Financial planning takes place in a dynamic economic environment created by the actions of government, business, and consumers. Your purchase, saving, investment, and retirement plans and decisions are influenced by both the present and future state of the economy. Understanding the economic environment will allow you to make better financial decisions. Consider that a strong economy can lead to high returns in the stock market, which in turn can positively affect your investment and retirement programs. The economy also affects the interest rates you pay on your mortgage and credit cards as well as those you earn on savings accounts and bonds. Periods of high inflation can lead to rapid price increases that make it difficult to make ends meet. Here we look at two important aspects of the planning environment: the major financial planning players and the economy.
The Players
The financial planning environment contains various interrelated groups of players, each attempting to fulfill certain goals. Although their objectives are not necessarily incompatible, they do impose some constraints on one another. There are three vital groups: government, business, and consumers. Exhibit 1.10 shows the relationships among these groups.
Government
Federal, state, and local governments provide us with many essential public goods and services, such as police and fire protection, national defense, highways, public education, and health care. The federal government plays a major role in regulating economic activity. Government is also a customer of business and an employer of consumers, so it’s a source of revenue for business and of wages for consumers. The two major constraints from the perspective of personal financial planning are taxation and regulation.
Taxation. The federal government levies taxes on income, state governments levy taxes on sales and income, and local governments levy taxes primarily on real estate and personal property. The largest tax bite for consumers is federal income taxes, which are progressive in that (up to a point) the greater the taxable income, the higher the tax rate. Changes in tax rates and procedures will increase or decrease the amount of income consumers have to spend, so you should factor the effects of taxes into your personal money management activities. Because of tax structure constraints and the potential magnitude of taxes, financial decisions should be evaluated on an after-tax basis.
The Players
The financial planning environment contains various interrelated groups of players, each attempting to fulfill certain goals. Although their objectives are not necessarily incompatible, they do impose some constraints on one another. There are three vital groups: government, business, and consumers. Exhibit 1.10 shows the relationships among these groups.
Government
Federal, state, and local governments provide us with many essential public goods and services, such as police and fire protection, national defense, highways, public education, and health care. The federal government plays a major role in regulating economic activity. Government is also a customer of business and an employer of consumers, so it’s a source of revenue for business and of wages for consumers. The two major constraints from the perspective of personal financial planning are taxation and regulation.
Taxation. The federal government levies taxes on income, state governments levy taxes on sales and income, and local governments levy taxes primarily on real estate and personal property. The largest tax bite for consumers is federal income taxes, which are progressive in that (up to a point) the greater the taxable income, the higher the tax rate. Changes in tax rates and procedures will increase or decrease the amount of income consumers have to spend, so you should factor the effects of taxes into your personal money management activities. Because of tax structure constraints and the potential magnitude of taxes, financial decisions should be evaluated on an after-tax basis.
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Regulation. Federal, state, and local governments place many regulations on activities that affect consumers and businesses. Aimed at protecting the consumer from fraudulent and undesirable actions by sellers and lenders, these regulations require certain types of businesses to have licenses, maintain specified hygiene standards, adequately disclose financial charges, and warrant their goods and services. Other laws protect sellers from adverse activities such as shoplifting and nonpayment for services rendered. Decisions related to achieving personal financial goals should consider the legal requirements that protect consumers and those that constrain their activities.
Business
As Exhibit 1.10 shows, business provides consumers with goods and services and, in return, receives payment in the form of money. Firms must hire labor and use land and financial capital (economists call these factors of production) to produce these goods and services. In return, firms pay out wages, rents, interest, and profits to the various factors of production. Thus, businesses are an important part of the circular flow of income that sustains our free enterprise system. In general, they create a competitive environment in which consumers may select from an array of goods and services. As noted previously, all businesses are limited in some way by federal, state, and local laws.
Consumers
The consumer is the central player in the financial planning environment. Consumer choices ultimately determine the kinds of goods and services that businesses will provide. The consumer’s choice of whether to spend or save also has a direct impact on present and future circular flows of money. Cutbacks in consumer spending are usually associated with a decline in economic activity, whereas increases in consumer spending help the economy to recover. Consumers are often thought to have free choices in the marketplace, but they must operate in an environment that includes government and business. Although they can affect these parties by voting and by their purchasing actions, consumers need lobbyists and consumer groups in order to have a significant impact. The individual consumer should not expect to change government or business and instead plan transactions within the existing financial environment.
