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If you follow the news on television or by reading the daily newspaper, you’re bound to run into economic terms that may be unfamiliar to you. For example, what is the “new economy”? What is an IPO? What is the consumer price index? Economist Frank Bonello, author of Taking Sides: Clashing Views on Controversial Economic Issues (2001), answers basic questions such as these, in addition to taking on larger issues, such as the future of Social Security, how to plan for retirement, what is the relationship between stocks and bonds, and why does the Federal Reserve raise and lower interest rates?
Q: What happens to a company when its stock price goes down or up?
A: On a day-to-day basis, variations in the price of a company’s stock typically have little meaning. In most cases the company is exactly the same in the evening after its stock price changed as it was in the morning before the price change. In this context, the variations in stock prices tend to be minor and simply reflect small changes in attitudes about owning the stock by those who hold the stock and those who are considering buying it. Frequently the day-to-day variations in a stock’s price will simply reflect the general behavior of the broader stock market, moving up on a day when stock prices generally increased. On a long-term basis, variations in a stock’s price reflect profit performance: Increases in profitability will move a company’s stock price upward, while declining profitability will move a company’s stock price downward.
Q: How can executives of failing dot-com companies be rich?
A: The executives of dot-com companies typically became rich when the price of the stock that they owned in their particular company increased. The price of a company’s stock may increase even if the company is not profitable because investors tend to evaluate companies on their expected profits rather than on their actual balance sheet. So when a company first makes its stock available for public trading with an initial public offering (IPO), its price will increase if investors are optimistic about the company’s future. But just because investors expect a company to be profitable does not mean that it will be. Some dot-com companies did not live up to the expectations of early investors, and their stock prices declined accordingly. So the stock still held by the dot-com executives is worth less—in some cases, substantially less. But the executives may still be rich if they sold some of their stock before the price of the stock declined.
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Q: What estimated rate of inflation should I use when planning for retirement?
A: The inflation rate is important for retirement planning. Basically, it determines how much you’ll need to live a certain lifestyle in the future. The higher the estimated rate of inflation, the more you have to save to achieve the lifestyle you want during retirement.
It’s difficult to determine the exact rate of inflation to use in planning for retirement. Factors to consider include how long you plan to live on your retirement and the amount of time you have before you retire. Most retirement planners use an average of past inflation rates. For example, if a person anticipates a retirement period of 25 years, one might use an average of inflation rates over the past 25 years as an estimate of inflation over the retirement period. If you want to be conservative, the estimate can be increased.
It’s always better to overestimate the inflation rate (save too much) than to underestimate the inflation rate (save too little). Taking a conservative approach is sensible because it’s easier to have too much money during your retirement than not enough.
Q: What is the difference between Gross Domestic Product (GDP) and Gross National Product (GNP)?
A: GDP is the market value of all the goods and services produced in an economy over some period of time. GNP is the market value of the goods and services produced by an economy’s productive resources over some period of time.
Here’s an example that can highlight the difference. Amanda is an American working in Chicago, so her production is included in both U.S. GDP and GNP. If Amanda takes a new job in London, her production is no longer included in U.S. GDP because she’s no longer producing within the geographic boundaries of the economy. As long as she is a U.S. citizen, however, her production is still included in U.S. GNP. GNP measures the production of Americans whether they are working in the United States or abroad.
For the United States, the difference between GDP and GNP is quite small, less than one-half of 1 percent in 1998.
Q: Why does the Federal Reserve raise interest rates to slow the economy?
A: The Federal Reserve tries to slow the economy when it thinks the economy is growing too rapidly. The Federal Reserve doesn’t want the economy to grow too quickly because this almost always results in inflation, when the general level of prices or the cost of living is increasing. Inflationary growth, in turn, is caused by excessive growth in the total demand for goods and services in the economy. So to slow the economy and prevent inflation, the Federal Reserve needs to constrain total demand. This is where the increase in interest rates enters the picture. Borrowing money finances much of total demand: consumers borrowing to buy new homes and cars, and business firms borrowing to purchase new facilities and equipment. Interest rates represent the cost of borrowing, so when the Federal Reserve raises interest rates, the cost of borrowing increases. Business firms and consumers are then less likely to borrow, reducing their demands for goods and services.
Q: I don’t understand the inverse relation between stock and bond prices. Why does one go up when the other goes down (and vice versa)?
