With memories of (and the fallout from) the Global Economic Crisis of 2007 to 2009 still painfully fresh for too many families, anxiety is high over recent economic fluctuations. The treasurer recently signalling a painful journey away from recession is upon us but many experts and everyday Australians alike see a recession looming. You may be among them — or you may be wondering what the hell “gross domestic product” and “recession” even mean, let alone how nervous you should be about them.
Don’t despair. Knowledge is power, so let’s go over some of the economic terms you should know.
A person or a country has an absolute advantage if the inputs it uses to produce a good are less than those of some other person or country. (An input, defined below, is any resource used to create goods or services, like labour, materials, or equipment.)
This refers to the lag between an outside change in labour market conditions and the movement of the economy toward equilibrium as a result. Or, how long it takes for the market to adjust to something new, like a labour shortage.
This is the practice of purchasing a good at a low price in one market to sell it at a higher price in another. Essentially, traders take advantage of lower prices in one country or region, then bring the goods they got at the low price to a country or region where those goods can bring them more money. Provided the cost of trading is lower than the price gap, they’ll profit. This term is also used in stocks. For instance, shares listed on both the London Stock Exchange and New York Stock Exchange can be arbitraged.
An asset is something that is owned that has value. It will have earning power or some other value to the owner. There is an expectation that the individual, corporation, or country that owns an asset will reap future benefits from it. If you own a home, for instance, that’s an asset.
This term will be familiar to anyone who knows about the Great Recession, but a bank bailout occurs when a country’s government buys an equity stake in a bank or otherwise intervenes to prevent it from failing. When discussing bailouts, you’ll also hear the term “capital injection,” which means the same thing.
This occurs when a court decides a debtor can’t make payments owed to a creditor. In some countries, the bankruptcy code protects firms from their creditors and is friendly to borrowers. In other countries, bankrupt firms are closed down more quickly and the debts are repaid as assets are sold off. The approaches to bankruptcy in each country are important to its economic status, as outstanding payments are bad for bottom lines, but so is discouragement of would-be entrepreneurs.
Bargaining gap and bargaining power
Economics is a complex field, but at the heart of money-making and -spending are laborers. Workers are essential and, as a result, can bargain to a degree (especially if they’re unionised), capitalising on their worth as an economic engine to their personal advantage. The bargaining gap is the difference between the real wage companies want to offer in order to give workers the incentive to do their jobs and the real wage that allows them to maximise profits. Bargaining power is the extent of someone’s advantage in getting a larger share of profits.
This is a kind of interest-bearing financial asset where the issuer promises to pay a certain amount over time to the holder. Bonds are issued by governments, companies, and some specialty organisations and are an alternative option for issuers to raise money, beyond selling shares or taking out bank loans.
This refers to all the money in circulation: The sum of bank money and the money held by the non-bank public.
This is the Australian economic system. The main form of economic organisation is the firm, where private owners of capital hire workers to produce goods and service with the goal of making a profit. In capitalist economic systems, private property, markets, and firms are the primary economic institutions.
Capital refers to cash or liquid assets that are held or obtained for expenditures. Basically, this includes all of a company’s assets that have monetary value. In budgeting terms, capital refers to cash flow. It’s the sum of money used to start a business, invest to make more money, or buy assets.
Consumer price index (CPI)
This is a measure of the general level of prices that consumers must pay for goods and services. It measures the average change over time in the prices paid.
Credit is a transaction between two parties wherein one — a creditor or lender — gives the borrower money, goods, services, or security. In return, the borrower promises to make future payments toward what was loaned. You’re probably familiar with credit cards and your credit score, so you get the idea here.
Default is the failure to make required repayments on a debt, whether it’s a failure to pay back interest or principal credit, and regardless of whether the debt is a loan or a security. Individuals and businesses can default, but so, too, can entire countries.
Demand is an economic concept that describes a consumer’s desire to purchase goods or services, as well as their willingness to pay a specific price for them. You’ll hear this used often with “supply,” which refers to how much of a specific good or service is available. The price of widely available goods is generally lower, as demand is lower, but when something becomes scarce, if people are willing to pay more for it to get it, prices will rise.
This is the gradual loss in value of an asset. It can occur because the asset is used (so, when a home is thoroughly trounced by a family but not renovated, for example) or because the asset is obsolete (think of outdated technology, like your computer from the 1990s). Conversely, appreciation occurs when an asset is worth more as time goes on, whether because it’s been well preserved or because it is increasingly rare.
A derivative is a financial instrument that can be traded. Its value is based on the performance of underlying assets like shares, bonds, or real estate. Derivative payoffs aren’t derived from ownership of cash flows by any one company. Basically, they’re impacted by outside sources, so there is some risk involved.
As investment in some area increases, the rate of profit from the investment can’t continue to increase. Essentially, after an optimal level of capacity is hit, output will diminish. This is why we largely (try to) stick to a 40-hour workweek: Productivity decreases, so returns diminish, after workers hit a certain point.
A person’s endowment are the facts about them that can affect their income. This can include their physical wealth (assets) or portfolio of shares (stocks), as well as their level and quality of education, special training, work experience, citizenship, nationality, gender, social class, and governmental work allowances.
This refers to the combination of economic variables, like price and quantity, toward which economic processes drive the economy. It’s self-perpetuating and does not change unless an external force alters it. When discussing the market, equilibrium means there is no tendency for quantities of things bought and sold to change.
