boost to the economy.

    How effective are these tools in reality?

    All these monetary policy tools only work when inflation is caused by demand-pull factors. However, if it is due to cost-push factors, this measure may cause more harm than good. Cost-push factors include supply shocks when the supply of the products is hampered. There could be many reasons for a reduction in supply such as increased cost of raw material and other inputs, and natural calamities. Trade restrictions such as sanctions imposed on a country can also cause supply disruptions.

    Also, there is a direct link between reducing inflation and reducing overall economic growth. Even though central banks aim for a soft landing when they raise interest rates to bring down inflation, sometimes it doesn’t go as planned.

    In economics, a soft landing means a moderate economic slowdown following a period of growth. In the past, the Fed in the US has had a mixed record in achieving a soft landing when it raised interest rates.

    In addition, inflation expectations continue to play a key role in how people react to the contractionary monetary policy. If people continue to believe the prices to go up, they will tend to make the purchases now, rather than in the future when the worth of their money can get further low.

    The board of governors at the Fed, as well as various economists that work there, take into consideration all these factors and keep a watch on the trend. They can alter the monetary policy according to the direction of its performance.

  • What are the Fed’s new monetary policy tools?

    Today we’re going to talk about a really important topic: what are the main tools that the Federal Reserve uses to influence the economy and how does it do it?

    We will also learn the tools that the Fed uses in its new monetary policy and how they are different from their old way. Don’t worry if you’re not familiar with economics, because I am going to break it down step by step.

    So, first things first, what is the Federal Reserve? Well, it’s the central bank of the United States and to put it simply, The Federal Reserve (the Fed) is like a bank for the U.S. government.


    If you look at the Federal Reserve website, it says “One of the most important functions of the Fed is to promote economic stability using monetary policy. The Fed’s goals for monetary policy, as defined by Congress, are to promote maximum employment and price stability.” This means the highest level of employment that the US economy can sustain while maintaining a stable inflation rate of around 2%.

    So how does the Fed control the economy?

    The Fed has some tools to control the economy, these are monetary policy tools. Imagine the economy is like a car. If it’s going too fast and might crash, then the Fed can step on the brakes. If it’s too slow, they can press the gas pedal.

    The FOMC is the money boss

    So let’s understand how the Fed works, The Federal Open Market Committee, or the FOMC is like the money boss of the Federal Reserve. They meet in Washington, D.C., eight times a year to talk about the economy. They look at economic data and statistics, talk to economists, and decide how much interest banks should charge each other.

    This interest is called the federal funds rate. Fed funds rate is the banks’ overnight lending and borrowing rate from each other. This rate matters because it affects how much regular people pay for things like houses and cars. If it’s high, things are a bit more expensive. If it’s low, things are more affordable.

    Let’s understand it step by step, Banks have a place where they put some of their money, called the Federal Reserve. They earn interest on it. Sometimes, one bank has extra money and another needs some to do their everyday stuff. So, the bank with extra money can lend it to the one that needs it. The important part is that the interest rate for this lending is not decided by the big boss or the Fed but by the banks themselves. They agree on a fair rate and it is thus market-determined.

    So how does the Fed steer this key interest rate in the target range set up by FOMC?

    The Fed uses its two administered rates – the first is the interest on reserve balance and the second is the rate on reverse purchase agreement. These are their main monetary tools to control the Federal funds rate in the current times.

    According to the Fed’s chair, Jeremy Powell, “The Federal Reserve sets two overnight interest rates: the interest rate paid on banks’ reserve balances and the rate on our reverse repurchase agreements. We use these two administered rates to keep a market-determined rate, the federal funds rate, within a target range set by the FOMC.”

    When the FOMC wants the fed funds rate to go up, the Fed moves the interest on the reserve balance up. This rate sets the lowest interest rate banks are willing to accept when lending out their money to anyone else. Since banks can also earn this interest by depositing their money at the Federal Reserve and keeping money with the Fed is a safe way to earn money, banks prefer to do this rather than lend it at a lower rate to another bank.

    This acts as a floor for the Federal funds rate, which means the banks will not accept any lower interest rate than this to lend money to one another for a short term.

