Archive for Monday, June 16, 2003

Knowledge of economic terms vital to financial health

June 16, 2003


I wince every time I hear people say they don't read the business section of their newspaper.

Inside my head I'm shouting: "Don't you know the information in the business section is so germane to your life?"

It might be titillating to read the latest entertainment news in the lifestyle section, but celebrity comings and goings won't help you understand why you or your friends or your family members are either losing jobs or getting paid less.

I know that to a reader who is not used to reading the financial news, business coverage can often seem boring or confusing. And yet it's vital to your financial health to learn as much as you can about what's going on with the economy.

For example, I received this question from a reader: "The Fed recently announced there was a slight chance of deflation affecting the U.S. economy. I have an idea about the nature of deflation. But I'm not certain. What is it?''

Good question.

Richard Sylla, an economics professor and acting chairman of the Department of Economics at New York University, was kind enough to provide an answer. He also explained a few other economic terms you might have heard (or hopefully read) about in the news lately:


It's a fall in the general level of prices. It's the opposite of inflation, which is a general rise in prices.

"Deflation is bad for a number of reasons,'' Sylla said. "Debt charges do not go down when the price level falls in a deflation. So deflation is especially bad for business debtors because, with prices lower, they have to sell more of whatever goods and services they deal in just to make their debt payments.''

During the Great Depression, prices fell a lot in just a few years. Borrowers could not repay their bank loans, so thousands of banks failed, wiping out the bank balances even of savers. When that happened, prices fell even more because people had lost their money.

"In general, business people and consumers make their plans based on price expectations, with the usual expectation being that prices will remain stable,'' Sylla said. "If instead prices fall, the profits of business tend to go down. So business curtails investment and employment, leading to reductions of consumers' incomes and an economic slowdown.''

Gross Domestic Product

The Gross Domestic Product measures the market value of final goods and services produced in our economy in a given time period. If we compare last year's GDP with this year's, we learn if our economy grew, contracted or stayed flat during that period. As Sylla points out, currently the GDP is not doing that well, which is why unemployment has been creeping up and why the politicians are debating measures to stimulate growth.

Consumer Price Index

The Consumer Price Index measures changes over time in the cost of a basket of goods and services bought by a typical American consumer. It measures consumer price inflation or deflation. Sometimes it is referred to as the "cost of living'' index. Thousands of goods and services are priced each month. Of course, not all consumers are typical, so the CPI only roughly measures changes in our personal costs of living.

Understanding CPI, Sylla said, is important because it is one of several key measures of inflation, and it enters into indexing formulas that determine the levels of a number of important payments people receive, such as Social Security payments for retirees. The CPI is available nationwide and also for regions, states and cities. These breakout numbers are helpful in knowing whether one lives in a high-cost, low-cost or average-cost part of the country. For example, if you have the choice between two jobs -- one where the CPI is high and the other where it's low -- knowing the area's CPI could help you decide which job to take.

Producer Price Index

The Producer Price Index is perhaps less relevant to the average consumer, but nonetheless it's important to understand. It measures the cost of a basket of goods and services (e.g., raw materials like iron ore, semi-finished goods like rolled steel, and finished goods like dump trucks) purchased by producers and businesses. The movements of this index tend to forecast movements in the CPI.

As the economy continues to falter, the slogan "it's the economy stupid'' has regained popularity among politicians and pundits. Of course they are directing the insult toward President Bush. But the sentiment should apply to all of us. We all should bone up on the economic terms that play an important role in our financial lives.

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