In this section, we will explain some of the most important lagging indicators in any economy.
Think of it as the cost of debt.
As we have briefly seen in “how the economy works”, institutions (like banks) that lend money (principal amount) to borrowers will require some extra payments for the trouble of lending money to borrowers. This is known as interest, is normally expressed as a percentage of the principal to be repaid, which is called the interest rate. So, in other words, interest rates represent the cost of borrowing money and are expressed in a percentage form.
For example, if you take out a $100,000 mortgage from the bank and you agreed to pay an interest rate on the loan of 10%, this means that you will have to pay the bank the original loan amount of $100,000 + (10% x $100,000) = $100,000 + $10,000 = $110,000.
Interest Rates As An Economic Indicator
Interest rates are such an important lagging indicator of economic health because they influence the willingness (and ability) of businesses and individuals to borrow money, which directly affects spending and business activity.
The US interest rates are very closely watched by investors and institutions and are based around the federal funds rate, which represents the rate at which money is lent from one bank to another and is determined by the Federal Open Market Committee (FOMC). These rates change as a result of economic and market events.
How interest rates affect the economy
When the federal funds rate increases, banks have to pay higher interest rates to borrow money from other institutions. So, banks, to compensate, will charge higher interests for lending money out to borrowers, which increases the cost of borrowing and may influence their ability to take out loans. This makes it harder for businesses to expand and individuals to take on debt. As a result, GDP growth may slow down, inflation decreases and the economy might enter a recession.
Conversely, when rates are low, businesses feel encouraged to borrow money to expand and individuals may be more comfortable with debt. This causes positive GDP growth, higher inflation and an economic expansion.
However, rates that are too low can lead to an extreme increase in demand for money and raise the likelihood of unhealthy inflation (we’ll discuss it below), which can distort the economy and the value of its currency.
Current interest rates change as a reaction to market events, such as severe market movements. These rates are thus indicative of the economy’s recent condition and can further suggest where it might be headed as well.
Think of it as the increased cost of living over time.
Inflation measures the change in prices for goods and services and is closely watched to determine the health of the economy.
The Consumer Price Index (CPI) is a measure of the changes in the cost of living, or inflation. The CPI is calculated by measuring the weighted average price level changes of a basket of essential goods and services (such as healthcare, housing, clothing, transportation, and electronics) purchased by households.
How inflation affects the economy
Inflation (a significant increase in CPI) wears away the value of money over time. Therefore, the real value of a unit of currency (e.g. one dollar) decreases in inflationary periods because things become more expensive, so you can progressively buy fewer things with it.
The bad side of inflation
A high rate of inflation (an increase in CPI) may erode the value of money faster than salaries grow, which may decrease people’s purchasing power. Purchasing power measures the amount of goods and services that can be bought with a specific amount of money.
For instance, if you walked into a store with a $5 bill in 2000 you could have bought 5 bags of chips; however, if you walked in with a $5 bill today, you’d probably only be able to buy 2 bags of the same type of chips. Therefore, your purchasing power decreased over these past 20 years.
Decreasing purchasing power may affect the average standard of living. Moreover, inflation can affect other factors, such as job growth, and can lead to decreases in the employment rate and GDP.
The good side of inflation
Inflation can be actually a good thing if controlled; if it is kept in line with changes in the average consumer’s income.
It encourages spending and investing, which can help grow an economy. Otherwise, the value of money held in cash would be simply corroded by inflation (as we saw in “why investing is important”). It keeps interest rates at a moderately high level, which encourages people and institutions to invest and provide loans to small businesses and entrepreneurs.
It’s not deflation, which can lead to an economic depression. Deflation is a condition in which the cost of living decreases. Although this sounds like a good thing, it is an indicator that the economy is in very poor shape. Deflation occurs when consumers decide to cut back on spending and is often caused by a reduction in the supply of money. This forces retailers to lower their prices to meet a lower demand. But as retailers lower their prices, their profits contract considerably. Since they don’t have as much money to pay their employees, creditors, and suppliers, they have to cut wages, lay off employees, or default on their loans.
