Economic Psychology and Indicators

Economy Series - Part 1

What do we mean by economics?

Economics is a term that is widely used for substituting a variety of terms. In this article, we focus on two widely used meanings of the word ‘Economy’. ‘Economy of State’ is commonly used to define the capacity of a region in terms of production and consumption of goods and services and the supply of money. While ‘Economy of Person’ or ‘Personal Economy’ deals with this capacity on an individual basis.
The reason we need to discuss these two economies is that one relies on the other to survive and thrive. Now, since we have divided the concept into two parts, let’s delve into the second part of the topic.

‘Psychology’ a science that is to date understood the least in connection with humans and yet attached to every aspect of human life and every action they take. Psychology is defined as the study of the human mind and its functions, especially those affecting behavior in a given context. The state is a collection of people and the people are a product of the system placed by the state. Hence, the psychological impact of the economy on the state is an aggregation of the psychological impact of the economy on the people included in the ‘state’.( State here refers to any area, country, region, or even in some contexts a community. )

This article will introduce the indicators of an economy and delve into the psychological impacts and implications of the indicators in both spheres of an economy.

Indicators of Economy

Determination of capacity of production and consumption of goods and services with the exchange of money and value of money is important to prepare for the future while keeping head in the present. This determination/prediction of the condition of the economy can be done by ‘Economic Indicators’. In this article, we would focus on Inflation, GDP, Employment, Sales/Retail Sales. The indicators will be discussed in the context of the Indian Economy and the American Economy. The interpretation and implications of these indicators are the writer's opinion and hence may differ from person to person. These indicators have a specific schedule for release, allowing people to plan investments and create sales targets based on certain indicators at a certain time. These indicators can be leading or lagging in terms of what they precede or succeed and hence are useful tools to not only determine the condition the economy is in but also what would increase or decrease in these indicators imply for the state and the people. This article will also try to use simple examples to explain how the fluctuations and changes in the value of these indicators impact the psychology of a state and a person individually.

Inflation

Source: Ministry of Statistics and Programme Implementation, 10 Years of Inflation Rate

The rate of increase in the price level of a basket of selected goods and services over a period of time is known as inflation. Inflation measures the average price change in a group of goods and services of daily or common use, such as transport, food, housing, clothing, and other services and goods. Inflation generally indicates the purchasing power of people in the state. Higher inflation is indicative of a decrease in the buying capacity of a state/nation’s currency, which then leads to lowered growth of the economy. Although, it is not the case that zero inflation or deflation is good for the health of the economy that is a certain level of inflation is necessary to hold and increase customer demand and consumption in order to deflate the idea of hoarding money via savings a standstill situation in the economy which then needs an external stimulus to keep the wheels moving and hence stimulate both production and consumption at the cost of some other loss such as a decrease in the value of the currency in the foreign market(exchange). There are two broad classes of inflation and both of them explain the causes of inflation as well as indicate their implications.

1. Demand-Pull Inflation: The words in themselves explain the meaning of this type of inflation that is, inflation is being pulled up by the demand in the market. If aggregate demand in the market is higher than the aggregate supply, basically if a lot of money is being used but the goods are very few. To set an example for this consider the situation of a person holding an auction of 5 art pieces by a great artist and there are 10 people who want to buy the art pieces. If the starting price was X then with every raises the value of the art piece goes up and ends up with some value higher than X, even if the first art piece does go out at its base price. The supply has then reduced hence the value of the other 4 pieces increase. The demand has pulled up the values since the supply is limited. A larger example can be seen in IPL auctions(I do not understand the football transfer market to give an example). This kind of inflation occurs when the economy of the state is growing faster than the predicted long trend rate of growth. Basically, with demand more than supply companies push up the prices. The spending of people personally increase and so does the consumption but this is mostly a positive trait since spending increases only if the people have enough spending power and hence showcases positive signals for both personal economy and the economy of the state. This can be a negative indicator in the case where a company establishes a monopoly over a market segment and as demand increases the inflation increases with out of proportions margins which creates a true negative condition in the economy since the spending power has not increased but due to increase in demand of the goods or services, people have to spend more. Reasons for demand-pull inflation can be total economic growth, forecasted inflation, a higher supply of money, an increase in spending by the state, or increased exports. The psychology behind this is very simple, once a need has been identified and a market segment is created out of that need. The need then needs to be satisfied hence even with increased price, to fulfill that need the spending increases. It is important to note that the need, in this case, is a necessary good or service since we are talking on a large scale while the examples above are very niche.
2. Cost-Push Inflation: This is might sound like the opposite of the first class but is quite different. ‘Cost-Push Inflation’ occurs when the prices of goods and services increase with production and raw material costs getting higher that can be due to a number of factors. A shortage of materials such as oil and food or an increase in wages of employees can lead to this type of inflation. This kind of inflation is bad for the economy since it lowers the state of living of people in general and is often regarded as a temporary phase but it can be quite detrimental to the economy of the state as the aggregate supply is less and even if aggregate demand is on a similar level the difference between both these values keeps on increasing and lesser the supply, the more prices get increased for it. Let us take an example of the yield from a farm being X kgs of wheat that is to be consumed by say 100 people in ‘Year 1' but next year the yield is Y where X>Y and it is still to be consumed by 100 people and the farmer had to pay more for the seeds this year than the last year. Therefore, to make ends meet the farmer increases the price of the yield while the people who are going to consume remain the same. The cost has been pushed due to factors of supply and raw material cost. The reasons for this inflation class are increasing nominal wages, rising prices for food and energy, rising oil prices, devaluation: that is rising imports in the state/region. These all lead to the costs of goods and services getting increased. The increasing costs have an impact on the psychology of people.

