1.3: Systemic or "Macro" Factors That Affect Financial Thinking

Learning Objectives

1. Identify the systemic or macro factors that affect personal financial planning.
2. Describe the impact of inflation or deflation on disposable income.
3. Describe the effect of rising unemployment on disposable income.
4. Explain how economic indicators can have an impact on personal finances.

Financial planning must take into account the broader economic conditions and the markets that comprise them. The labor market, the capital market (which encompasses both cash and assets), and the credit market (where capital is loaned and borrowed) exist within a dynamic economic environment. Considering those dynamics and environmental realities is part of sound financial planning.

Business Cycles

An economy tends to be productive enough to meet the needs of its members. Typically, economic output increases as the population grows or people's expectations rise. An economy's output or productivity is measured by its Gross Domestic Product (GDP), which represents the value of goods and services produced within a specific period. When the GDP increases, the economy is expanding, and when it decreases, the economy is contracting. An economy that contracts for half a year is said to be in recession; a prolonged recession is a depression. The GDP is a closely watched barometer of the economy (see Figure 1.3.1 ).

Figure 1.3.1 : GDP Percent Change^[1]

The economy tends to be cyclical, usually expanding but sometimes contracting. This is called the business cycle. Periods of contraction are generally seen as market corrections or the market regaining its equilibrium after periods of growth. Growth is never perfectly smooth, so certain markets may become unbalanced and require self-correction. Over time, the periods of contraction seem to have become less frequent, as you can see in Figure 1.4. The business cycles still occur, nevertheless.

There are many metaphors to describe the cyclical nature of market economies, including "peaks and troughs," "boom and bust," "growth and contraction," and "expansion and correction," among others. While each cycle is born in a unique combination of circumstances, cycles occur because things change and upset economic equilibrium. Events alter the balance between supply and demand in the economy as a whole. Sometimes demand grows too quickly, and supply can't keep up; at other times, supply grows too quickly for demand. There are many reasons that this could happen, but whatever the reasons, buyers and sellers react to this imbalance, which then creates a change.

Employment Rate

An economy produces goods and services to meet the needs of its members and provides employment opportunities for its citizens. Most people participate in the market economy by trading their labor, and most rely on wages as their primary source of income. Therefore, the economy must provide opportunities for people to earn wages, allowing more individuals to participate in the market. Otherwise, more people must be provided for in some other way, such as through a private or public subsidy (e.g., charity or welfare).

Unemployment also suggests that the economy is not efficient, as it cannot utilize all its productive human resources effectively. The employment rate, also known as the labor force participation rate, measures an economy's effectiveness in creating opportunities for labor and utilizing its human resources efficiently. A healthy market economy uses its labor productively, is productive, and provides employment opportunities and consumer satisfaction through its markets. Table 1.3.2 shows the relationship between GDP and unemployment during each stage of the business cycle.

Table 1.3.2 : Cyclical Economic Effects

	Boom	Expansion	Recession	Depression
Rate of GDP Increase	Unsustainably High	Positive	Negative	Unsustainably Low
Rate of Unemployment	Unsustainably Low	"Natural" or Minimal	Higher	Unsustainably High

At either end of this growth scale, the economy is in an unsustainable position: it is either growing too fast, with excessive demand for labor, or shrinking, with insufficient demand for labor.

If there is too much demand for labor (with more jobs than workers to fill them), wages will rise, which in turn will push up the cost of everything and cause prices to increase. Prices typically rise faster than wages for several reasons. Higher prices discourage consumption, and lower consumption in turn discourages production, causing the economy to slow down from its "boom" condition into a more manageable growth rate.

If there is too little demand for labor (with more workers than jobs), wages will fall or, more typically, there will be people without jobs (unemployment). If wages become low enough, employers will theoretically be encouraged to hire more labor, thereby raising employment levels. However, it doesn't always work that way, because people have job mobility; they are willing and able to move between economies to seek employment.

If unemployment is high and prolonged, then too many people will be without wages for too long and unable to participate in the economy because they have nothing to trade. In that case, the market economy is not working for too many people, and they will eventually demand a change. This is how most revolutions start.

Other Indicators of Economic Health

Other economic indicators give us clues as to how "successful" our economy is, how well it is growing, or how well positioned it is for future growth. These indicators include statistics such as the number of houses being built or existing home sales, orders for durable goods (e.g., appliances and automobiles), consumer confidence, producer prices, and others. However, GDP growth and unemployment are the two most closely watched indicators, because they get at the heart of what our economy is supposed to accomplish: to provide diverse opportunities for the most people to participate in the economy, to create jobs, and to satisfy the consumption needs of the most people by enabling them to get what they want.

An expanding and healthy economy will offer more choices to participants trading labor and capital. It will offer more opportunities to earn a return or income, and, therefore, offers more diversification and less risk.

Everyone would prefer to operate in a healthy economy, but this is not always possible. Financial planning encompasses preparing for the risk that economic factors may impact financial realities. A recession may increase unemployment, lowering the return on labor (wages) or making it harder to anticipate an income increase. Wage income could be lost altogether. A temporary, involuntary loss of wage income is likely to occur for most people at some point in life, as everyone inevitably experiences economic cycles.

