Basic Economic Concepts

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Inflation

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"the result of too many dollars chasing a limited supply of goods and services."

a loss of purchasing power as measured by the Consumer Price Index (CPI)

makes things more expensive to buy

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Deflation

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the supply of goods and services suddenly is greater than demand.

makes things cheaper to buy

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Federal Reserve Board

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directs the operations of the Federal Reserve System

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Federal Open Market Committee (FOMC)

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council of the Federal Reserve officials that sets monetary policy based on economic data. The money supply is tightened to fight inflation, loosened to provide stimulus to a faltering economy.

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Loose money policy

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provides stimulus to a faltering economy. The Fed lowers rates and reserve requirement to get more money out in the economy.

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Tight money policy

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tightens inflation. The Fed raises rates and reserve requirement to get money out of the economy and lower rates

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Stagflation

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a rare economic climate in which inflation and stagnation occur simultaneously

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Consumer Price Index (CPI)

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measures inflation/deflation

a measure of inflation/deflation for basic consumer goods and services.

a rising CPI represents the greatest risk to most investors.

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Core inflation

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the CPI after food and energy are excluded.

removes the more weather-related and volatile pricing associated with food, oil, natural gas, etc. when measuring the overall rise or drop in pricing.

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Inflation adjusted return

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the real rate of return. An investment's return after the rate of inflation/deflation has been factored in.

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If an investor receives 4% interest on her bond when the CPI is 2%, her inflation-adjusted return is...

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2%

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Producer Price Index (PPI)

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index measuring price changes at the wholesale or producer level

shows prices received by producers at certain stages of production cycle

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interest rates

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the extra money you pay to borrow a principal over time

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basis points

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a way of measuring bond yields or other percents in the financial industry.

Each basis point is 1% of 1%

Ex: 2% = 0.200 = 200 basis points

20 basis points = .2% or 2/10ths of 1%

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Discount rate

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the rate banks have to pay when borrowing from the Federal Reserve

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Fed funds rate

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the rate banks charge each other for overnight loans in excess of $1 million. Considered the most volatile rate, subject to daily change

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Broker call loan rate

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the rate broker-dealers pay when borrowing on behalf of their margin customers

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Prime rate

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the rate the most creditworthy corporate customers pay when borrowing through unsecured loans

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London InterBank Offered Rate, LIBOR

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a benchmark rate that many large international banks charge each other for short-term loans

Rate fixed daily by British Banker's Association and represents an average of the world's most creditworthy banks' interbank deposit rates for large loans with maturities between overnight and one year.

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London Interbank Market

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where large international banks go to get short-term loans at the most competitive rates possible.

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Yield Curve

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a graph representing the yields of debt securities of similar credit quality across various maturities

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Normal yield curve

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the typical state of the bond market in which yields on debt securities rise as their maturities lengthen.

Implies economic conditions are stable.

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Yield Spread

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the difference in yield between two types of debt securities, e.g. junk bonds vs. investment-grade, or junk bonds vs. US Treasury's

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Narrow yield spread

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Investors are confident in the low rated bond's ability to pay and don't demand a much higher yield than higher rated bonds. Good economy status.

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Wide yield spread

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Investors are demanding a higher yield on low-rated bonds that on high-rated bonds because they are nervous about the issuer's ability to repay. A negative indicator for the economy.

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fixed exchange rate system

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when a country ties it's currency to either a commodity such as gold, or to another currency

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floating-rate currency system

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a system allowing the value of a nation's currency to raise and fall due to supply and demand

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exchange rate

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the relative value of two currencies, e.g. US dollars to Yen or Euro, impacting exports and imports

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balance of trade

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the difference between a nation's imports and exports.

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trade surplus

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excess of exports over imports in a nation's balance of trade with a trading partner

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trade defecit

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excess of imports over exports in a nation's balance of trade with a trading partner.

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balance of payments

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the total inflow or outflow of capital for imports/exports and investments/financial products

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American Depository Receipt (ADR)

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foreign stock on a domestic market. Toyota and Nissan are two examples of foreign companies whose ADRs trade on trade American stock markets denominated in dollars.