Equity refers to a person or company’s investment in a project. It’s the value of an investment that would be returns to a person or shareholders if all the assets of the company were liquidated and the company’s debts were paid off. Basically, it’s a personal stake in a company or investment.
Gross domestic product (GDP)
This is actually a very simple concept: GDP refers to the total value of the goods a country produces and the services provided there during one year.
Any expenditure by the government to buy goods and services is government spending.
As mentioned, workers are the heart of finance. Human capital refers to the knowledge, skills, attributes, and characteristics that determine productivity and earnings by laborers. Investments in human capital (education, training, and socialisation) can increase productivity on an individual level, which leads to economic growth.
You know what inflation is because we’re living with it every day, but its definition is any increase in the general price level in an economy. It’s measured over a year, which is why when we discuss gas prices, for instance, we compare today’s price in a region to what it was in that same region a year ago. Inflation-adjusted prices, then, are prices that take these changes into account. The cost of production rises in periods of inflation, so the cost of goods and services does, too.
Interest is the monetary charge associated with the privilege of borrowing money. Basically, when you take out a line of credit or a loan, you have to buy it, so you’ll pay back what you borrowed plus interest, which is essentially the fee you’re paying to get all that money upfront. You can also earn interest on your own investments in the market.
An investment is a purchase of goods that won’t be consumed immediately, but will be used over time to generate wealth. It can refer to an asset bought with the goal of making more money in the future. Buying stocks or a home when prices are low is considered an investment because, hopefully, when you sell those things one day, you’ll make a profit. The problem is, of course, external factors will influence the market — and you may end up losing money.
This is the number of people in a given population who are of working age and are laboring outside the household. It also includes those who are unemployed but are working to get a job. The employment rate, then, refers to how much of the labour force is working, and the unemployment rate refers to how much of the labour force is not working.
The lending rate refers to the average interest charged by commercial bands, both to firms and to households.
The ease with which any asset or security can be converted into cash without affecting its market price is known as liquidity. Cash, then, is the most “liquid” asset. The faster you could turn something into cash, the more liquid it is, so stocks and bonds that can be sold quickly by a broker are very liquid, too, as are gold coins or collectibles that can be readily sold. If something can’t be exchanged for cash rapidly enough to prevent a financial loss, it has a liquidity risk.
A margin refers to the difference between how much it costs to produce a good or service and how much it’s sold for. It’s the ratio of profit to revenue. If it costs $1 to produce a slice of pizza and the slice is then sold for $2, the profit margin is $1.
In economics, we refer often to “the market.” This is the means by which the exchange of goods and services takes place. Buyers and sellers are in contact in the market, but the market is impersonal.
If you own a home (or even dream of owning one) you know what a mortgage is: It’s an agreement between a borrower and lender that gives the lender the right to take your property if you don’t pay it back with interest. Mortgage-backed security (MBS) is a financial asset that uses mortgages as collateral.
Net is used often in economics. It refers to the amount of something that results after accounting for two or more variables, so think of it as a way to describe the remaining value of something after certain factors are considered. Net income refers to total income minus depreciation, for instance. Net worth refers to assets minus liabilities, which are outstanding sums of money owed by a person or company.
This one is sort of complicated, but any time you hear “Pareto,” it’s in reference to the Pareto criterion and you can assume it means no one involved will be worse off. So, if something is Pareto dominant, it means one party involved in a transaction or exchange might be better off than the other, but neither will be worse off. A Pareto improvement is a change that benefits at least one party without hurting anyone else.
A price gap is a difference in the price of a good in the country exporting it and its price in the country importing it, including transportation costs and trade taxes. Ideally, when global markets are in competitive equilibrium, the difference will be made up entirely of trade costs. (This one is closely related to arbitrage.)
Any policy that places a high value on reducing the likelihood of a disastrous outcome, even if it’s costly, is a prudential policy. It’s better to spend a little more time and money to avoid catastrophe than to forge ahead quickly and risk ruin. This comes from the word “prudent,” which means using care and forethought.
A recession is a period when output is declining. Recessions end when the economy starts to grow again, but a recession can still be taking place when the economy is in a state of growth if output is below its normal level. In that case, it’s not over until the output has grown back to normal rates. Trade and industrial activity are reduced during a recession, meaning likely job loss as well as inflation.
A share is a part of some assets that may be traded. A company’s capital can be divided into equal parts. Holders of these shares are entitled to a portion of profits.
A stock is a security that represents ownership of a fraction of an issuing corporation or company. Stocks are divided into the “shares” mentioned above. If you own stock in a public company, you really own a little piece of that company, and the more stock you own, the more of the company you own. If the stock rises in value, your investment will yield more when you sell if. If it shrinks, you’ll lose money. Shares and stocks are traded along with other financial assets on a stock exchange.
A firm or individual is considered solvent when their net worth is positive or zero. If a bank has assets that are more than its liabilities, it’s solvent. If you have assets that equal more than what you owe, you’re solvent, too.
Subprime borrowers are those whose credit scores are low and are considered to be a higher risk for lenders, since they may have difficulty paying back what they borrow. A subprime mortgage, then, is one issued to one of these higher-risk borrowers. These tend to have higher interest rates, which are tougher for a person to pay off, but are designed to compensate the lender for accepting the greater risk of loaning money to a subprime borrower.