A: I suspect the confusion regarding the relation between the prices of stocks and bonds arises because people tend to look at only one part of the investment decision. There are actually two decisions that need to be made, and the outcome of these decisions influences the prices of stocks and bonds. The first concerns the size of the portfolio, or how much in total should be invested in both stocks and bonds. The second concerns the composition of the portfolio, or how much of total investment should consist of stocks and how much should consist of bonds.
With respect to the first part of the investment decision, most people invest in both stock and bonds as a way of reducing financial risk. This is simply the old idea about not putting all your eggs in one basket—in this case, not putting all your savings in stocks or all in bonds. The size decision suggests that the prices of stocks and bonds should move together—both rising when people are increasing the size of their portfolios, or investing, and both falling when people are decreasing the size of their portfolios, or selling.
For the second part of the portfolio decision, people must decide how much of their portfolios should consist of stocks and how much should consist of bonds. One of the most important determinants of the composition of the portfolio is the relation between the expected return on bonds and the expected return on stocks. For example, suppose a person initially has a portfolio that consists of 50 percent stocks and 50 percent bonds. Now suppose, for whatever reason, the expected return on stocks falls while the expected return on bonds remains the same. This change in expected returns will lead the person to reduce stock holdings and increase bond holdings, perhaps changing the composition of the portfolio so that it now consists of 25 percent stocks and 75 percent bonds. This means the person will sell some of the stocks and use the funds obtained from selling the stocks to buy bonds. The sale of stock will lead to a decrease in the price of stock, and the purchase of bonds will lead to an increase in the price of bonds.
In general the relation between stock and bond prices is dominated by the second part of the portfolio decision. To put it another way, given the size of the portfolio, or total investment, stocks and bonds are substitutes. This means if people increase their holdings of bonds, they must sell stocks. This leads to an increase in both the demand and price of bonds as well as to a decrease in both the demand and price of stocks.
Q: Why can’t just anyone get in on an initial public offering (IPO)?
A: When a company has an initial public offering, it offers securities to the public for the first time. This offering usually takes place through an investment banker or a group of investment bankers called a syndicate. The investment banker assists the company in determining the types of securities to be issued and the price at which they will be sold.
Securities issued during an IPO are limited in quantity—a set number of shares of stock or a set volume of bonds. Supply and demand of the stock determines whether everyone who wants to buy the security is able to obtain some at the initial sale. If the demand is larger than the supply, then some potential buyers will not be able to get any or all of the securities they want at the IPO. Success in getting the new securities depends on a variety of factors. In some cases, potential buyers who have been good customers of the investment banker in the past, or buyers who seek to purchase large quantities of the new securities, may have an advantage.
Q: Why does American organized labor object to the North American Free Trade Agreement (NAFTA)?
A: Organized labor focuses on promoting the well-being of union members and related workers. Organized labor’s opposition to NAFTA is based on the view that this trade agreement would make it much easier for American firms to relocate their production facilities to Mexico. Thus, American workers would be worse off because of the loss of good-paying jobs.
Firms may want to relocate to Mexico to take advantage of the lower wages they could pay to Mexican workers or less stringent environmental and worker-safety regulations. Organized labor argues that unsafe working conditions and increased pollution bring undue harm to the Mexican workers and economy. The only winners in this shift of international production facilities, they argue, are business firms.
Q: What does the term margin requirement mean?
A: Financial assets such as stocks and bonds can be purchased with borrowed funds. The term margin requirement is the percent of the purchase price of the financial asset that the purchaser must make as a down payment. For example, suppose that Alex decides to purchase 100 shares of a company’s stock that is currently selling for $100 a share. Ignoring any transaction costs, the value of the purchase is $10,000. If Alex has a margin account with his broker, and if the margin requirement is 50 percent, Alex must make a down payment of $5,000 (50 percent of $10,000). The broker is, in effect, lending Alex the remaining $5,000 of the purchase price. For these kinds of credit transactions, the margin requirement is set by the Federal Reserve. The Federal Reserve raises the margin requirement if conditions in the stock market are too speculative, because a higher margin requirement makes purchasing stock more difficult.
Q: Why is the United States stock market so heavily influenced by the price of oil from the Middle East?
A: Oil is an important energy source in the United States. If the price of oil from the Middle East increases, U.S. consumers have to pay more to heat their homes and to drive their cars. United States business firms have to pay more to power their factories and drive their machinery. The increased costs to consumers and business firms can lead to an economic contraction with decreased corporate profits. The expected or actual decline in corporate profits makes investors less willing to buy the stocks of these corporations. When investors are less willing to buy stocks, stock prices are likely to decline.
