College of Agriculture and Life Sciences. Academics. Research. Extension

Perspectives Online

« YOU DECIDE: Do we live by economic cycles? | Main | New Director Named for N.C. State's Agricultural Institute»

YOU DECIDE: How can you better understand the economy?

January 12, 2007

By Dr. Mike Walden
North Carolina Cooperative Extension Service

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

Dr. Mike Walden
Media representatives: For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

Most people are very busy with their lives - earning a living, raising children, trying to save a little money - so they don't have time to analyze and study the economy. At best, they may have some time to read the economic headlines or hear a 30-second statement about financial affairs on the evening news.

But there are some easy principles you can use to better understand the economy, even if you don't have much time. Here are three:

Always adjust for inflation. The relentless general rise in prices called inflation reduces the dollar's purchasing power. This isn't a unique U.S. phenomenon. All countries experience inflation to varying degrees, so all currencies devalue within their country over time.

The fact that the dollar's purchasing power falls over time makes comparing dollar amounts in different years deceptive. For example, we're quick to be envious of consumers who bought cars, homes or land priced much less years ago compared to today, because we think those buyers got a bargain. Or we may feel sorry for workers whose pay was lower in decades past compared to workers in similar jobs today.

All of these comparisons are thrown off because, although we're comparing dollars, we're not comparing dollars of the same value. For example, due to inflation, it takes $1.54 today to equal the purchasing power of $1 in 1990, and $2.45 is required now to be the same as $1 in 1980.

So, a worker making $20,000 in 1980 was earning the equivalent of $49,000 ($20,000 x 2.45) today, and a house costing $50,000 in 1990 is like a house priced at $77,000 ($50,000 x 1.54) today.

The lesson is to never, never directly compare dollar amounts - whether it be a price, cost, salary, profit, government budget or anything similar - over time until you've first adjusted the dollar amounts for their differing purchasing power. Fortunately, there's an easy-to-use calculator at www.bls.gov to help you do this.

Use real interest rates. Like comparing dollars, comparing interest rates can also be tricky. My favorite example of this principle is from calls I received a couple of years ago from investors who complained about the relatively low interest rates they were earning on their CDs (certificates of deposit, not compact discs), when rates were 2 percent or 3 percent. The callers longed for the days in the early 1980s when CDs were paying 11 percent or 12 percent.

Actually, the more recent CD rates of 2 percent or 3 percent were better because what matters is not the nominal, or observed, interest rate, but the "real," or inflation-adjusted, interest rate. When inflation, or the increase in the cost-of-living, was running at only 2 percent annually, as it was a couple of years back, then a CD rate of 3 percent meant the certificate was paying 1 percent point above inflation. Think of this as the profit from investing in the CD. But in the early 1980s annual inflation was topping out at 13 percent. So a CD rate of 12 percent actually left the investor in the red by 1 percent.

The rule here is to always subtract the current inflation rate from an investment interest rate before deciding how well the investment did.

Put large numbers in perspective. The economic news is filled with large numbers: a $2.5 trillion government budget, a $300 billion budget deficit or an $8 trillion national debt. These numbers are mind-numbing to the average householder with an average income of less than $50,000.

For national numbers, like those cited above, express them as a percent of total national earnings in one year (technically called "gross domestic product"), which now is $12 trillion. Do the same for state level or local numbers. Then compare the resulting percentages from year to year to see how they're changing. It's like seeing how slices of the economic pie change over time.

So the next time you hear or read an economic headline, apply one or more of these principles and decide if they give you a different outlook on what’s reported.

You may feel better - or you may not!

-30-

Dr. Mike Walden is a William Neal Reynolds Professor and extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

Posted by Dave at January 12, 2007 08:30 AM