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PERSONAL FINANCE
CH 1 OBJECTIVE 3
I.
Understanding the Economic Environment of Personal Finance
a. Economy: a system of managing the productive and
employment resources of a country, community, or business.
b. The economy is the arena in which your investments will
perform.
c. It is the financial “real world.”
d. Inflation: a steady rise in the general level of prices.
e. Deflation: a falling of prices.
II.
The State of the Economy
a. Economic growth: a condition of increasing production and
consumption in the economy, which increases national income.
b. Business cycle (economic cycle): a wavelike pattern of
economic activity that includes temporary phases that undulate
from boom to bust
i. Whole cycle usually takes about 3 to 4 years.
c. Expansion phase: this is where we want to be. Production is
high, little unemployment, retail sales are high, and inflation
and interest rates are falling.
i. It is easy to get credit during expansion
ii. Buying homes and cars is easy because interest rates are
down.
iii. This is where we are right now and have been for a
couple of years.
d. Recession: a decline in business activity or a downturn in the
economy.
i. Usually lasts about 6 months and characterized by
contractions in different sectors of the economy.
ii. Consumers are hesitant to buy goods and services that
aren’t needed.
e. GDP (Gross Domestic Product): the value of all goods and
services produced by workers and capital located in the US.
i. It is an indicator of the state of the economy.
ii. Below 2% is considered low.
iii. Greater than 4% is considered vigorous growth.
III.
How Inflation Affects Income and Consumption
a. Inflation: a steady rise in the general level of prices.
i. It is measured by seeing what the change in prices is of a
standard “market basket” of goods and services a typical
household would use.
ii. When the money supply is higher than the supply of the
goods and services.
1. This surplus of goods is usually because of high
demand or because the cost of production is high.
2. During high inflation, the purchasing power of the
dollar declines.
3. Fixed incomes suffer the most. (elderly/SS money)
iii. Purchasing power: a measure of the goods and services
that one’s income will buy.
1. Your income must increase with the rate of
inflation to keep the purchasing power of your
money the same. (see example on p. 7 and 8)
2. Real income: reflects the actual buying power of
your current dollars (money or nominal income).
3. If your real income increases as inflation does, the
illusion that you have more money at your disposal
is created. (see example on p. 8 and 9)
IV.
How Inflation Affects Borrowing, Savings, and Investments
a. When inflation is low, there is more money out there to lend
and interest rates are low.
b. Interest rate: the price you pay to borrow money.
c. Investments do better during low inflation because people are
spending money on investing; thus driving stock prices up.
d. To project inflation issues the best weapon is knowledge
i. Pay attention to financial news
ii. What is the Federal Reserve doing with interest rates?
iii. Look at what Congress and the President are doing.
e. Inflation MUST be considered when planning long and shortterm investments.
i. Assume inflation to the high side when planning.
f. High interest rates will decrease stock prices:
i. This is a major indicator of how the stock market will
react to higher interest rates.
ii. Companies will have higher payments on their debts;
higher expenses for the company = lower earnings
iii. Future earnings will not be as high in the future as they
are today.
iv. Investors will invest in interest paying investments such
as money markets, cd’s, and bonds because interest rates
are higher.
g. Federal Funds Rate: this is the rate the Fed charges normal
banks to borrow money. They then turn around and lend it to
us at a slightly higher rate (the bank’s mark up).
i. If the Federal Funds Rate goes down, so will the rate
your bank charges to lend you money for a house or car.