Q: What happens to money after it is deposited in a savings account?
A: Financial institutions such as commercial banks, credit unions, and savings and loan associations are known as financial intermediaries. This means that they attract funds from savers, or persons who spend less than their incomes, and then lend the funds to borrowers, or persons who spend more than their incomes. The funds that some of us place in savings accounts are just recirculated to other people who will be using the borrowed funds to buy cars and houses. These financial institutions will also lend the funds to business firms that are trying to expand their operations. The financial intermediaries will also use the funds to buy securities that have been issued by the federal government and state and local governments.
Put another way, the financial intermediaries offer deposits, including savings deposits, as a source of funds. The loans and the securities purchases they make represent the use of these funds. A financial intermediary will be profitable so long as the cost of its funds (the interest paid on the savings accounts) is less than the revenues it receives on its use of funds (the interest earned on the loans and the securities).
Q: Why do Democrats and Republicans come up with different estimates for the United States federal government budget surpluses?
A: Estimates or forecasts are based on assumptions. A weather forecast, for example, includes assumptions regarding the speed at which various fronts will move. Budget forecasts are no different, as they are based on assumptions regarding economic conditions. Economic conditions greatly affect the budgets of federal, state, and local governments. Different individuals and different organizations often forecast different budget positions because they make different assumptions about economic conditions.
If forecasters assume the economy will grow, they anticipate that the government will collect more in tax revenues. A growing economy may also mean less government spending on items such as unemployment benefits. The more robust the economy is, the greater the government’s budget surplus (or the lower its budget deficit) will be. Because Democrats and Republicans often have differing views on the strength of the economy, they come up with different budget forecasts.
Q: When, if ever, will Social Security run out?
A: When people speak of Social Security running out of money, they are speaking of the expected situation when Social Security expenditures will exceed Social Security revenues. This is also what they mean when they speak of a Social Security crisis or bankruptcy.
Currently the Social Security system collects more in receipts than it pays in benefits. The excess is accumulated in the Social Security Trust Fund. At the end of 1999 the trust fund was valued at almost $800 billion. By approximately 2020 the situation will be reversed, with Social Security payments exceeding receipts. When that happens, the trust fund could be used to cover the difference. But the trust fund would be exhausted by about 2035. At that point, Social Security receipts will cover from 60 percent to 75 percent of payments.
If the current-law structure of receipts and payments remains unchanged until 2035, and if current projections on receipts and expenditures hold, then there must be either an increase in Social Security taxes or a reduction in Social Security benefits.
Q: How is the money I pay in federal income taxes spent?
A: Personal income taxes constitute the single largest source of revenue for the federal government. The income tax you pay is combined with revenue from corporate income taxes, social insurance, retirement receipts, and other sources to finance a large number of activities. These include activities in national defense; international affairs; general science, space, and technology; energy; natural resources and environment; agriculture; transportation; community and regional development; education and training; health; Medicare; income security; Social Security; veterans benefits; administration of justice; general government; and net interest.
For the calendar year 1999 the federal government’s revenues totaled $1.8 trillion, with expenditures of about $1.7 trillion. The three largest outlay categories were Social Security ($390 billion), national defense ($275 billion), and net interest ($230 billion).
Q: How is unemployment related to inflation?
A: Economists have two answers to the question regarding the relationship between unemployment and inflation. The two answers depend on the time period under consideration—the long run and the short run.
Based on the experiences of several economies, including the American economy during the 1960s, economists once held that in the short run, decreases in inflation require an increase in unemployment. This short-run relationship is referred to as the Phillips curve. Since then, however, there have been short-run periods in the American economy when both unemployment and inflation have increased (from 1973 to 1975) and when unemployment has decreased without any significant increase in inflation (from 1998 to 2000).
Today when economists evaluate short-run periods, they argue that there is no systematic relationship between unemployment and inflation. Instead, they believe that unemployment in the long run is fixed at a natural rate, defined as the unemployment that remains after the economy has adjusted to short-run fluctuations.
Q: In the stock market, what constitutes a bear market?
A: A bear market is simply defined as a market in which prices, on average, are falling. In the case of the stock market, a bear market is a market in which stock prices, on average, are falling during some extended period of time. The average behavior of stock prices is summarized by stock indexes such as the Dow Jones Industrial Average (an index that averages the behavior of the prices of 30 stocks listed on the New York Stock Exchange), the Standard and Poor’s 500 (an index that averages the behavior of the prices of 500 stocks that are listed on the New York Stock Exchange), and the NASDAQ Composite (an index that averages the prices of all the stocks traded through the National Association of Securities Dealers Automated Quotation system).
