This page of our SIE Study Guide covers economics, including interest rates, the business cycle, and economic indicators.
Monetary vs. Fiscal Policy
The Federal Reserve (The Fed): The Fed is responsible for keeping the economy in good health by using a variety of financial techniques to maintain high employment and low inflation, and interest rates within reasonable parameters.
Monetary policy refers to actions taken by the Fed to maintain or promote the health of the U.S. economy, separate from Congress and the President. Within the Fed is the Federal Open Market Committee (FOMC) which meets eight times a year to review economic conditions and evaluate any necessary policy changes.
- The most typical policy change is an increase or decrease in the federal funds rate which will in turn affect interest rates on credit cards, bank loans, mortgages, and more. When the Fed wishes to stimulate the economy, they lower the federal funds rate which then encourages consumer spending.
Fiscal policy, on the other hand, refers to actions taken by Congress and the President in setting tax rates and policies. An example of taxation policy would be making retirement savings advantageous, which is currently supported by Congress for pre-tax 401(k) and IRA accounts and their post-tax Roth equivalents.
- Pre-tax retirement accounts are funded with pretax contributions, with taxation occurring after withdrawal, while Roth contributions are made post-tax. Because wealthier taxpayers will be in a higher tax bracket when they retire, the Roth versions have a lower maximum annual contribution in order to not give an unfair advantage to wealthier taxpayers. Think government spending and taxation policy when discussing fiscal policy. Both of these items have significant impacts on the U.S. economy.
Open Market Activities & Impact on Economy
Another way for the Fed to stimulate economic activity is by increasing available lendable money supply at the banks, which leads to a decline in bank interest rates and more spending by consumers. On the other hand, when the Fed wishes to slow down the economy—discourage excessive consumer spending—they will shrink lendable money supply at the banks, thereby increasing interest rates and driving consumer spending down (lowering inflation).
Prime Rate: Base interest rate offered by commercial banks for consumer loans, including credit cards. It has a direct relationship with the discount rate—if the discount rate goes up then so does the prime rate, and vice versa.
Discount Rate: Rate offered to member banks who borrow money from the Fed in order to keep their reserves up.
Federal Funds Rate: Target rate set by the Fed in order to control inflation.
Business Economic Factors: Financial Statements
Balance Sheet: Details a company’s assets, liabilities, and shareholders’ equity at a specific point in time. Used in conjunction with the other financial statements, the balance sheet assists analysts and investors in gauging the overall health of the company.
Income Statement: Details a company’s revenues and expenses over a period of time, typically a quarter or a fiscal year. Subtracting a company’s expenses from their total revenue reveals whether they had a profit or a loss during that period (net income).
Cash Flow Statement: Unlike the income statement, the cash flow statement details a company’s cash inflows (cash going in) and outflows (cash going out). The three different sections on the statement are cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.
Shareholder Equity Statement: Details the changes in a company’s equity accounts over a specific period of time, which might include purchasing shares back from investors (treasury stock) or issuing new common shares. Accounts typically found on the statement are preferred stock, common stock, treasury stock, additional paid-in capital, retained earnings, and noncontrolling (minority) interests.
The Business Cycle
Historically, the U.S. economy follows a cycle of ‘ups’ and ‘downs’ which can be traced back at least 100 years or more. If a securities analyst can accurately predict where the economy is headed and when, then they can make sound predictions on which stocks to buy and which ones to sell.
The stages of the business cycle include expansion, peak, contraction, trough, and recovery:
- Expansion: The economy is growing. Gross Domestic Product (GDP) shows healthy growth in the 2% to 3% range.
- Peak: The economy can be said to be “overheated.” Prices hit their highest level and economic indicators stop growing.
- Contraction (Recession): Economic growth weakens and GDP growth falls below 2 percent. When GDP declines for two or more consecutive quarters, then the economy has entered a recession. Layoffs make headline news and unemployment rate begins to rise. Consumers and businesses find it hard to secure credit.
- Trough: The economy reaches its lowest point before transitioning from the contraction phase to the recovery phase.
- Recovery: Low prices help foster demand. Employment and production begin to rise, and lenders are more willing to lend.
Economic indicators are classified into three categories according to their usual timing in relation to the business cycle:
- Leading: Indicate where the economy is headed in the short term. These can be useful when trying to predict the next phase of the business cycle. Examples include stock market returns, index of consumer expectations, building permits, and the money supply.
- Lagging: Reveals trends in the economy after major economic, financial, or business events have occurred. The unemployment rate is the most prominent lagging indicator, since employment tends to increase for two or three quarters following an upswing in the economy. Other examples include corporate profits and the consumer price index (CPI).
- Coincident: Statistics that tell analysts how the economy is currently. Examples include gross domestic product, industrial production, personal income, and retail sales.
Inflation: Occurs when the purchasing power of money declines. For example, if the prices of goods and services increase but earnings remain the same, then those earnings can no longer purchase as much as they used to. They have lower purchasing power. During periods of inflation, stock prices are generally volatile.
Effects on Bond & Equity Markets
Cyclical: Businesses that follow the standard business cycle, thus the name ‘cyclical.’ Think of the leisure, luxury, and cruises/travel industries, which do well in a good economy but poor in a down economy.
Defensive: Businesses that make goods we use as a part of our daily lives and are not impacted in a material way by how the economy is doing. Examples would be public utilities, basic food and clothing, consumer goods such as soap, shampoo, cosmetics, etc. You don’t use more electricity when you get a raise at work, and you don’t use less if your hours get cut. That’s what defensive refers to.
Growth: Industries expected to grow faster than the economy in general. Examples include technology, health care, and biomedical.
Principal Economic Theories
Keynesian: Theorizes that an increase in government expenditures and a decrease in taxes can prevent or repair an economic recession.
- The government’s role is significant.
Monetarist: Theorizes that controlling the money supply and letting the market work itself out can curb inflation and is essential for a healthy economy.
- The government’s role is minimal.
International Economic Factors
Balance of Payments refers to the net transactions completed between one country’s government bodies, companies, and individuals, and those of outside countries. For example, let’s say U.S. consumers and businesses purchase goods worth 500 billion dollars from Japan in the year 2021, and these expenditures are offset by consumers and businesses in Japan buying goods worth 400 billion dollars from the U.S. The difference would be referred to as a trade ‘deficit’ for the U.S. and a trade ‘surplus’ for Japan. Viewed another way, there is a 100-billion-dollar trade imbalance.
Gross Domestic Product (GDP): The total value of all goods and services produced within a country by its nationals and foreigners alike. It is one measurement that economists and analysts use to determine the rate at which an economy is growing from one year to the next.
Gross National Product (GNP): The total value of all goods and services produced by the citizens of a country, no matter where they live.
Exchange Rates: The rates at which one currency will be exchanged for another. For example, an exchange rate of 108 Japanese Yen to the U.S. dollar means that ¥108 will be exchanged for each $1, or that $1 will be exchanged for each ¥108. This rate will vary based on the spot exchange rate at the actual time of the exchange.