Photo by: Kheng Guan Toh
Economic conditions can be considered the economic characteristics that describe the state of an economy. Often, people comment that the economy is in terrible shape, that the economy is doing well, or that the economy is inherently sound. All such statements are based on certain characteristics of the economy that the issuer of the statement has in mind.
There are a large number of variables or characteristics used to gauge the health of an economy, with four of them usually referred to as the key macroeconomic variables: aggregate output or income, the unemployment rate, the inflation rate, and the interest rate. There are, however, numerous additional measures or variables that are collected and used to understand the behavior of an economy. In the United States, for example, additional measures include: the index of leading economic indicators (which gives an idea where the economy is headed in the near future); retail sales (which indicate the strength of consumer demand in the economy); factory orders, especially for big ticket items (which indicate the future growth in output, since the orders will have to be filled); housing starts (robust increase in housing starts are usually taken as a sign of good growth in the future); the consumer confidence index (which indicates how likely consumers are to make favorable decisions to buy both durable and nondurable goods, services, and homes). Other variables tracked are more innocuous than the ones included in the preceding list, such as: aluminum production, steel production, paper and paperboard production, industrial production, hourly earnings, weekly earnings, factory shipments, orders for durable goods, new factory orders, new-home sales, existing-home sales, business inventories, initial jobless claims, help-wanted advertising, purchasing manager's survey, and the foreign trade deficit.
An economy's overall economic activity is summarized by a measure of aggregate output. Since the production or output of goods and services generates income, any aggregate output measure is closely associated with an aggregate income measure. The United States uses an aggregate output concept known as the gross domestic product (GDP). The GDP is a measure of all currently produced goods and services valued at market prices. One should notice several features of the GDP measure. First, only currently produced goods (produced during the relevant year) are included. This means that if you buy a 150-year old classic Tudor house, it does not count towards the GDP, but the service rendered by your real estate agent in the process of buying the house does. Secondly, only final goods and services are counted. In order to avoid double counting, intermediate goods used in the production of other goods and services do not enter the GDP. For example, steel used in the production of automobiles is not valued separately. Finally, all goods and services included in the GDP are evaluated at market prices. Thus, these prices reflect the prices consumers pay at the retail level, including indirect taxes such as local sales taxes.
A measure similar to GDP is the gross national product (GNP). Until recently, the government used the GNP as the main measure of the nation's economic activity. The difference between GNP and GDP is rather small. The GDP excludes incomes earned abroad by U.S. firms and residents and includes earnings of foreign firms and residents in the United States. Several other measures of output and income are derived from the GNP. These include the net national product (NNP), which subtracts from the GNP an allowance for wear and tear on plants and equipment, known as depreciation; the national income, which mainly subtracts indirect taxes from the NNP; the personal income (measures the income received by persons from all sources, and is arrived at by subtracting from the national income such items as corporate profit tax payments and social security contributions that individuals do not receive, and adding such items as transfer payments that individuals do receive but are not part of the national income); and the personal disposable income (which subtracts personal tax payments such as income taxes from the personal income measure). While all these measures move up and down in a related manner, it is personal disposable income that is intimately tied to consumer demand for goods and services, the most dominant component of aggregate demand.
It should be noted that the aggregate income/output measures discussed above are usually quoted both in current prices (in "nominal" terms) and in constant dollars (in "real" terms). The latter are adjusted for inflation and are thus most widely used since they are not subject to distortions introduced by changes in prices.
When is the economy considered to be in good shape? Of course, zero growth in the real gross domestic product (a stagnant economy) or negative growth in the real GDP (a shrinking or a recessionary economy) is not a good reflection on the economy. Positive growth is considered desirable. Whether or not a given positive growth rate is good enough, however, depends on whether it can be sustained without generating serious inflationary pressures. Once an economy reaches full employment, a 3 percent rise in the real GDP is considered sustainable on a long-term basis—higher rates are considered inflationary. Nevertheless, when an economy is coming out of a recession, a growth rate of more than 3 percent may not generate a serious inflationary pressure due to unemployed resources. Thus, how well an economy is doing in terms of real GDP growth should be judged on the basis of the 3-percent benchmark, with appropriate upward adjustment for slack in the economy.
