5 Economic Concepts Every Savvy Investor Knows

Infographic that explains what macroeconomics is

“Macro” in the term Macroeconomics comes from a Greek prefix “Makro,” which means “large.” That, combined with economics, makes Macroeconomics a branch of economics that deals with the study of the economy at large or as a whole. Thus, macroeconomics is all about gathering and analyzing substantial economic concepts and data sets collected from all countries around the globe. This data assists the governments and policymakers in developing and appraising a wide range of economic policies.

Investors study several macroeconomic indicators to analyze the impact of fiscal policies and to aid with investment decision-making. Some of these economic concepts are Gross Domestic Product (GDP), National Income, Unemployment, and Inflation. Understanding and tracking these economic concepts and many others help policymakers understand the impact of macroeconomic policies and prepare for reasons and consequences of short-term vacillations in national income. These fluctuations are commonly known as business cycles

Let’s go through each of these macroeconomic concepts one at a time.

Economic Concept 2: Gross Domestic Product (GDP)

Infographic that explains the difference between gross domestic product and gross national income

GDP is an economic concept that measures the monetary value of all the final goods and services produced in an economy in a specified period. Putting GDP in perspective, in 2019, the United States had the world’s largest economy with a GDP of $21.4 trillion. This means that the country produced $21.4 trillion worth of goods and services. Thus, the country’s GDP surpasses the GDP of all other economies by a wide margin. Next comes China, with a GDP of $14.4 trillion.

The GDP is different from Gross National Product (GNP). GNP measures the value of all goods and services produced by the citizens of a country at home and abroad. In contrast, GDP is the value of final products and services produced within a country’s borders by citizens or organizations of any country.

In 1991, the United States switched from Gross National Product (GNP) to GDP. The U.S. made this swith much later than most other economies in the world.

GDP is a complex calculation that excludes the value of intermediate goods and instead focuses on final products only. It is assumed that the value of final goods will also cover the cost of the inputs that have gone into producing the final goods. 

So, for example, America’s GDP will include the price of a car manufactured in the country but will not include the cost of a battery that went into the car because the battery is an intermediate good, and its value is built into the price of the vehicle. The same methodology applies to a Hyundai car manufactured in the U.S., despite Hyundai being a Japanese company.

GDP is one of the most widely used and significant economic indicators. However, it is not so useful in isolation. Therefore, economists compare the current period’s GDP with that of the previous period to calculate GDP growth. This growth rate tells us the relative improvement of the economy compared to the prior year. 

The growth measure is essential for many purposes, including checking the GDP growth rate against the population growth rate. When a country’s population grows faster than its GDP in a specific year, it is not a healthy sign. It means that fewer resources are available to its citizens than the previous year.

The same growth rate helps us compare the relative performance of different economies. So, for example, if the U.S., with its $21.4 trillion economy, grows by 3% next year, it adds $642 billion to its annual economic activity. In comparison, when India, with a lower GDP of $2.94 trillion, grows by 7%, it will only add $205 billion to its GDP.  Therefore, a higher GDP growth rate doesn’t automatically mean a higher absolute value of goods and services produced within a country. In economic parlance, this is called a base effect. Lower growth on a higher base can still mean a higher absolute addition to the economic activity.

Another important economic indicator used by economists is GDP per capita. This is a country’s GDP divided by its total population. Higher per capita GDP signifies better economic conditions and a higher standard of living for citizens of a nation. Even countries with much smaller GDPs and even smaller populations can be prosperous because they have a higher GDP per capita.

Economic Concept 2: Inflation

infographic that explains how to calculate inflation using CPI

Inflation measures the increase in the general price level of goods and services in a particular period. 

Inflation is the percentage increase in the price of a pre-determined basket of goods and services (Consumer Price Index) over the same period versus last year. The basket is revised periodically to include and exclude elements based on the new realities of the world. This means that obsolete products will be excluded while new products are added. In the U.S., the data is collated and published by the U.S. Bureau of Labor Statistics (BLS) every month.

For example, the inflation level is 2% in the United States. This means that the cost of living has gone up by 2% compared to the same period last year. So, a basket that used to cost $100 last year will cost $102 today. 

Consider this, an average burger in the U.S. used to cost $1.19 in 2005 and $2.64 in 2018. So, while you could buy 8 burgers in 2005 with $10, the same $10 can only buy you 4 burgers in 2018. So that is 4 fewer burgers due to inflation over the years.

A stable, low inflation rate is healthy for an economy. However, if the price increases become rampant, it can pose significant problems to the people and government alike. If people’s income doesn’t keep pace with inflation, they will have to forego some part of their consumption. This is an unsustainable phenomenon in the long run. Historically, the gravest inflation episodes have even led to civil unrest and the toppling of governments.

In the last decade, the average inflation rate in the United States was 1.57%. Therefore, any investment that would have returned less than this rate in the last decade would actually lose money.

Now that we understand what inflation is let’s get to understand what causes it. 

Inflation can be a result of the demand-side of supply-side factors. If there is an increase in demand for a commodity, more money chases the same commodity volume, leading to an increase in price.  On the other hand, if there is a short supply of a commodity for any reason, the same amount of money now chases a lower volume of commodity increasing its price.

In the U.S., investments like savings accounts, certificates of deposits, and long-term treasuries, which returned an average of 1-2%, would have led to a sustained decrease in the purchasing power of invested money. On the other hand, stocks with returns hovering around 10%, would have increased in its purchasing power. Finally, instruments like corporate and municipal bonds would have resulted in a slight increase in purchasing power with yields between 3% and 5%.

Economic Concept 3: Stagflation

Infographic that explains what stagflation is

We covered inflation and how your investing returns should exceed inflation to keep your money relevant. Next, We will discuss another intriguing economic concept called stagflation.

