We’ve all been there. Just made our oats and have a coffee in hand to ensure that we are fully equipped to take on the day. Wanting to see what has been happening in the world we flick on the T.V to see the familiar face of the money expert.
Watching them quote numbers from the iPad, chatting live to people from banks (seriously do those guys ever sleep?) and pointing away at these numbers and lines. We don’t really know what has just happened but we do know there had been $40bn wiped off the share market and we should perhaps start to panic.
Our philosophy at Cheeky Investor isn’t about telling you what to think but rather how to think. Teaching someone how to think is much, much more powerful. Today we’ve put together the 5 key points you need to know to understand what impacts our economy and ultimately you.
The assumptions – Economics has some pretty basic assumptions about people and their families.
- People will receive an income (work or Government Support). Economists like to call this disposable income.
- Income will be spent buying things (consumption)
- People will save their money (savings)
- People will invest their money (investing)
The other assumption is that supply and demand will set the price of things. This is known as the S & D curve and somewhat became the bane of my existence during my first year at uni.
The concept is simple enough. If supply is high and demand is low price will be low. If supply is low and demand is high then price will be high. The best example of this is through ticket sales. When a popular band sells out a show people take to eBay to get tickets.
We often see some crazy prices! That’s because demand is higher than supply so price goes higher. But when a second show is announced there is now more supply so price starts to stabilise.
If more people become unemployed it means that they have less money to spend and that the government will receive less tax because they have less wages to tax. With no income people can’t spend as much at the shops.
If people aren’t buying things at the shops then business owners need less staff as they can’t afford to pay them so they let them go. And it creates a cycle. However, the most interesting thing is how unemployment is calculated.
The criteria below for unemployment is actually the international standard. To be deemed as unemployed a person must be:
- Over 15 years of age
- Not working one hour or more
- Actively seeking work and
- Available for work
How crazy is that? You are actually deemed to be employed if you work at least 1 hour per week. This method is really misleading and a number of economists believe that doubling the unemployment figure released actually gives you a more accurate number.
So an unemployment rate of 6% would actually be closer to 12%. I will be doing a separate post on unemployment as it is and weird and crazy topic.
This is simply a way of tracking the increase of price for good and services over a period of time. The best way that I learnt about inflation was by doing something that I loved to do as a little kid. Collecting football cards.
If a football card cost $1 and I had $10 pocket money, well I knew I could buy 10 cards. But what if waited for a few months before buying? Now the cards cost $1.10 each. I would take that same $10 note but get less cards then I would have just a few months back. This is also an example of a reduction in my purchasing power.
The other aspect that inflation brings attention to is the time value of money. So let’s say that your parents had $4,000 in 1970 and wanted to buy themselves a brand new car. Instead they though that they would wait until 2016 and spoil their child with a new car.
So they put the money under their mattress. 2016 comes along and they take their money from under the mattress and head to the local car yard. They are shocked when the salesman and the dealership bursts out laughing when they ask for a new car and present them with $4,000. So over time the value of their money had decreased.
And that is the essence of why people invest. If the $4,000 was invested returning between 2%-3% per year (inflation target) then a new car could have been purchased in 2016.
In terms of knowing what impacts inflation well there have been 1000s of academics write a PHD on that subject. But briefly there is a belief that when the economy is good people spend more so prices increase due to demand increasing.
The other thought is that when employees demand pay rises they are passed onto the consumer by increasing the price of their good and services.
Interest rates –
So interest rates can be used as a tool by the Reserve or Central Banks to encourage (control) how people spend their money. If inflation is getting too high then the Reserve Bank can increase interest rates.
This will result in people spending less money at the shopping centre and more on their mortgage repayments that have just gone up. It may also encourage people to save rather than spend their money as the return on their savings has increased. By decreasing the demand good and services inflation will come back down to its desired rate.
A decrease in interest rates can have the opposite effect on the economy. If interest rates go down mortgage obligations decrease and people don’t get a good return on their savings. So they decide to spend more instead.
The more people spend, the more staff that a business needs to hire to keep up with consumer demand. If more people are working then more people have more money to spend and boost the economy. If this goes too well and inflation increases more than expected, well it’s back to the drawing board for the government to possible increase interest rates. It’s a vicious cycle.
Global events –
Carrying on from above. If interest rates get to a really low point as they did after the GFC, then investors will start to look for overseas opportunities to place their cash. So in 2012 the U.S had 0% interest rates and Australia’s was around 4%.
So essentially in America you could borrow money at 0% and place it in an Australian bank account and receive 4%. What this done was increased the value of the Australian dollar.
This happens because there is an increase in demand for Australian dollars and placing more money in the economy. More money in the economy can often lead to higher inflation.
A high exchange rate is awesome for when you want to import goods into a country. Like when I bought a pair of Macbeth skate shoes in the US for $60 American but it only cost like $54 Australian! But it really sux for an exporting business.
Let’s say I started selling ties for $100 to an American company when 1 Australian dollar equalled 1 American dollar. Simple, the American company would pay me $1000 for 10 ties. But what happens if the Aussie dollar increased by 10%?
Well I still want $100 for my ties but now the American company need to come up with $110 American dollars to buy them. So now they only buy 9 ties instead of 10 and spend only $990 (9x $110) instead of $1000. Now my sales and revenue have both decreased.
Other international events will depend on how much exposure an economy has to the market that is being impacted. So with the Chinese economy slowing this has an impact on Australia as we export a lot of our raw materials to Asian markets.
If the Chinese economy demands less of our raw materials and products then we have less money coming into the country. Natural resources and agriculture are massive industries in Australia so when these industries start to decline then the rest of the economy will follow.
Other international events may only affect an economy psychologically. As in investors start to take action based on fear of what has happened in overseas markets assuming the worst is going to happen in their country. Fear is a massive contributor to global economic issues.
So that’s the 5 key pieces I believe that people should know about economics. It’s really only the tip of the iceberg but now you will have a better understanding of what the media are reporting and form your own opinions and not just rely on those of others.
Picking up a copy of the Australian Financial Review or Wall Street Journal (or whatever your countries go to finance publication is) once a week or fortnight will be enough to keep your finger on the pulse of what is happening in the global economy.