5 Economic terms explained really, really simply
The economy has dominated the headlines over the past few months, but how many of the terms we see in the news do you really understand?
In Radio 4 podcast Understand: The Economy, financial journalist Tim Harford and guests go back to basics to explain the terms we hear every day - from inflation to interest rates, from the stock exchange to bonds - and what they mean for you.
Here’s a quick guide to five economic terms you should understand, that affect everything from your weekly shop to mortgage rates.
Listen to all episodes of Understand: The Economy on Βι¶ΉΤΌΕΔ Sounds
1. Inflation
Inflation is a general rise in prices, affecting everything from pasta to iPhones. It’s calculated by the Office for National Statistics via some impressive number-crunching: a network of 300 people visit 20,000 shops, across 141 locations, to retrieve 180,000 price quotes for 730 goods and services! What they come up with is the average of all of those prices rises known as the ‘inflation rate’. It represents what Richard Davis, economics professor at Bristol University, describes as: “a kind of imaginary person who's the average of all of us.”
Inflation can be caused by costs rising, sometimes known as cost-push inflation. An example of cost-push inflation occurred during the pandemic when shuttered businesses decided to renovate. The demand for timber created a scarcity, and suppliers raised prices.
Inflation can also be caused by a surplus of money in the economy. When there is more money in the economy, the value of money can go down – meaning that people usually need to pay more for the same goods and services.
Experts agree that a low and stable rate of inflation is good for the economy.
Although it may seem counter intuitive to want prices to rise, most economists agree that the opposite is much worse. If prices seem to be falling, people are less likely to spend money and then everyone from shopkeepers to car manufacturers would start to lose money, which would spread throughout the economy and weaken it.
Listen to the full episode about Inflation here, and find out why Christopher Columbus was responsible for the first known case of inflation.
2. Interest Rates (and how they affect your mortgage)
Interest rates are the price of borrowing money over time, and it’s how banks make their money. “They gather money from us as depositors, and then they lend it out in the form of credit cards, mortgages and other types of loan,” explains Richard Davis.
Banks charge interest to protect themselves from risk. They use the interest they collect from people to make up for the losses they face when others can’t pay back their loans for reasons of ill health or unemployment, for example.
The Bank of England is the bank for the high street banks that provide most mortgages. When the Bank of England raises its interest rates, it means it’s more expensive for the high street banks to store their money or borrow, so their costs go up. They push this cost on to their customers and put up mortgage rates they charge their customers. If interest rates go down, mortgage rates should decrease too.
Crucially, interest rates are a tool for the Bank of England to influence inflation. Higher interest rates mean people prioritise saving and stop spending their money. This lowers demand in the shops, so inflation comes down. Lower interest rates encourage people to spend their money so this is meant to help the economy grow. “Whether you spend today or spend tomorrow, is how the Bank of England really aims to influence the economy,” notes Richard.
Listen to the episode here to find out more about Interest Rates, how the Bank of England was formed and why there are no windows on its ground floor.
3. Economic Growth and GDP
Gross Domestic Product (GDP) has been the standard measurement of economic growth for nearly 100 years. GDP is measured in three ways: the total value of all goods and services being produced in the economy; national expenditure (domestic, business and government) and income generated (wages in households, profits by companies and tax take by the government). “Whether we’re measuring by how much has been produced, how much has been spent or how much has been generated, all three have to add up to the same number,” explains Darren Morgan at the Office for National Statistics.
"Higher interest rates mean people prioritise saving and stop spending their money. This lowers demand in the shops, so inflation comes down."
Making more things essentially means more growth in the economy. However, as Dimitri Zenghelis, co-founder of The Wealth Economy Project at the University of Cambridge, explains, if that growth comes as a result of unsustainable practices, that isn’t generally regarded as a good thing. This could include unsustainable use of natural resources, an increase in production due to war, or rebuilding from natural disasters.
Governments can encourage growth through changes to taxation, though this is a balancing act. Reducing corporation tax, for example, might attract investment and mean jobs are created, new factories are built providing jobs and activity in other sectors. But if tax cuts are funded by a reduction in public spending on things like infrastructure, hospitals and schools, that can make a country less attractive for businesses to invest in and can harm long term growth, as we need healthy, well educated people. GDP shouldn’t be the only measure we look at to check if a nation is doing well or not, as it doesn’t tell the whole picture. Instead we should look at a dashboard of measures that include things like happiness and health and inequality.
Listen to the episode here and find out why the actions of King Charles (the Second) brought about the idea of measuring the economy.
4. Bonds, Stocks and Shares
A bond is actually a way for a government or a company to borrow some money. To focus on governments first, if they need to borrow some money to build a new train line, they can ask us if we’d lend them some money. Then they promise to pay us back and they’ll even give us a bit of interest to say thanks.
Governments of stable countries are generally regarded as a safe place to keep your money. That’s because they go on forever, they won’t die after 80 years like a person who might run out of time to pay off their debts. They can also raise taxes, meaning if they’re struggling to pay back their debt, they can find more money. That’s why pension funds like to buy government bonds as they need a safe place to store their money as they have to pay out many years down the line.
Companies can sell bonds, but they can also sell shares.
The concept of shares was first realised by the Earl of Cumberland in 1600. He wanted to raise money for a dangerous and risky expedition to the Spice Islands (Maluku Islands, Indonesia). A total of 218 people contributed and were rewarded with a share in the profits when he returned home with a ship load of spices to sell. These people now had a share in what became the East India Company, and would keep getting a share of the profits when the goods were sold.
More and more people started asking for money in this way and it eventually grew into the Stock Exchange, where stocks and shares are traded and where the value of shares is entirely dependent on a collection of optimistic and pessimistic views of how they will fare. If you don’t have any shares and are wondering how a rise or fall in the stock market affects you, the main link is your pension fund. Your pension fund may be affected if there is a big move up or down.
Listen to the episode here and find out why coffee houses are so crucial to the history of the economy.
5. Recessions
“The technical definition of a recession”, explains Richard Davis, “is when an economy goes through two consecutive quarters of negative growth.” This is another way of saying the economy has been shrinking.
"A recession can be caused by something that makes us poorer, or makes us feel poorer, and stops us spending money"
A recession can be caused by something that makes us poorer, or makes us feel poorer, and stops us spending money. This in turn means other people have less coming in, and that they have less to spend. This process keeps on rippling through the economy, until it causes it to go into recession.
There are two main types of recession. The first is when an external shock hits the economy, which makes the value of assets from the stock market to the value of people’s houses either stall or go down. When these assets have less value, people see their overall wealth decrease, and tend to cut down on their spending. This in turn leads to other people’s income decreasing – and in some cases unemployment - and their spending decreasing too.
Recession can also be caused by a long period of the level of wages going up at a slower rate to the level of prices. When this happens, the buying power of workers goes down, and the amount people spend generally goes down too.
Governments can have a role to play in preventing recessions. Ideally, explains Richard, “when households are feeling the pinch, you want the government to go out there spending and lowering tax.” If a shock hits the economy and people suddenly become unemployed and able to spend less, the government would ideally start spending more – building new schools and hospitals, and creating more jobs for people. This, in theory, would get people spending and the economy growing again. But it’s a balance to make this sustainable.
