From GDP to inflation: Understanding economic basics

There is a wealth of economic news out there, from in-depth reports on individual companies to analysis of political developments and investment recommendations, and much of it involves complex terms and unusual acronyms. While most of us have a rough idea about the meaning or the seriousness of some of these concepts, we are often a little fuzzy about the details.

So, whether you want to know what causes inflation or how GDP is calculated, we’ve put together explanations of three of the main economic concepts that are most commonly used and that will help you to keep up with the economic and financial news.

Gross domestic product

You’ve almost certainly heard of gross domestic product or GDP as it is usually known. You may also have a vague idea that it has something to do with the size of a nation’s economy, and you’d be right.

GDP is often used as a tool for quick comparisons between nations, although the most common use of the GDP figure is to assess whether a nation’s GDP is growing or falling, with rises in GDP associated with a healthy economy and falling GDP indicating the opposite.

So how is it calculated? Different nations have their own processes, but in the US, the Bureau of Labor Statistics collates the figures, which are analyzed by the Bureau of Economic Analysis and turned into a GDP figure. GDP essentially represents a snapshot of the value of goods and services across the entire economy during one period of time, which is usually a quarter.

GDP is often converted to net domestic product (NDP) by accounting for the effect of inflation between time periods. This makes it possible to compare the GDP from different periods and identify decreases or increases. The bigger the GDP, the bigger the economy. Faster rates of growth indicate economic health, although as with most metrics, GDP gives you a broad picture not a detailed analysis.

Interest rates

Interest rates represent the cost of borrowing. They are usually set by a central bank, such as the Federal Reserve, and are used as an economic tool to control the national economy. They set the national interest rate, which in the US is the Federal Funds Rate. This tells banks and other economic institutions the rough price at which they should lend money.

Increasing interest rates makes borrowing less attractive, while a decrease has the opposite effect. When a fast-growing economy is in danger of creating a ‘bubble’ — in which price increases are far in excess of the value of assets — the Federal Reserve may increase interest rates. When the economy is slowing down, a cut in the rate is often used to encourage more borrowing and spending.

Interest rates can also be seen as the ‘price’ of a currency, so when the Federal Reserve raises the rate, outside lenders are keener to lend money in USD, and the value of the currency rises.

Inflation

If interest rates are the main tool used to control the economy, then inflation, along with GDP, is one of the two key measures economists use to assess economic conditions.

Inflation is the increase in the price of goods and services that occurs over time. The rate of inflation indicates how quickly prices are increasing. It is measured by taking a representative sample of prices of goods and services from across the whole economy, which is known in the US as the Consumer Price Index. These figures are published every month.

Generally, a small amount of inflation is considered ideal for the economy. However, when interest rates increase significantly, it can have major economic implications. Wage increases for employees, which are set annually, usually lag behind inflation, so rising inflation can leave some households struggling to pay their bills as their purchasing power declines. The increasing cost of materials can also impact businesses at every point of the supply change and impact profitability.

If inflation rises unchecked, it can eventually become hyperinflation. This is when inflation is out of control, and prices are spiraling upwards rapidly. In this scenario, a nation’s currency becomes increasingly worthless and investors scramble to switch to other currencies. If inflation heads the other way and prices start to fall rather than rise, that is known as deflation, which can also have severe economic impacts.

Summary

Economics can be a highly technical and complicated subject, but you don’t need to be an expert to be able to correctly read the main economic indicators. By understanding the fundamentals of concepts such as GDP and inflation, you will be better placed to make wise financial decisions.