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foreign currencies

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the currencies of various industrialized nations, including the US Dollar, the Euro, the Australian Dollar, the British Pound, and the Yen, etc. Speculators trade such currencies via FOREX

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FOREX

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the term used for trading foreign currencies. Short for foreign exchange

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Foreign exchange risk

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the risk to an American ADR holder that the American dollar will strengthen vs the currency used by the foreign corporation.

aka: currency exchange risk

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and American holding the Toyota ADR is at risk that the US dollar will _______ vs the yen

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strengthen

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Foreign currency options

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standardized options in which the underlying instrument is a foreign currency, e.g., the yen, the euro, etc.

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Gross Domestic Product (GDP)

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measures the total output of a nation's economy. It is an estimate of the total value of all goods and services produced and purchased over a three-month period.

Tells us what is produced here in America, whoever is doing that work (citizens and foreigners)

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3% GDP

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the economy grew at an annual rate of 3% over the financial quarter

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-3% GDP

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the economy is shrinking at an annual rate of -3%

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real GDP

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GDP numbers that are factored for inflation

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economic indicator

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data providing economists with important information about the current state and possible future direction of the economy and various sectors of the economy

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employment indicators

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economic indicators relating to employment, e.g., weekly unemployment claims, non-farm payroll

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If people aren't working, that signals an economic slowdown, and the Fed might have to lend a hand by

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lowering interest rates to free up money in the economy

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If too many people are working, that signals inflation, and the Fed might have to cool things down by

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raising interest rates to get money out of the economy

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leading indicator

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(predict changes in the economy)

economic indicator used to predict future developments in the economy, e.g., new claims for unemployment, building permits, bond yields, S&P 500, etc.

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coincident indicator

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economic indicator used to determine where the economy is currently, e.g., personal income, manufacturing & trade sales

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lagging indicator

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economic indicator used to confirm a recent trend(do not confirm), e.g., duration of unemployment, inventory, the ratio of consumer credit outstanding to personal income

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business cycle

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"boom-and-bust" cycle.

a progression of expansions, peaks, contractions, troughs, and recoveries for the overall (macro) economy

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expansion

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phase of the business cycle associated with increased activity

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peak

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phase of the business cycle between expansion (good times) and contraction (bad times)

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trough

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phase of the business cycle representing the "bottoming out" of a contraction, just before the next expansion/recovery

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contraction

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phase of the business cycle associated with general economic decline, recession, or depression

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cyclical industries

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an industry sensitive to the business cycle, e.g., steel, automobiles, and construction equipment

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depression

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a prolonged economic slump, more severe than a recession

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interest-rate sensitive

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a fixed-income security, or any common stock where the issuer's operations are directly affected by interest rate changes, e.g., financial firms

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defensive, "non-cyclical"

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an industry or company that can perform well even during bad economic times.

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Food and basic clothing represent two products purchased through both good and bad economic times; therefore stocks of food and basic clothing companies would be

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"defensive" instruments

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Gross National Product (GNP)

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the economic output of a nation's citizens, wherever they are located.

Tells us how much American workers are producing wherever they're stationed (locally, Japan, etc.)

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Fiscal Policy

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the process of taxation and spending done by the US Congress

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Monetary Policy

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what the FRD implements through the discount rate, reserve requirement, and FOMC open market operations. Monetary policy tightens or loosens credit in order to affect short-term interest rates and, therefore, the economy

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Keynesian Economics

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economic school of thought that advocates government intervention through fiscal policy as a way to stimulate demand for goods and services

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Monetarists

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those who advocate and/or implement monetary policy

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The cost of borrowing money

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interest rates

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reserve requirement

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the % of deposits that a bank must lock up in reserve, established by the FRB

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multiplier effect

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the outsized effect that a change in the reserve requirement can have based on the percentage of deposits banks are required to hold on reserve

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open market operations

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what the FOMC engages in when buying or selling US Treasuries to achieve targets for short-term interest rates

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To fight inflation the Fed slows things down by

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raising interest rates

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To stimulate a stalling economy the Fed pumps air back into the economy by

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lowering interest rates

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Tight credit or Tight money policy

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when the Federal Reserve is fighting inflation

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Loose credit or Loose money policy

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when the Fed is pumping inflation back into the economy

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If the economy starts going to fast, the Fed fights inflation by

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raising the reserve requirement

raising the discount rate

selling Treasury securities (drives price down, and yield/rates up)

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if the economy starts to slow down, the Fed fights deflation by

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lowering the reserve requirement

lowering the discount rate

buying Treasury securities (drives prices up, and yield/rates go down)