Think of it as the power of a currency if compared to others.
Currency strength reflects the relative purchasing power of an economy’s currency when compared to that of other currencies.
How currency strength affects the economy
A strong currency increases a country’s purchasing and selling power with other nations. The country with a stronger currency can sell its products overseas at higher foreign prices and import products more cheaply.
However, there are advantages to having a weak dollar as well. When the dollar is weak, the United States can draw in more tourists and encourage other countries to buy U.S. goods. In fact, as the dollar drops, the demand for American products increases.
Think of it as the number of people that are jobless and are able and looking for work.
The unemployment rate is the percentage of the total labor force (which is formed by those who are either working or actively looking for work) yet to find work. The unemployment rate measures the extent to which the economy is operating at full capacity.
How unemployment affects the economy
This measure is extremely important and closely watched by the media as it affects not only the unemployed but the entire economy. This is because it impacts the level of disposable income of households, affecting purchasing power and consumer spending. In addition, high levels of unemployment may negatively affect productivity and levels of economic output. As you can see, the effects of high unemployment affect every aspect of an economy.
Income and Wages
Think of it as the amount employees receive for working.
Income and wages reflect the amount of money that individuals that are part of payroll receive in return for work performed during a particular accounting period (weekly, bi-weekly, or monthly).
Nonfarm payroll employment is a closely watched monthly metric that provides data on the number of workers in the economy excluding farm, private household, and non-profit organization employees.
How income and wages affect the economy
In an efficient economy, incomes are bound to increase regularly to keep up with the average cost of living increases (inflation). However, when incomes decline, it is a sign of economic slowdown because employers may be cutting pay rates, laying workers off, or reducing their hours. Declining incomes tend to affect spending and overall market confidence, which can also reflect investments not performing as well.
Incomes are presented by the Bureau of Labor Statistics in the US and are dissected into different demographic groups, such as gender, age, ethnicity, and level of education, which give insight into how wages change for various groups. This is critical because an alarming wage gap increase between groups may suggest there is an income problem (in some cases, it can even be a social issue) for the entire country, rather than just the groups it directly affects.
Think of it as the money companies earn in excess of expenses.
Business (or corporate) profit is the money that is left after companies pay all their expenses (employee salaries, materials, rent, machinery…). Profits (also known as net income, net earnings, etc.) are calculated by subtracting all expenses from a company’s revenues. Later on, we will examine this in a lot more detail on a company level.
Now, we will discuss the aggregate business profit in an entire economy. Corporate profit is a measure reported quarterly by the US Bureau of Economic Analysis that captures the total net income of all companies in the US economy.
How corporate profits affect the economy
From our GDP section, you might recall that a significant portion of GDP is tied to business spending. Therefore, corporate profits are directly tied to GDP growth.
If profits are strong, companies have more money to spend and grow. Hence employment may improve and household incomes may go up. In addition, more goods and services might be produced and consumer spending may go up as well.
However, growth in corporate profits is not always a sign of a healthy economy. For instance, at the beginning of the 2008 recession, many businesses saw higher profits due to job cuts and outsourcing, which took jobs out of the economy, weakening it even further.
Think of it as what an economy buys from other economies versus what it sells.
Trade balance looks at two major factors in the global markets: imports and exports, which we introduced in our GDP section. This measures the difference between an economy’s exports (things it sells to other economies) and its imports (things an economy buys from others) in a certain time period.
How trade balance affects the economy
A country that exports more than it imports creates a positive trade balance (or a trade surplus), which may be desirable if controlled because it receives more money for its goods than what it pays to buy foreign goods. If the surplus is too high, however, an economy may not be taking full advantage of purchasing foreign goods, which may not be ideal.
If a country imports more than it exports, it creates a trade deficit, which may affect its currency’s strength and create too much debt.
In the next section, we will discover the government entities and policies that influence an economy.