Governments aim to grow the economy, keep employment high and prices stable. The economy is what enables individuals to have goods and services, which includes housing, food and recreational activities.
Economic Indicators
There are many indicators that point to the state of an economy. These can be categorised into three indicators:
Coincident indicator: show the current state
Leading: changes that pre-empt a future trend, usually 3-12 months. If a leading indicator increases this suggests the economy will grow, and the same is true in reverse. For example, assessing building permits, manufacturing hours worked and any recent unemployment claims. If building permits have declined, manufacturing hours are down and unemployment claims are up this suggests the economy is likely to shrink in the future.
Lagging: changes that follow a trend. For example, the average length of unemployment. If this is long then this might indicate the economy is shrinking.
Gross Domestic Product (GDP)
One example of a coincident indicator is the Gross domestic product (GDP). This is often used to demonstrate how well the UK economy is doing. UK GDP represents the total value of all goods and services produced in the UK in a given year.
There are different ways of calculating GDP.
Income approach: add up the total income of firms, households and the government
Expenditure approach: add up the costs of goods and services individuals use (consumption), any investment in the economy, government acquisitions (for example construction or the army) and net exports (total value of exports minus total value of imports).
If GDP increases then the economy is growing, if it decreases then the economy is shrinking.
There are four main factors affecting GDP:
Households
Companies
Government
International market
Money moves through these four players in a circular manner. The diagram shows how this occurs:
Economic Cycles
Economics go through cycles, there are periods where they grow (expansion) and get smaller (contraction). These periods of expansion and contraction define the business cycles, which usually take 3-5 years.
When an economy is contracting it is in recession and when it expands it is in recovery. You might have heard of the boom / bust cycle which economies go through. At the height of the boom or the peak, which is the highest point in the business cycle this also signals that a recession will occur soon. The same is true in reverse; at the trough of bottom of the business cycle it signals the economy will start to recover. There are four stages:
Recession
Full recession or depression
Recovery
Prosperity or full recovery
There are different indicators at different points in the cycle. During prosperity when the economy is expanding, the employment rate is high, incomes rise and individuals purchase more products and services. This gives more tax to the government and companies also take advantage by buying more raw material, producing more items and bringing them to market. This all causes an increase in GDP.
When there is a recession, the opposite occurs. The unemployment rate increases, and people have less disposable income so businesses have lower revenue. A recession is often defined when GDP declines for two quarters in a row.
Sometimes the depression stage is skipped, this is where the economy has been in recession for a reasonable length of time. There are actions the government can take to stimulate the growth of the economy when it is in a recession and unemployment is higher to bring it into recovery sooner. These include:
Increasing spending, for example on construction to create jobs
Decreasing interest rates, to make it cheaper for individuals and companies to borrow money for loans or mortgages
Lowering taxes, so individuals and companies have more disposable income to spend on services and products
Reducing regulations, so it is easier to create and grow businesses
Employment
The rate of employment is a key measure for the health of the economy. The labour force includes the total population who are able to work. The employed means people who are working and the unemployed means people who aren’t working but have been actively seeking within the last four weeks. The way the unemployment rate is calculated is the unemployed divided by the labour force multiplied by 100.
For people who are not actively searching for a job, aka outside the 4-week window but who are able to work are called discouraged workers. They are also excluded from the labour force, which only includes active job seekers.
There are different types of unemployment:
·Cyclical: occurs due to the bust cycle in the economy – when there is a recession
Frictional: occurs due to the length of time it takes to find employment
Seasonal: occurs when jobs are only available for certain seasons, for example fruit picking
Structural: occurs when there is a skills gap between a job applicant and the job
When an economy is growing and there is no cyclical unemployment it is said to be at full employment, usually at roughly 95%. Creating jobs is crucial to grow the economy as individuals spending on goods and services is a key factor in GDP. Jobs enable individuals to do this therefore governments aim to have as high employment rates as possible and to ensure there are jobs for everyone who wants one.
In a recession companies are reluctant to hire or may lay off staff as demand for their services and goods decreases. Similarly, consumer confidence is lower and individuals may be less likely to spend money as they might be worried about the market, for example being made redundant. Consumer confidence surveys are carried out regularly to assess what individuals plan to buy in the future and their view of the economy. It is another leading indicator, as nervous consumers tend not to purchase or purchase cheaper goods.
Consumer Price Index (CPI)
The Consumer price index (CPI) takes the average household and establishes the cost of purchasing regular goods. This could include food, housing, clothing, transport etc. This is calculated on an annual basis. The increase in cost between purchasing these goods one year to the next is used to work out the rate of inflation. This is essentially the percentage change in how much it costs to purchase the same goods. For example, in 1980 the cost of purchasing typical items was a lot lower than the same goods would cost in 2021. The rate of inflation is seen as a key indicator on the health of the economy. Generally, some inflation is seen as good, roughly 2% to encourage individuals to purchase goods and services. However, if it increases too quickly this is seen as the economy starting to struggle, as prices are increasing indicating that demand is higher than supply. There are debates on how much inflation is ideal for an economy and what a change in interest rate means.
To sum up
Overall, there are many factors impacting an economy, the tracking of these can indicate the health of it. Being aware of the business cycles and leading indicators can also help you know what might be happening with the economy, and also some indication of how your investments might perform.