So a “bearish” stock market describes a period when these indexes are falling. During a bear market there may be days or slightly longer periods of time when average prices are rising, but the longer trend for prices is downward. The opposite of a bear market is a bull market: A “bullish” stock market is defined as a market in which stock prices, on average, are rising over some extended period of time.
Q: What is the consumer price index?
A: The consumer price index, or CPI, is a statistical construct that measures the average behavior of the prices of the goods and services purchased by the typical household. When consumer prices, on average, are rising, the CPI increases and there is inflation. When consumer prices are decreasing, the CPI decreases and there is deflation.
The Bureau of Labor Statistics (BLS) of the U.S. Department of Labor compiles the CPI. First, they determine what the typical household purchases, or the so-called market basket. Then, each month the BLS determines the prices that consumers must pay for the goods and services in the market basket. The percentage change in the price index represents the rate of inflation or deflation.
The CPI is frequently interpreted as a measure of the cost of living. That is, an increase in the CPI means the typical household needs more money to purchase the market basket and, therefore, the typical household’s cost of living has increased.
Q: What does the term leading economic indicator mean?
A: Over time economies tend to behave in a cyclical manner. That is, they experience periods of boom or prosperity when production, income, and employment are rising, followed by periods of contraction or recession when production, income, and employment are falling. This cyclical activity does not follow a predictable path. Sometimes the booms are long and sometimes they are short. The same is true of the contractions. Consequently, no one can predict the path of the economy with great accuracy. But in an effort to better anticipate the economy’s cyclical movement, a set of so-called leading economic indicators has been developed. These leading economic indicators are data series that turn before the overall economy. For example, the average length of the workweek is considered a leading economic indicator; a decline in the average length of the workweek suggests the economy is weakening and may be heading toward a contraction. But no single data series is a perfect leading indicator, so a number of them have been combined into an index of leading indicators. The Conference Board announces the index every month.
Q: How much money do middle-class people make?
A: There are several ways to answer this question. A simple answer is to use some sort of average, such as mean household income (the nation’s total household income divided by the number of households) or median household income (the income figure that divides households into upper and lower halves). In 1999 mean household income was $56,237 and median household income was $42,038. A more complex answer involves a more detailed look at income distribution. In this case, middle-class income may be defined as the income range that excludes the poorest 20 percent of households and the richest 20 percent. This defines middle-class income as the income range that covers the middle 60 percent of households. For 1999 this income range was from $17,197 to $79,375.
For detailed information on income distribution, see the U.S. Census Bureau’s publication Money Income in the United States.
Q: What is meant by the term “new economy”?
A: The term “new economy” is used in several different ways, and it means different things to different people.
Some people believe the term applies to the current evolutionary state of the economy. This definition recognizes that the American economy was primarily agricultural until the late 1800s and early 1900s, when it was transformed into a primarily industrial economy. They believe the economy is currently undergoing another fundamental transformation, from an industrial economy to an information-based economy.
Another group of individuals uses the term “new economy” to refer to the increased importance of international economic and financial relations. They cite as evidence the growth in the volume of imports and exports, the enhanced ability of firms to move producing facilities across national borders, and the growth and rapid movement of finance throughout the world.
A third group uses the term to describe the explosive growth of Web-based e-commerce and e-business, as represented by companies such as Amazon.com. This group also points to the increasing importance of computers in more traditional lines of business.
A final group believes that the new economy is best defined as a set of conditions in which unemployment can be reduced without the creation of inflation. These individuals would cite as evidence the experience of the American economy over the last decade.
A truly comprehensive definition of the new economy would actually incorporate all these characteristics.
Q: When I buy stock, who gets the money?
A: The answer to this question depends on whether the stock is a new issue. If the stock is a new issue, the money goes to the company. The company, in fact, issues the stock, usually with the assistance of an investment banker, in order to obtain funds to finance its business operations—to build factories and office space, to buy machinery and computers, and so on. If the stock is not newly issued, it is outstanding stock. In the case of outstanding stock, the issuing corporation receives none of the funds associated with the purchase and sale of its stock. Instead money is simply transferred between the persons or organizations who are selling the stock and the persons or organizations who are buying the stock. Most transactions on stock exchanges are of this variety.
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United States (Economy); Business; Stock (business); Free-Market Economy
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