    Another important concept to understand here is called “arbitrage,” which is like making a profit by buying low and selling high. So let’s say the federal funds rate is 5.5%, and the Fed pays 6% for deposits to be kept at Fed, banks can borrow at 5.5% from other banks and then deposit at 6% to make a profit.

    This pushes the federal funds rate up until it’s close to the interest on reserve balances rate (6%). Similar to the interest on reserve balance which is mainly for commercial banks, the Fed also has other tools, like the “Overnight Reverse Repurchase Agreement Facility,” which is the interest other broader financial institutions can earn by keeping money at the Fed. Thus, it serves the same purpose as the interest on reserve balance and sets a floor for the federal funds rate, which means the federal funds rate won’t go below this.

    The other tool the Fed uses is the Discount Window. Because banks will not likely borrow at a higher rate than they can borrow from the Fed, this acts as a ceiling. It is set higher than the interest on reserve balances rate and the overnight reverse repurchase agreement rate.

    So these are two tools that the Fed is now using in the ample reserves case.

    The Fed’s tools before the 2008 crisis

    The Fed used to use this tool called Open Market Operations as its primary tool, where it bought treasury securities to pump money into the economy. However, after the 2008 financial crisis, it has ample reserves that it only buys government securities to make sure the reserves remain ample in the banking system. So, it uses open market operations only as a supplement tool.

    So how does the FOMC decide on the target interest rate?

    Economic data on inflation and unemployment helps the FOMC decide its target interest rate. Over the years, FOMC has been changing this Federal funds rate target range up and down to help the economy. Think of it like a volume knob on your music player.

    When the economy was in trouble after the 2008 financial crisis, the Fed turned the volume to almost zero to help it get better in 2015.

    Then, when the COVID-19 pandemic happened, they quickly turned the volume back down to almost zero to help the economy during that tough time.

    Most recently, since last June 2022, the Fed has been raising the interest rate to control inflation. As of today, the target range for the Federal funds rate is between 5.25 to 5.50%.

    So, you can think of the Fed as a DJ for the economy, adjusting the volume to keep things running smoothly.

  • How government intervention is needed for social benefit?

    Today, we’re diving into the fascinating world of economics to discuss a crucial concept that often goes unnoticed but has a profound impact on our daily lives – externalities.

    What are externalities?

    Before we delve into examples, let’s define what externalities are. In economics, externalities refer to the unintended consequences of economic activities that affect individuals or entities not directly involved in the transaction. These external effects can be positive or negative, and they often lead to a divergence between private and social costs or benefits.

    Some Examples of Positive Externalities

    1. Education

    To better understand positive externalities, let’s take the example of education. When an individual pursues education, they gain knowledge and skills that benefit them personally. However, education also has positive externalities that extend beyond the individual. When educated people enter the workforce, they contribute to the economy’s productivity, innovation, and overall growth.

    2. Vaccination

    Another example is when the Government provides Vaccination. In the most recent case of the COVID-19 pandemic, people who got vaccines were less likely to get extremely sick or spread the virus to others.

    Similarly, any vaccination for other infectious illnesses provides health benefits not just to the person receiving the vaccine but also to the entire community of people he or she comes in contact with.

    Negative Externality

    Now, let’s shift our focus to negative externalities, using the example of pollution.

    When a factory produces goods, it incurs private costs like labor and raw materials. However, it may also release harmful pollutants into the air or water, causing damage to the environment and people nearby.

    Impact of Externalities

    Externalities can significantly impact market efficiency. When externalities are present, markets may fail to achieve an optimal allocation of resources, leading to overproduction or underproduction of goods and services.

    How can government intervention solve the problem?

    Governments can step in to correct the market failure caused by positive externalities. For example, they may provide subsidies to educational institutions or offer tax breaks to individuals pursuing education. This encourages more people to invest in education, leading to a better-educated workforce and more prosperous society.

    Similarly, to address negative externalities like pollution, governments may impose regulations, taxes, or fines on polluting industries. By internalizing the external costs into the production process, these measures encourage businesses to adopt cleaner and more environmentally friendly practices.

    Conclusion

    Externalities are all around us, influencing our decisions and shaping our economy in both positive and negative ways.