In stagflation, the economy experiences stagnating or negative GDP growth along with high inflation. Stagflation is a horrible situation for any economy as negative GDP growth increases unemployment. This results in less money for workers, rising prices, and a decrease in purchasing power of the money people already have.

How does any economy get into such a grave situation? There could be two causes of stagflation. 

The first is a supply shock. This means an abrupt and steep price increase in an essential commodity like oil due to a supply shortage. An oil price inflation increases the overall cost of producing and transporting goods, making products expensive. Unfortunately, not all businesses can withstand the increase in production costs because they are unable to pass on the higher prices to their customers. This results in lower demand, reduced investments, and rising unemployment. The combination of the factors above produces a double whammy stagflation in the economy – stagnant economy and rising inflation.

The other cause of stagflation can be unfavorable government policies that slow the industry combined with expansionary monetary policy and fiscal policy that increases the money supply. An increase in money supply is usually the result of a country’s central bank printing money. This increases inflation while the slowing industry stagnates growth and increases unemployment.

In the next section, we discuss unemployment in a little more detail

Economic Concept 4: Unemployment

infographic that explains unemployment in the USA

Unemployment measures what portion of the workforce is out of work due to a lack of employment opportunities. So, if the economy is firing on all cylinders and GDP growth is high, the unemployment rate will be low. But, on the other hand, if the economy is not growing or falling for any reason, the unemployment rate will be high. 

Consider what happened in America in the global financial crisis of 2007-08. The collapse of credit markets led to a 6% decline in GDP in the last quarter of 2008 and the first quarter of 2009, and the unemployment rate peaked at 10.1% by October 2009.

How to calculate the unemployment rate?

The calculation of unemployment is a function of a variety of factors. The most important factors are the working-age population, labor force participation, and the number of people out of work at any point.

Let’s look at the American example to understand the unemployment calculation better.

The total working-age population is the number of people above the country’s legal working age. In the U.S., the legal working age is 16. Therefore, any American citizen over the age of 16 can go out and seek work in the U.S

At the end of the fourth quarter of 2019, America’s total working-age population was 260 million. But not all of these 260 million people were available and willing to work during the quarter. This brings us to another metric called “labor force participation rate.” The labor force participation rate measures the proportion of people in the working-age population who are available and willing to work. The number stood at 63.2% in the fourth quarter of 2019.

Labor force Participation Rate = Labor Force / Working-age Population

Where Labor Force is the number of people employed or actively seeking employment  

Therefore, only 63.2% of people above the age of 16 were participating in the labor force. The other 36.8% were either retirees, homemakers, surviving on investments, or simply unwilling to look for work.

That brings us to 164 million people (63.2% of 260 million) in the labor force.

Out of those 164 million people, 158.6 million had active jobs and were employed in the quarter. So nearly 5.8 million people were out of work but were seeking active employment. 

So, here comes our final economic concept – the actual unemployment rate, calculated using the below-mentioned formula.

Unemployment Rate = Number of Unemployed/Labor Force

That brings us to 3.5% (5.8 million/164 million), which is the official U.S. unemployment rate in the last quarter of 2019.

That is a massive improvement from the peak unemployment rate of 2009. The improvement in unemployment was a result of recovery from the financial crisis and renewed confidence in businesses. The confidence was, in turn, led by huge investments and the emergence of innovative new-age companies that kept the economic engine roaring. 

Let’s understand how all these economic concepts fare in changing business cycles.

Economic Concept 5: Business Cycles

Graphic that shows the difference between a seasonal and a structural business cycle

Businesses – small and large – go through cycles several times in their lives. When economic activity is high, enterprises are running at full capacities, and profits are soaring. Then, when demand goes down, production capacity becomes under-utilized, and businesses have to lay off workers for their survival. 

Economies and businesses see two kinds of cycles – seasonal and structural. 

Seasonal cycles are simpler to deal with because business owners know how the demand will turn out. So, for example, an online store sees a significant jump in order volume in the festive season at the end of the year. The business owner knows that this spurt will not last once the festivities end and people return to their normal lives. Therefore, the owner makes temporary arrangements to handle the increase in demand. In this case, the problem is easily taken care of as the outcome is anticipated. It is assumed that the online store does the same level of business every year.

To understand the structural business cycles, let’s add an assumption to our earlier example that the online store generates in its ordinary course. In this case, it will still see seasonal spurts in sales, but the business lows will also move up because the business is growing.

Here, the “growth” is the structural change in the business, which is why the chart does not look as linear as it looks in the seasonal business cycles. The business expands and contracts, but the overall growth trend remains intact and keeps raising the graph. 

We can further this economic concept of business cycles to the economy as well. Economies also see such cycles of rapid growth followed by moderations – sometimes severe and sometimes not-so-severe. 

However, the economic cycles are much longer, ranging from a couple of years to decades. Such periods of rapid growth in an economy are led by increased investments, a reformist government, and breakthrough technologies and discoveries. The cycle peaks at some point when businesses build excesses, and the base gets larger. It then starts moderating and declining, sometimes even going into the negative territory based on how badly the economic activity was impacted.

In an expansionary economic phase, the country’s GDP growth accelerates, inflation increases, and unemployment plummets. In addition, the growth in GDP leads to higher income for workers, which results in demand-pull inflation as more money starts chasing limited goods and services. 

During contraction, the GDP growth decelerates (sometimes hitting negative territory), unemployment increases, and inflation declines. As more workers are out of jobs and wage growth is stable, people spend less, which brings down inflation. In severe contractions, when the economy registers negative GDP growth for two consecutive quarters, the economy is in a recession. 

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.