The Economy
Our economy is influenced by interactions among government, business, and consumers as well as by world economic conditions. Through specific policy decisions, the government’s goal is to manage the economy to provide economic stability and a high level of employment. Government decisions have a major impact on the economic and financial planning environment. The federal government’s monetary policy programs for controlling the amount of money in circulation (the money supply) is used to stimulate or moderate economic growth. For example, increases in the money supply tend to lower interest rates. This typically leads to a higher level of consumer and business borrowing and spending that increases overall economic activity. The reverse is also true. Reducing the money supply raises interest rates, which reduces consumer and business borrowing and spending and thus slows economic activity.
The government’s other principal tool for managing the economy is fiscal policy its programs of spending and taxation. Increased spending for social services, education, defense, and other programs stimulates the economy, while decreased spending slows economic activity. Increasing taxes, on the other hand, gives businesses and individuals less to spend and, as a result, negatively affects economic activity. Conversely, decreasing taxes stimulates the economy. The importance of fiscal policy is illustrated by the government’s massive spending to stimulate the U.S. economy in 2008 and 2009 as the way to address the prevailing financial crisis.
Economic Cycles
Although the government uses monetary and fiscal policy to manage the economy and provide economic stability, the level of economic activity changes constantly. The upward and downward movement creates economic cycles (also called business cycles). These cycles vary in length and in how high or low the economy moves. An economic cycle typically contains four stages: expansion, recession, depression, and recovery.
Exhibit 1.11 shows how each of these stages relates to employment and production levels, which are two important indicators of economic activity. The stronger the economy, the higher the levels of employment and production. Eventually a period of economic expansion will peak and begin moving downward, becoming a recession when the decline lasts more than 6 months. A depression occurs when a recession worsens to the point where economic growth is almost at a standstill or even negative. The recovery phase, with increasing levels of employment and production, follows either a recession or a depression. For about 75 years, the government has been reasonably successful in keeping the economy out of a depression, although we have experienced periods of rapid expansion and high inflation followed by periods of deep recession. And many would argue that the financial crisis of 2008 and 2009 came close to precipitating a depression.
Between 1945 and 2001, ten business cycles have been officially recognized in the United States. The most recent complete cycle started in 2001 and reached its peak at the end of 2007; a recession followed. The most recent expansion lasted 73 months, whereas the prior expansion of the 1990s lasted 120 months. The United States has
Business
As Exhibit 1.10 shows, business provides consumers with goods and services and, in return, receives payment in the form of money. Firms must hire labor and use land and financial capital (economists call these factors of production) to produce these goods and services. In return, firms pay out wages, rents, interest, and profits to the various factors of production. Thus, businesses are an important part of the circular flow of income that sustains our free enterprise system. In general, they create a competitive environment in which consumers may select from an array of goods and services. As noted previously, all businesses are limited in some way by federal, state, and local laws.
Consumers
The consumer is the central player in the financial planning environment. Consumer choices ultimately determine the kinds of goods and services that businesses will provide. The consumer’s choice of whether to spend or save also has a direct impact on present and future circular flows of money. Cutbacks in consumer spending are usually associated with a decline in economic activity, whereas increases in consumer spending help the economy to recover. Consumers are often thought to have free choices in the marketplace, but they must operate in an environment that includes government and business. Although they can affect these parties by voting and by their purchasing actions, consumers need lobbyists and consumer groups in order to have a significant impact. The individual consumer should not expect to change government or business and instead plan transactions within the existing financial environment.
The Economy
Our economy is influenced by interactions among government, business, and consumers as well as by world economic conditions. Through specific policy decisions, the government’s goal is to manage the economy to provide economic stability and a high level of employment. Government decisions have a major impact on the economic and financial planning environment. The federal government’s monetary policy programs for controlling the amount of money in circulation (the money supply) is used to stimulate or moderate economic growth. For example, increases in the money supply tend to lower interest rates. This typically leads to a higher level of consumer and business borrowing and spending that increases overall economic activity. The reverse is also true. Reducing the money supply raises interest rates, which reduces consumer and business borrowing and spending and thus slows economic activity.
The government’s other principal tool for managing the economy is fiscal policy its programs of spending and taxation. Increased spending for social services, education, defense, and other programs stimulates the economy, while decreased spending slows economic activity. Increasing taxes, on the other hand, gives businesses and individuals less to spend and, as a result, negatively affects economic activity. Conversely, decreasing taxes stimulates the economy. The importance of fiscal policy is illustrated by the government’s massive spending to stimulate the U.S. economy in 2008 and 2009 as the way to address the prevailing financial crisis.