Psychological Impact on People: The rising costs of goods and services leads to people to consume less if the society at large starts consuming less and start saving money in anticipation of inflation increasing, even more, stops the cogs in the wheels of the financial system. This is a problem since it will stop money flowing through the system and will lead to lowering the living standard of people in the region and as such decreasing the stature of society. The psychology behind saving for the future is very existential and survivalist in nature.

Indexes of Inflation

Consumer Price Index Trend 10 Year

1. Consumer Price Index(CPI): This index measures the weighted average value/prices of consumer goods and services and it covers almost all the categories from health to food to real estate to transportation. The index quite inclusive is a bit unpredictable due to being too inclusive, hence does not depict and capture the nature of inflation properly. The value of CPI in July is 154.20 units from June’s 151.80 units and with the trend in mind is expected to hit 162.20 points in 2021 and if current trends continue next year too, we are expected to hit about 168 points in 2022 as per the long-run trend. Food and Beverages have the largest/most important part in the basket of goods and services baskets whose weighted average is measured.
2. Core Consumer Price Index: It is a measure of the change in the value of goods and services excluding more of the volatile products and services such as food and energy. This is a better measure since volatile goods and services will be misleading information for the market and these volatile goods and services often have a large share of the basket which is being measured.
3. Producer Price Index: It is the measure of the change in average selling prices of the producers of goods and services of their product/output. This is a measure from the perspective of the producers rather than the consumers. Producer Price Index in India increased to 120.60 points in July from 119.30 points in June of 2020. This means that it cost 1.20% more to create generate the products in July than in June since this is a change in the average selling prices. In the long-run trend, India’s Producer Price Index is projected to trend around 133.55 points in 2021 and 139.56 points in 2022.

Producer Price Index over 10 years(Source: Office of the Economic Advisor, India)

Gross Domestic Product- GDP

This indicator is considered to be the most popular indicator and is considered mostly to determine the size and output of the economy. It measures the total value of the output of all goods and services produced within a country in a given time period. Currently, the United States of America has the greatest GDP with almost 21.5 Trillion USD, while India is projected to end at 2.61 Trillion USD this year. In a very basic overview economy. GDP is calculated as a sum of consumption by people(households), investments by businesses, spending by government, and net exports. There are many values of GDPs that are discussed and another article will discuss all of them in detail. Since GDP is a very well known measure and considered a good indicator of the health of the economy, therefore, it should impact the buying and selling patterns of people the most. The most amazing thing to note here is that while GDP does influence the buying and selling patterns at a very large scale but the influence of it on person to person in daily life is not much. The reason is that gross domestic product is popularised not as an economic indicator of the health of the economy but as an index of competition between countries and states. This creates GDP as a concept that is not singular to one person but something which is only indicative of a large group. This is the reason people do not understand the difference between GDP and GDP per capita and how it influences there daily life. While we discuss GDP, there is one value concerned with GDP which is quite vital and is often ignored in the discussions is the Debt to GDP ratio. ‘Debt to GDP ratio’ is a measure of the capacity of a state to pay-off its debt. For example, this measure for the United States of America was 110% in the first quarter of 2020.

GDP is defined broadly in two forms as Nominal and Real GDP’s. Nominal GDP takes into account the natural movement of prices and checks on with the increase in the value of the economy over a given period of time. Nominal GDP uses current prices as an account of the economy without factoring in inflation or deflation. On the other hand, real GDP factors in inflation. This means that it takes into account the overall rise in price levels. For understanding how it adjusts for deflation, a concept of GDP price deflator needs to be understood.

GDP Price Deflator: It measures the changes in prices for all of the goods and services produced in an economy. The GDP price deflator expresses the extent of price level changes, or inflation, within the economy on all products and services not holding onto a choice basket of goods and services. This includes the prices paid by industries, corporates, the government, and also the consumers. Therefore, this being a more realistic model than CPI, adjusts the nominal GDP implicitly and based on differences between the current and base year that is defined, then calculated/adjusted as per the price deflator and shown as the Real GDP. This value of GDP is important as it shows the production and growth of the state and as such investors and policymakers use this as an indicator. When the state of the economy is good, there are usually lower unemployment levels, and salaries tend to increase as more people are required in production to meet the growing demand of the economy. Negative growth in the economy is an alarming signal as it may showcase either recession or an economic downturn which means either production has gone down or the capacity of people to buy has gone down severely. The best example can be seen in today’s world, the economy of the world as a whole has suffered greatly due to the unprecedented COVID-19 spread. The cogs in the wheel have stopped and lead to slowed production as countries went into lockdown. For investors though, GDP while, a great measure to understand the differences in the condition of countries is also a great measure to understand how the increase or decrease in the economic growth and production has impacted stocks and their investments currently and in the past but is not a good indicator of the future of the market.

Source: World Bank

The following websites have great information on all the topics the article touches above:

1. Investopedia
2. Trading Economics

Economics shape up almost all our financial and sometimes non-financial decisions too, hence to understand the economy and the impact it has on us financially and the two-way psychological street is important.

The next article in this series will deal with two more factors influencing the economy of the state: Employment/Labor and Production.

Until Next Time,

Adios!