  • Top 6 economic trends

    In this post, we will discuss the top 6 economic trends that will become more popular in the year 2024.

    1. The rise of artificial intelligence and automation in various industries, such as manufacturing and transportation. For instance, self-driving cars will become more prominent, which may reduce the need for human drivers.

    2. The continued growth of e-commerce and online retail, with companies like Amazon expanding their reach and dominance. As people increasingly prefer shopping from the comfort of their homes, traditional brick-and-mortar stores may face challenges.

    3. The increasing importance of sustainability and environmentally-friendly practices in business operations. Companies that adopt sustainable measures and invest in renewable energy may gain a competitive edge.

    4. The rise of the gig economy and freelance work, as more people choose flexible jobs and remote work options. Platforms like Fiverr and Upwork will continue to thrive, connecting freelancers with work opportunities.

    5. The impact of demographic changes, such as an aging population and changing consumer preferences. Industries catering to healthcare, elderly care, and wellness will experience significant growth.

    6. Let’s not forget about cryptocurrency and blockchain technology’s impact on the financial sector. These technologies have the potential to revolutionize the way we handle transactions and secure data.

    Conclusion

    To sum it up, the top 6 economic trends in 2024 are the rise of AI and automation, the gig economy, sustainability, e-commerce growth, and cryptocurrency’s influence.

    These are just a few examples of the economic trends we expect to see in 2024. It is essential for individuals and businesses to adapt and stay informed about these changes to thrive in the future.

  • The economics behind overbooking done by the Airlines

    Picture this: you’ve arrived at the airport, excited about your upcoming trip, only to hear those dreaded words at the gate, “We regret to inform you that this flight has been overbooked.” Frustrating, isn’t it? But have you ever wondered why airlines resort to overbooking flights? Let’s find out.

    Today, we’re delving into a question that has puzzled many passengers: Why do airlines overbook flights?

    What is overbooking?

    But first things first, what exactly is overbooking? Put simply, it’s when an airline sells more tickets for a flight than the available seats on the aircraft. Seems counterintuitive, right? Well, airlines engage in this practice based on historical data and statistical analysis.

    Reason 1: No-show Passengers: Airlines overbook flights because they expect a certain number of passengers to not show up. This happens more often than you might think. Passengers may miss their flights due to various reasons, such as traffic delays, personal emergencies, or even connecting flight issues.

    So, why do airlines take the risk of overbooking flights?

    Overbooking allows airlines to maximize their revenue and efficiently utilize their available resources. It’s a balancing act, predicting the number of no-show passengers to ensure a full flight without causing excessive inconvenience to passengers.

    Overbooking helps airlines maintain high load factors, which means filling as many seats as possible on each flight. This leads to optimal fuel usage, better cost management, and a higher chance of profitability. Moreover, a full flight reduces the need for rescheduling or canceling flights, which can disrupt passengers’ travel plans.

    Reason 3: Compensation Options

    When an airline realizes that a flight is overbooked and there are not enough volunteers to give up their seats, they might have to involuntarily deny boarding to some passengers. In such cases, the passengers are entitled to compensation, which can vary depending on local regulations. This compensation usually includes options like rebooking on a later flight, accommodations, meal vouchers, and sometimes monetary compensation.

    Now It’s clear that airlines have their reasons for overbooking, but it’s important to address passengers’ concerns as well. Let’s talk about that.

    So how do airlines handle the frustration and inconvenience caused by overbooking?

    Airlines understand that overbooking can be frustrating for passengers, and they strive to minimize the impact. They typically use sophisticated algorithms and predictive models to estimate the number of no-shows accurately. If a flight is overbooked, airlines prioritize finding volunteers willing to give up their seats in exchange for compensation before resorting to involuntary denial of boarding.

    Conclusion

    Thus, airlines overbook flights to optimize their operations, maximize revenue, and account for the possibility of no-show passengers.

  • Does more money make people happier?

    The answer to this question is not very easy. I think it depends on a person’s income or wealth level and state of their mind.

    When someone is poor, any additional money they get will bring them a lot of happiness and satisfaction. The value of $100 is much more to a homeless person than to a millionaire.