Economic Cycles
Although the government uses monetary and fiscal policy to manage the economy and provide economic stability, the level of economic activity changes constantly. The upward and downward movement creates economic cycles (also called business cycles). These cycles vary in length and in how high or low the economy moves. An economic cycle typically contains four stages: expansion, recession, depression, and recovery.
Exhibit 1.11 shows how each of these stages relates to employment and production levels, which are two important indicators of economic activity. The stronger the economy, the higher the levels of employment and production. Eventually a period of economic expansion will peak and begin moving downward, becoming a recession when the decline lasts more than 6 months. A depression occurs when a recession worsens to the point where economic growth is almost at a standstill or even negative. The recovery phase, with increasing levels of employment and production, follows either a recession or a depression. For about 75 years, the government has been reasonably successful in keeping the economy out of a depression, although we have experienced periods of rapid expansion and high inflation followed by periods of deep recession. And many would argue that the financial crisis of 2008 and 2009 came close to precipitating a depression.
Between 1945 and 2001, ten business cycles have been officially recognized in the United States. The most recent complete cycle started in 2001 and reached its peak at the end of 2007; a recession followed. The most recent expansion lasted 73 months, whereas the prior expansion of the 1990s lasted 120 months. The United States has
endured ten other recessions since the 1940s. One recession lasted 16 months, but the average recession lasted 10 months. Economic growth is measured by changes in the gross domestic product (GDP), the total of all goods and services produced within the country. The broadest measure of economic activity, GDP is reported quarterly and is used to compare trends in national output. A rising GDP means that the economy is growing. The rate of GDP growth is also important. Although the long-term trend in absolute GDP typically is positive, the annual rate of GDP growth varies widely. For example, real GDP rose by 2.03% in 2007 and by only 1.30% in 2008.
Another important measure of economic health is the unemployment rate. The swings in unemployment from one phase of the cycle to the next can be substantial. For example, between 1960 and mid-2009 the unemployment rate has fluctuated between a low of 3.4% and a high of 10.8%. In addition to GDP growth and the unemployment rate, numerous economic statistics such as inflation, interest rates, bank failures, corporate profits, taxes, and government deficits directly and profoundly affect our financial well-being. These factors affect our financial plans: our level of income, investment returns, interest earned and paid, taxes paid, and prices paid for goods and services we buy.
Inflation, Prices, and Planning
As we’ve discussed, our economy is based on the exchange of goods and services between businesses and their customers consumers, government, and other businesses for a medium of exchange called money. The mechanism that facilitates this exchange is a system of prices. Technically speaking, the price of something is the amount of money the seller is willing to accept in exchange for a given quantity of some good or service for instance, $3 for a pound of meat or $10 for an hour of work. The economy is said to be experiencing a period of inflation when the general level of prices increases over time. The most common measure of inflation, the consumer price index (CPI), is based on changes in the cost of consumer goods and services. At times, the rate of inflation has been substantial. In 1980, for instance, prices went up by 13.6%. Fortunately, inflation has dropped dramatically in this country, and the annual rate of inflation has remained below 5% every year since 1983, except in 1990 when it was 5.4%. Since 2000, the rate of inflation has ranged between 1.6% and 3.8%.
Another important measure of economic health is the unemployment rate. The swings in unemployment from one phase of the cycle to the next can be substantial. For example, between 1960 and mid-2009 the unemployment rate has fluctuated between a low of 3.4% and a high of 10.8%. In addition to GDP growth and the unemployment rate, numerous economic statistics such as inflation, interest rates, bank failures, corporate profits, taxes, and government deficits directly and profoundly affect our financial well-being. These factors affect our financial plans: our level of income, investment returns, interest earned and paid, taxes paid, and prices paid for goods and services we buy.
Inflation, Prices, and Planning
As we’ve discussed, our economy is based on the exchange of goods and services between businesses and their customers consumers, government, and other businesses for a medium of exchange called money. The mechanism that facilitates this exchange is a system of prices. Technically speaking, the price of something is the amount of money the seller is willing to accept in exchange for a given quantity of some good or service for instance, $3 for a pound of meat or $10 for an hour of work. The economy is said to be experiencing a period of inflation when the general level of prices increases over time. The most common measure of inflation, the consumer price index (CPI), is based on changes in the cost of consumer goods and services. At times, the rate of inflation has been substantial. In 1980, for instance, prices went up by 13.6%. Fortunately, inflation has dropped dramatically in this country, and the annual rate of inflation has remained below 5% every year since 1983, except in 1990 when it was 5.4%. Since 2000, the rate of inflation has ranged between 1.6% and 3.8%.
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