INFLATION

Inflation is a sustained rise in the prices of goods and services. As a result, currency loses its value because with the increased prices, each unit of currency buys fewer goods and services. The two types of recognized inflation are demand-pull inflation and cost-push inflation.

Demand-pull inflation is an imbalance in supply and demand (strong consumer demand which causes prices to go up significantly). This occurs when too many consumers are purchasing the same product. The money supply begins to shrink.

Cost-push inflation is when prices increase due to an increase in raw materials and cost of wages. Manufacturers pay more for the raw materials, and to compensate, they increase the price of the product. In other words, since retailers must pay more for goods, they forward this cost to their future consumers.

DEFLATION

Deflation is a decrease in the prices of goods and services. This is caused by a slow market demand and a level supply. When demand is stagnant, purchasing power increases. In turn, fixed-income securities become more appealing, and producers must lower their prices to compete with the limited demand. Inflation is negative for equities that are "interest rate sensitive" (i.e. smaller companies that rely on debt financing to grow; cyclical businesses that produce heavy machinery, automobiles, steel, other capital goods, etc).

MONETARY POLICY

Monetary policy and fiscal policy are the two general types of economic policies that describe the role and manner in which a government addresses economic factors. Monetary policy is how central banks manage liquidity to sustain a healthy economy. It mainly concerns itself with money supply and private sectors. The fundamental idea behind this policy is that the quantity of money (money supply) is the major determinant of price levels. Those who endorse this policy believe that price stability allows private businesses to plan their growth and invest in their business.They also believe it keeps the economy growing at a steady pace without an over or under-supply of goods.

The Federal Reserve Board (also called the Fed ) is the primary driver of all monetary policy decisions. It consists of seven members appointed by the president of the United States and is subject to Senate confirmation. It governs the regional Federal Reserve Banks and hundreds of state and national banks. All of these make up the Federal Reserve System. Very few organizations have the ability to move the market like the Federal Reserve. Aside from determining monetary policy and banking policies, it also acts as several other governing capacities, such as the following:

•an agent of the U.S. Treasury
•regulator of the U.S. money supply through open market sales and purchases, discount rate adjustments, and reserve requirement changes
•implementer of the reserve requirements of its members
•supervisor of currency printing
•clearer of fund transfers
•examiner of member compliance (to federal banking regulations)

FISCAL POLICY

Fiscal policy is an economic theory that addresses changes in the allocation and levels of economic resources. In other words, it helps the government monitor and influence the nation’s economy by adjusting its spending levels and tax rates. Though they sound similar, fiscal policy is quite different than monetary policy. Monetary policy involves changing the interest and influencing money supply. Fiscal policy involves the government changing tax rates and levels of government spending in order to influence demand. During this process, the government considers the following when evaluating its budget:

•federal spending
•money raised through taxes
•deficits or surpluses

Expansionary fiscal policy is appropriate during the economic downturn like recessions and troughs in the business cycle. When unemployment is high, business profits are low and are not operating at full capacity. Government spending is increased and taxes for individuals and small businesses are reduced to stimulate the economy.

Contractionary fiscal policy occurs when the business cycle is near its peak. Unemployment is low, and businesses are at full capacity with high profits. Consequently, the government will decrease its spending and increase taxes for individuals and businesses. A government will often wipe out its deficit and create a surplus during this period.

ECONOMIC ACTIVITY AND TAXES

When businesses and individuals have easier credit access, they expand their operations and consume more goods. This stimulates the overall growth of economic activity. Conversely, when the credit environment is unfriendly towards businesses and consumers, the price of goods rises due to the limited supplies. Then, manufacturing activity contracts and economic growth slows down. Lower tax rates stimulate spending by leaving more money in the hands of consumers and businesses. The opposite is true for raising tax rates. Less money stays in the pockets of businesses and consumers, resulting in a declination of economic activity.

ECONOMIC INDICATORS

There are several economic factors that change before, during, and after the business cycle. Economic analysts use these factors to determine the state of the economy. Leading, lagging, and coincident indicators are measurable.

Leading indicators change before the economy starts to follow a pattern or trend. They predict changes in the economy but are not always accurate. Bond yields are good leading indicators of the market because traders can anticipate and speculate trends in the economy. Other examples of leading indicators are as follows:

•building permits for new private housing
•industrial production rates
•money supply
•S&P 500
•the average of weekly-submitted insurance claims of the unemployed

Lagging indicators change after the economy has followed a pattern or trend. They confirm long-term trends but do not predict them. Interest rates (especially the prime interest rate) are a good lagging indicators because they are always affected after severe market changes occur. Other examples of lagging indicators are employment rates, corporate profits, and labor cost (per unit of output).

Coincident indicators are metric factors that vary directly and simultaneously with the business cycle, thus, forthrightly indicating the current economic state. Non-agricultural employment, personal income, and inventory sales ratios are good examples of coincident indicators.

The balance of trade (BOT) is the difference between a country's exports and imports for a given period of time. A country has a trade deficit if it imports more than it exports, and a trade surplus if it exports more than it imports. The BOT is the most misunderstood of the economic indicators. For instance, many people believe that a trade deficit is a bad thing. However, whether or not a trade deficit is a negative thing is contingent upon the business cycle. During a recession, countries like to export more, creating more jobs and high demand. In a strong expansion period, countries like to import more, providing price competition (which limits the inflation without increasing the prices, providing goods beyond the economy's ability to meet supply). Therefore, trade deficit is not beneficial during a recession but may be key during an expansion.

The balance of payments (BOP) is a record of all transactions made by one country during a certain period. It compares the amount of economic activity between one country and other countries.

Debit items include the following:

•imports
•foreign aid
•domestic spending abroad
•domestic investments abroad

Credit items include the following:

•exports
•foreign spending in the domestic economy
•foreign investments in the domestic economy

International economic factors also impose risk to investors and should be considered. A company that collects revenues in a foreign currency is either long or short in that currency. When a company receives more revenue than it paid in expenses, it is long in currency. Conversely, when it receives less revenue than it paid in expenses, it is short in currency.

In general, currency exchange rates can have a huge impact on business profits and security prices. Changes in currency rates also play a huge role. These rates are expressed as the ratio of the price of one currency against another. When the U.S. dollar weakens against another currency, the other currency is worth more dollars. In this case, foreign investment in the U.S. dollar will decline (because the value of the U.S. dollar is less). Imports decline as they become more expensive to U.S. businesses and consumers. On the other hand, a weaker dollar attracts the foreign countries to import U.S. goods. In turn, exports increase. When the U.S. dollar strengthens against another currency, the dollar buys more of that currency. Foreign investors will invest more when the U.S dollar is strong. In turn, U.S. imports will increase since it is cheaper for U.S. businesses and consumers to purchase foreign goods. Finally, U.S. exports will decrease since U.S. goods will be expensive for consumers in many foreign countries.