    Happiness Economics

    A subfield of economics, known as happiness economics, studies various factors that affect the well-being of a person. In 1974, American economist Richard Easterlin came up with an interesting concept called Easterlin Paradox.

    His findings showed that happiness doesn’t increase with an increase in income or wealth after a certain point. This graph shows the Paradox of how the happiness curve rises with income in the initial stages but becomes flat when the income keeps rising.

    He based his findings on the belief that money has diminishing returns. What it means is that at a low level of income, you get more happiness and satisfaction with any additional money that you get. However, at higher levels of income, that additional benefit becomes less and less. In fact, after a point, it just does not bring any additional happiness.

    We value something when we have less of it, but when we have too much of it, we don’t value it as much.  It is as simple as this.

    If you study behavioral economics, you will know that the key assumption of conventional economics – human beings are rational, doesn’t always hold true. People do not always choose the option that maximizes their material well-being.

    Economics deals with humans and human minds are complex. Various factors, both at the macro and micro level play a role in determining what choices humans make.

    So what factors other than income affect your well-being?

    There are a lot of factors that affect a person’s happiness than just their income or overall wealth.

    The big, macro factors are the things we can’t directly control like:

    • good governance
    • good healthcare
    • clean air and water
    • right to good education
    • political stability in a country
    • availability of jobs for people in the labor market
    • good community and social support
    • good infrastructure
    • woman’s equality in that country
    • Corruption free society
    • and overall safety.

    Yes, I know many of these macro factors are more favorable in rich countries, as a lot of these cost money. Developed countries can provide good infrastructure, healthcare, public safety, and better jobs more easily.

    But there are factors beyond individual incomes and the economic development of a country, which affect the happiness of its people.

    World Happiness report findings

    The survey done by the World happiness report shows that the countries with the highest level of satisfaction in the world are not the ones with the highest GDP per capita.

    In 2021, Finland’s GDP per capita was $53,982, and the US GDP was $69,287 according to World Bank data. Even with a lower GDP compared to that of the US, Finland ranks first in the happiness index. The US, which has the 6th highest GDP per capita ranks lower in the happiness index, coming at number 16.

    Though the data shows a strong correlation between the countries with high GDP per capita and happiness, it is not perfect.

    According to the analysis done by World happiness report 2022, the six variables: GDP per capita, social support, healthy life expectancy, freedom to make life choices, generosity, and freedom from corruption are key in determining overall happiness.

    I got this table from their report and it shows their regression analysis. You may skip this section and scroll to the next if this seems very mathematical. But I want to explain their findings so you can understand.

    The weird part of economics is that it tries to explain the obvious through data and mathematics

    Regression analysis is an Econometrics tool to study how well different “independent factors or variables“ explain a phenomenon or the “dependent variable“.

    In their survey report, the six independent variables are the log of GDP per capita, social support, healthy life expectancy, freedom to make life choices, generosity, and perceptions of corruption.

    The dependent variable is the average happiness across countries. A total of 156 countries were surveyed using data from the years 2005 to 2021.

    In the table below, wherever you see three stars *** next to an independent variable value in paranthesis, it shows that the variable (of the six I mentioned) is statistically significant in explaining the average happiness (dependent variable).

    It means the majority of the people surveyed reported that factor to be an important determinant in explaining their happiness level.

    If you look at the statistics I circled above, called Adjusted R-squared, you will see a value of 0.753. This means together these six factors explained more than 75% of the variation in national annual average happiness scores.

    Thus, as you see real GDP per capita is only one of the indicators for measuring the prosperity of a country. Other variables that are part of the happiness index actually tell a better story of the well-being of a country’s population.

    Economist Simon Kuznets, who invented the concept of GDP, in his first report to the US Congress in 1934 said “the welfare of a nation can scarcely be inferred from a measure of national income.” So, we see that GDP per capita, has limitations and I will cover those in a separate post later.

    So are there other factors that the report missed?

    There could be some internal factors that the report hasn’t covered explicitly. These are the factors that we have more control over.

    When we see on social media people vacationing and throwing big parties, we instantly assume that they must be very happy. Because we think this happiness can only come from the extra money they have, to afford that extravagant lifestyle.