Currency Value

Stable currency value is another important indicator of a healthy economy and a critical element in financial planning. Like anything else, the value of a currency is based on its usefulness. We use currency as a medium of exchange, so the value of a currency is based on how it can be used in trade, which in turn is based on what is produced in the economy. If an economy produces little that anyone wants, then its currency has little value relative to other currencies, because there is little use for it in trade. So a currency's value indicates how productive an economy is.

A currency's usefulness is based on what it can buy, or its purchasing power. The more a currency can buy, the more useful and valuable it is. When prices rise or things cost more, purchasing power decreases; the currency buys less and its value decreases.

When the value of a currency decreases, it indicates inflation in an economy. Its currency has less value because it is less useful. After all, less can be bought with it. Prices rise, and it takes more currency to buy the same amount of goods. When the value of a currency increases, on the other hand, an economy has deflation. Prices are falling; the currency is worth more and buys more.

If there is deflation, prices fall, so maybe a year later, you could buy ten video games with $20. Then, each game will cost only $2, and each dollar buys half a game. The same amount of currency buys more games: Its purchasing power has increased, as has its usefulness and its value (Figure 1.3.3 ).

Table 1.3.3 : Dynamics of Currency Value

	Inflation	Deflation
Prices	Rise	Fall
Purchasing Power	Decreases	Increases
Currency Value	Falls	Rises

Inflation is most commonly measured by the Consumer Price Index (CPI), an index created and tracked by the federal government. It measures the average nationwide prices of a "basket" of goods and services purchased by the average consumer. It is an accepted method of tracking rising or falling price levels, which are indicative of inflation or deflation. Figure 1.3.4 shows the percentage change in the Consumer Price Index as a measure of inflation from 1965 to 2020.

Figure 1.3.4 : Inflation, 1965-2020.^[2]

Currency instabilities can also affect investment values, because the dollars that investments return don't have the same value as the dollars that the investment was expected to return. Say you lend $100 to your sister, who plans to pay you back one year from now. There is inflation, so over the next year, the value of the dollar decreases (it buys less as prices rise). Your sister pays you back on time, but now the $100 she gives back to you is worth less (because it now buys less) than the $100 you gave her. Your investment, although nominally returned, has lost value: You have your $100 back, but you can't do as much with it; it is less useful.

If the currency value - the units in which wealth is measured and stored - is unstable, then investment returns are more complex to predict. Under such circumstances, investment involves greater risk. Both inflation and deflation are currency instabilities that are troublesome for an economy and the financial planning process. An unstable currency affects the value of income purchasing power. Price changes affect consumption decisions, while changes in currency value impact investment decisions.

It is human nature to assume that things will stay the same, but financial planning must include the assumption that you will encounter and endure economic cycles throughout your life. You should try to anticipate the risks of an economic downturn and the possible loss of wage income and/or investment income. At the same time, you should not assume or rely on the windfalls of an economic expansion.

Summary

• Business cycles include periods of expansion and contraction (including recessions), as measured by the economy's productivity (gross domestic product).
• An economy is in an unsustainable situation when it grows too quickly or too slowly; each situation causes stress in the economy's markets.
• In addition to GDP, measures of the health of an economy include
  • rates of employment and unemployment
  • currency value (the consumer price index)
• Financial planning should consider that periods of inflation or deflation change the currency value, affecting purchasing power and investment values.
• Thus, personal financial planning should take into account changes in
  • business cycles
  • the economy's productivity
  • the currency value
  • other economic indicators

Exercises

1. Review the Business Cycle Dating chart published by the National Bureau of Economic Research (www.nber.org/research/business-cycle-dating). The chart illustrates the business cycles in the United States, along with their durations, starting in 1948. What patterns and trends do you see in these historical data? Which years saw the longest recessions? How can you tell that the U.S. economy has tended to become more stable over the decades?
2. Record in your financial journal the macroeconomic factors influencing your financial thinking and behavior today. What are some specific examples? How have large-scale economic changes or cycles, such as the pandemic or high inflation of 2022-2024, affected your financial planning and decision-making?
3. How does the health of the economy affect your financial health? How healthy is the U.S. economy right now? On what measures do you base your judgments? How will your appreciation of the big picture help you plan for your future?
4. How do business cycles and the economic health affect the value of your labor? In terms of supply and demand, what are the optimal conditions for selling your labor? How might further education increase your mobility in the labor market (the value of your labor)?
5. Consider effective personal financial strategies for
   • protecting against recession
   • hedging against inflation
   • mitigating the effects of deflation
   • taking realistic advantage of periods of expansion

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^[1] Based on data from the Bureau of Economic Analysis, U.S. Department of Commerce, St. Louis Fed. fred.stlouisfed.org/series/A191RL1Q225SBEA#.

^[2] Based on data from the World Bank, U.S. Inflation 1965 - 2020. fred.stlouisfed.org/series/FPCPITOTLZGUSA#.