The level of employment is the next crucial macroeconomic variable. The employment level is often quoted in terms of the unemployment rate, defined as the fraction of labor force not working (but actively seeking employment). Contrary to what one may expect, the labor force does not consist of all able-bodied persons of working age. Instead, it is defined as consisting of those working and those not working but seeking work. Thus, the labor force as defined leaves out people who are not working but also not seeking work—termed by economists as being voluntarily unemployed. For purposes of government macroeconomic policies, only people who are involuntarily unemployed really matter when calculating the unemployment rate.
For various reasons, it is not possible to bring down the unemployment rate to zero in the best of circumstances. Realistically, economists expect a fraction of the labor force to be unemployed at all times—this fraction for the U.S. labor market has been estimated to be 6 percent. The 6-percent unemployment rate is often referred to as the bench mark unemployment rate. In effect, at 6 percent unemployment, the economy is considered to be at full employment.
Whether or not the economy is doing well in terms of the unemployment rate depends on how far this rate is above the 6-percent benchmark. If the economy has an unemployment rate around 6 percent, it is said to be doing well. Higher unemployment rates reflect worse economic conditions. During the Bush recession, the unemployment rate peaked at 7.7 percent; during the Reagan recession, it peaked at 9.7 percent; and during the Great Depression, it reached more than 25 percent.
The third key macroeconomic variable is inflation. The inflation rate is defined as the rate of change in the price level. Most economies face positive rates of inflation year after year. The price level, in turn, is measured by a price index, which measures the level of prices of goods and services at a point in time. The number of items included in a price index varies depending on the objective of the index. Government agencies periodically report three kinds of price indexes, each having their particular advantages and uses. The first index is called the consumer price index (CPI); it measures the average retail prices paid by consumers for goods and services bought by them. A couple thousand items, typically bought by average households, are included in this index.
A second price index used to measure the inflation rate is called the producer price index (PPI). It is a much broader measure than the consumer price index. The PPI measures the wholesale prices of approximately 3,000 items. The items included in this index are those that are typically used by producers (manufacturers and businesses) and thus include many raw materials and semifinished goods. The third measure of inflation is the called the implicit GDP price deflator. This index measures the prices of all goods and services included in the calculation of the current GDP. It is the broadest measure of price level.
The three measures of the inflation rate are most likely to move in the same direction, even though not to the same extent. Differences can arise due to the differing number of goods and services included in compiling the three indexes. In general, if one hears about the inflation rate in the popular media, it is most likely to be the one based on the CPI.
Zero percent inflation may appear ideal, but it is neither practical nor desirable. A moderate rate of inflation—1-2 percent—is considered desirable by a vast majority of economists. An inflation rate of up to 5 percent is tolerable. Double-digit inflation rates, however, are definitely considered undesirable by most economists.
The concept of interest rates used by economists is the same as that used widely by other people. The interest rate is invariably quoted in nominal terms—that is, the rate is not adjusted for inflation. Thus, the commonly followed interest rate is actually the nominal interest rate. Nevertheless, there are literally hundreds of nominal interest rates, including: savings account rate, six-month certificate of deposit rate, 15-year mortgage rate, variable mortgage rate, 30-year Treasury bond rate, 10-year General Motors bond rate, and the commercial bank prime-lending rate. One can see from these examples that the nominal interest rate has two key attributes—the duration of lending/borrowing involved and the identity of the borrower.
Fortunately, while the hundreds of interest rates that one encounters may appear baffling, they are closely linked to each other. Two characteristics that account for this linkage are the risk worthiness of the borrower and the maturity of the loan involved. So, for example, the interest rate on a 6-month Treasury bill is related to that on a 30-year Treasury bond, as bonds/loans of different maturities command different rates. Also, a 30-year General Motors bond will carry a higher interest rate than a 30-year Treasury bond, as a General Motors bond is riskier than a Treasury bond.
Finally, one should note that the nominal interest rate does not represent the real cost of borrowing or the real return on lending. To understand the real cost or return, one must consider the inflation-adjusted nominal rate, called the real interest rate. Tax and other considerations also influence the real cost/return. But the real interest rate is a very important concept in understanding the main incentives behind borrowing or lending.