    People start comparing themselves to their peers and get depressed. They are not unhappy because they have less money, but because their friends or relatives have more. People immediately associate more money with happiness.

    But is it always the case?

    Increased urbanization has taken away the simplicity of life. The materialistic nature of western countries has engulfed every single country now.

    To earn higher incomes, many times people live away from their families and work in jobs that increase their stress levels.

    Long working hours are physically and mentally draining for most people

    Their progress at work comes at a cost of missing family time because they are overworked. If people don’t have time to focus on their health, then that additional income is not even worth it. There is this huge opportunity cost to having a higher income, which we mostly overlook.

    Conclusion

    I feel a person’s health and relationships also play a huge role in determining the level of their happiness.

    In a true sense, a person’s happiness depends on their state of mind. They should have enough money to lead a fulfilling and healthy life. But we need to be aware that there will be, always, many people above or below us in terms of wealth and income.

    People should be able to meet their needs and most of their wants, but not at the price of their health and relationships. Wants are never ending and are different for each income level.

    For most people, money, and happiness can go together if they spend their extra money the right way.

    If people can pursue a quality life, then they could be actually happy. Worthwhile acts like donating to charities, getting the time to pursue their interests, having a work-life balance, and the ability to spend leisure time with family and friends, all affect the quality of life. In the absence of these, wealth alone may not bring true happiness.

    Similarly, people with less means can also lead a happy life. In fact, I notice that many times, people with low levels of income are more satisfied with their life. This could be because they have lower expectations and get content easily compared to relatively wealthy individuals.

    On a personal level, it is the state of my mind that influences my ability to find happiness. It could come from small things and moments in my life, and from the big ones, where I worked hard. Having a clean home, good health and a supportive family and friends are the things that make me truly happy.

    My ability to follow my interest and passions, share my thoughts about things that matter to me, and do charity give me happiness. Wealth matters, but being content with what I have achieved so far without comparing it with others matters more to me.

    What do you people think? Do share your views in the comment section below. It will be nice to know!

  • How does people’s expectation about inflation affect the actual inflation?

    What people like you and me think about inflation directly impacts the actual inflation rate. So, if we think inflation will be high in the coming months, it will most likely be. In this post, I will explain how this phenomenon works.

    If we expect that overall prices are going to rise in the coming months, we may buy more things now, rather than in the future. If a lot of people do that, this increases the demand for goods and services.

    High inflation is directly linked to a higher demand that is not immediately matched by an increase in supply. As a result, firms increase the prices of goods and services when there is more demand. This enables them to make more profit. As a result, we see increased prices passed on to the consumers causing higher inflation.

    On the other hand, if people expect prices to fall in the future, they may delay spending now to get a better deal. This will result in a decrease in demand for goods and services and businesses will end up lowering prices to clear up their stock.

    So, now we understand how inflation expectations affect actual inflation. If you want to know more about inflation and how it is calculated, you can refer to my post here.

    What is the current inflation expectation in the U.S.?

    After suffering from really high inflation close to 8%-9% for over half a year, we foresee some good news. A survey conducted by the Fed reserve bank of New York shows a decrease in these expectations.

    People in the U.S. feel that one and three-year-ahead inflation are now going to be 5.7 % and 2.8 % respectively.

    These are clearly lower than 6.2 % and 3.2 % in June for one and three years ahead inflation rates respectively. In the figure from the Federal Reserve of New York website, you can see how there is a decline in the curve of the expected inflation rate towards the end. This is the survey done in the month of August 2022 about what people think inflation may look like for 1 year and 3 years.

    It shows that people’s expectations are consistent with what the Fed is trying to achieve. By raising interest rates, the Fed is trying to slow down the demand in the U.S. When borrowing becomes expensive, people generally tend to borrow less for things like cars, mortgages, etc.

    In their September 20 meeting, the Fed is most likely going to raise the key federal funds rate by another 75 basis points. The Fed has been raising interest rates to fight the high inflation in the U.S for the last 6 months. Central banks in a lot of other countries fighting inflation have been doing the same.

    To learn more about the role of the central bank, stay tuned for my next post.

  • 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!

  • 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. 🙂