The desirable level of the nominal interest rate is linked to the desirable level of the inflation rate. If we consider that an inflation rate of 1-2 percent is desirable, then the short-term nominal interest rate will lie in the 4-5 percent range (assuming a real interest rate of 3 percent).
There are a number of economic variables that are used to project or forecast future economic conditions. There exist theoretical as well as empirical reasons why economists believe that certain variables are harbingers of future economic activities. Some of the variables often used by economists and policy makers to gauge future economic conditions are briefly described below.
Changes in the number of houses being built (simply referred to as housing starts) have an important implication for the direction in which the economy is headed. Notice first that houses are bulky items involving large sums of money—in fact, in the United States, a home is considered an individual's biggest investment. Thus, potentially, housing starts can either lead to a powerful expansion in the economy (by augmenting the aggregate demand) or a serious downturn (by reducing the aggregate demand), depending on the direction and the magnitude of the change in housing starts. Housing starts project the future state of the economy for two main reasons. First, once construction on a house starts it will, most likely, be completed. Thus, work on a "started house" will continue for several months. Second, once the new house is completed, the first occupant of the newly completed house may need to buy additional items (such as a refrigerator, washer, or dryer) to make the house comfortable. This provides a secondary (and, generally, quite large) push to the aggregate demand for goods and services in the economy. Because of these reasons, housing starts are routinely used by economists and participants in financial markets to gauge the future direction of the economy.
Building permits indicate the intention of builders to start building new homes and buildings. Thus, the number of building permits issued today tells us something about the number of housing starts in the near future, with the usual implications for changes in output and employment. If the number of building permits issued is rising, it bodes well for future economic growth. A falling number of building permits issued, on the other hand, has the opposite implication.
Building permits, by nature, can project future economic conditions even further than housing starts, since a building permit must be obtained before construction on a house begins. Nevertheless, one should notice that building permits are far less potent in projecting future growth than housing starts. Although houses started are normally completed, a building permit obtained does not imply that a house will necessarily be built—a change in circumstances can force the builders to defer or scrap building plans.
New factory orders indicate new orders for goods by retail outlets or other businesses. An increase in these orders will generally lead manufacturers to increase production of the items ordered. Thus, an increase in new factory orders is a precursor to an increase in output and employment in the economy. A fall in factory orders will have the opposite effect.
While looking at new factory orders, economists particularly concentrate on big ticket items, items that involve relatively large sums of money. Big-ticket items can be consumer goods, such as automobiles, washers, or dryers, or capital goods, such as machines and equipment. An increase in orders for big-ticket items provides a big forward push to the economy not only because these items have to be produced, but also because they can generate secondary demands for raw materials. For example, an increase in automobile production would necessarily increase the demand for steel, causing steel production to go up as well.
Businesses maintain certain levels of inventories to meet unexpected product demand—economists often refer to businesses' usual inventory levels as normal levels of inventories. When firms stock up on inventories, output and employment rise. Rising or falling inventories serve to indicate the future direction of output and employment as well. This can be explained as follows. Suppose that business inventories rise far above the normal level because firms are unable to sell the current output of goods. Businesses have only one sure cure to trim the piling inventories—cut future production. Thus, a rise in inventories can often be precursor to a decline in output and employment in the next period. The opposite is true when business inventories fall far below the normal level. To replenish inventories, manufacturers must increase production in the near future, spurring economic growth and lowering the unemployment rate.
The consumer confidence index is an index that attempts to measure the level of consumer confidence. This index is based on a survey of consumers regarding their outlook. An increase in the consumer confidence index implies that consumers feel more confident about the economy and their own economic well-being. A rise in the consumer confidence index is most likely to lead to an increase in consumer spending, increasing the level of aggregate demand. This, in turn, implies that output and employment will increase in the near future. By contrast, decline in the consumer confidence index will most likely lead to a decline in output and employment.
The index of leading indicators combines several factors that are considered useful in indicating the future course of the economy. In the United States, the index of leading economic indicators (often abbreviated as the LEI) is based on about a dozen economic series that are deemed capable of forecasting future economic activities. Some of the important leading variables included in the construction of the LEI are: new orders for durable goods, average workweek, building permits, stock prices, certain wholesale prices, and claims for unemployment insurance.
If the index of leading indicators keeps increasing, then economists take this as a sign that the economy will keep expanding (if it is already growing) or that it will start expanding (if the economy is in a recession or if it is experiencing stagnation). The opposite is the case if the index starts to decline. In that case, economists take this as a warning sign that the economy will slow down or even dip into a recession (if the economy is growing) or that the downturn will become worse (if the economy is facing a recession or stagnation).
While changes in the index of leading indicators have been successful in forecasting future economic activity, the LEI has failed several times in the past to live up to its predictions about the future of the U.S. economy.
As is apparent from the preceding discussion, economists and financial observers use observations on numerous economic variables to understand the behavior of an economy. However, the four key macroeconomic variables—aggregate output measure, the unemployment rate, the inflation rate, and the interest rate—do summarize the most important characteristics of a macroeconomy. These four variables can be reduced to an even smaller group because they are related.
Notice that if the real gross domestic output goes up, employment will go up sooner or later. Producers may first request overtime from existing workers if they are not sure whether the increased level of output can be maintained in the future. But as soon as they feel reasonably sure that the increased output level is relatively permanent, they will hire additional permanent workers. This will raise the level of employment of the labor force in the economy and will, in general, reduce the unemployment rate. Thus, the aggregate output measure and the unemployment rate variable go hand in hand. Either will suffice to convey roughly the same information about economic conditions in the economy. Of the two, it is has been customary to use the unemployment rate because it is more readily understood than a measure of aggregate output such as GDP.
Similarly, the nominal interest rate and the inflation rate are linked. If the inflation rate goes up, so does the nominal interest rate. This is because people care about the real interest rate (the interest rate adjusted for the inflation rate). Thus, if the inflation rate goes up, the real value of a given nominal interest rate declines. As a result, savers require higher nominal interest rates in order to be compensated for the higher inflation rate. Usually, the difference between the nominal interest rate and the inflation rate is 3 percent—a level at which lenders feel comfortable lending. Thus, the nominal interest rate and the inflation rate also go hand in hand. Out of these two variables, it has been customary to use the inflation rate to describe economic conditions because the public readily understands it.
Thus, the minimum number of characteristics used to describe economic conditions are two: the unemployment rate and the inflation rate. They both have negative connotations—neither a higher unemployment rate nor a higher inflation rate is considered desirable. Even reporting information on these two variables gets a little complicated as it is widely believed that there is a trade-off between the unemployment rate and the inflation rate. That is, macroeconomic policy makers can follow an economic policy that may lower one rate while increasing the other. Thus, an expansionary monetary policy may reduce the unemployment rate by increasing the aggregate demand in the economy—due to a lower interest rate, consumers are able to finance additional spending through borrowing, and businesses are able to invest more as the cost of borrowing goes down. The upward pressure on aggregate demand, however, also places upward pressure on the price level, raising the inflation rate.
Because of the above mentioned trade-off, it is desirable to examine information on both the unemployment rate and the inflation rate to better understand the economic conditions in the economy. Sometimes, these two variables are combined, in an attempt to give a better picture than when unemployment and inflation rates are looked at separately. The sum of the unemployment rate and the inflation rate has been dubbed as the misery index. The adjective "misery" alludes to the negative connotations associated with the unemployment and inflation rates. Adding them together takes care of the trade-off—one rate may go up and the second may go down, but the misery index captures both. Thus, the higher the value of the misery index, the worse are the overall economic conditions. One must, however, realize that the use of a single broad concept such as the misery index is probably not adequate to describe economic conditions properly. At the bare minimum, one should use the unemployment rate and the inflation rate separately to summarize the economic conditions of an economy.
[ Anandi P Sahu , Ph.D. ]
Froyen, Richard T. Macroeconomics: Theories and Policies. 6th ed. Prentice Hall, 1998.
Gordon, Robert J. Macroeconomics, 7th ed. Addison-Wesley, 1998.
Sommers, Albert T. U.S. Economy Demystified. Lexington Books, 1985.