Absolute advantage is an economic concept that refers to a country’s ability to produce a particular good or service more efficiently than another country. In other words, a country has an absolute advantage in producing a product when it can produce it using fewer resources, less time, or at a lower cost than another country.
Absolute advantage is an important concept in international trade, as it helps to explain why countries often specialize in producing certain goods or services and then trade with other countries for the products they don’t produce as efficiently. By doing so, countries can increase their overall production efficiency and benefit from lower prices and greater availability of goods and services.
Active management is a branch of investment management that aims to outperform the market by selecting a limited number of assets and trading them frequently. Active managers seek to identify mispricings in the market and take advantage of them by buying undervalued securities and selling overvalued ones.
Active management is a highly competitive field, and not all managers are successful at outperforming the market. Active management is often compared to passive management, which aims to track the performance of a benchmark index rather than trying to outperform it.
Activist investing refers to a strategy in which an investor or a group of investors takes a stake in a company and then seeks to influence its management or strategy to increase shareholder value. Activist investors may push for changes such as cost-cutting measures, share buybacks, or mergers and acquisitions.
Activist investing is often used by institutional investors such as hedge funds and private equity firms, who have the financial resources and expertise to take a large stake in a company and influence its direction. Activist investing is controversial, as it can sometimes be seen as a way for investors to put their own interests ahead of the company’s or other shareholders’.
Adverse selection is a phenomenon in which individuals with higher risks or more adverse health conditions are more likely to seek and purchase insurance than healthier individuals, leading to an increase in the overall cost of providing insurance. One way to mitigate adverse selection is to require everyone to purchase insurance, as is often the case with car insurance.
Agency costs are the expenses incurred when an individual or a firm hires a third party to carry out a task on their behalf. This includes costs such as management fees paid to investment managers, or the costs associated with monitoring the performance of professional managers running a business. The principal-agent problem is closely related to agency costs.
Aggregate demand refers to the total amount of spending on goods and services in an economy over a given period of time. It is influenced by factors such as consumer confidence, interest rates, and government policies. Changes in aggregate demand can impact economic growth and employment levels. It is possible for aggregate demand to decrease even when people’s income and wealth are unchanged, if they choose to save rather than spend.
Agriculture is the process of cultivating crops and rearing animals for food production. For centuries, agriculture has remained the primary economic activity for humankind.
Alpha refers to the portion of investment returns that is attributed to the fund manager’s skill. This element is difficult to quantify and measure.
Amortisation is the process of gradually reducing the value of an asset over time. Regular payments are made to amortise debts, such as mortgages. Companies also use amortisation to decrease the value of intangible assets on their balance sheets.
Animal spirits is a term coined by economist John Maynard Keynes to describe the mood and sentiment among business people and consumers. Depressed sentiment can make it difficult for economies to recover from recessions.
Antitrust refers to the set of laws and regulations aimed at preventing companies from exploiting their dominant market positions at the expense of competitors and consumers. For further information, refer to our Schools Brief on the topic.
Appreciation refers to the increase in value of an asset, with currencies often used as an example. When the value of a currency rises, it is said to appreciate, whereas a decrease in value is referred to as depreciation.
Arbitrage is the practice of exploiting price differences in various markets. For example, buying an asset cheaply in one market and selling it at a higher price in another market. Due to the rapid flow of information in modern times, opportunities for risk-free arbitrage are scarce. For more information, see regulatory arbitrage.
An asset is a resource that can be used to create economic value. Assets can be tangible, such as real estate or equipment, or intangible, such as patents or brand names. Assets represent one side of a company’s balance sheet, with liabilities representing the other.
Asset stripping is the practice of buying a company and quickly selling off its parts in order to make a profit. This often results in significant business disruption and job losses.
Asset value is a metric used by investors to determine the value of a company. It is calculated by deducting a company’s debts from its total assets. Another term for this is book value.
Asymmetric information is a condition where one party involved in a transaction has more information than the other party. This can lead to market abuse, such as insider trading, or to inefficiencies, such as the lower prices that buyers of used cars may be willing to pay due to the lack of information. Adverse selection and moral hazard are related concepts. For more information, check out our Schools Brief.
Auctions are traditionally used for the sale of livestock, art, and antiques, but they have gained popularity among economists as a way to ensure that sellers receive the best price for a wide range of assets. For example, governments use auctions to sell parts of the electromagnetic spectrum to mobile telecom companies.
Austerity measures refer to attempts to decrease the proportion of public spending in a country’s GDP, typically seen during the 2010s. Keynesian economists are opposed to such programmes during economic weakness as they can reduce demand, but free-market economists worry that without austerity, the government’s economic role will expand continuously.
Austrian school of economics
The Austrian school of economics is a group of libertarian economists, including Friedrich Hayek and Ludwig von Mises. They are focused on individualism and deeply skeptical of state planning, developing in opposition to communism and social democracy, and support low taxes and minimal state intervention.
Autarky policy refers to a self-sufficient approach. Some authoritarian regimes adopt this policy to reduce their reliance on other countries. Economists consider this approach to be inefficient, as trade in goods and services enables countries to specialize in their most competitive activities and exploit comparative advantage.
Authoritarian capitalism is an economic system in which large corporations operate alongside an authoritarian government. In such a system, businesses are allowed to make profits, but criticism or non-compliance with government policies may result in criminal or financial penalties.
Backwardation refers to a situation in the commodity market when the spot price is higher than the price for delivery in the future. It is usually a sign of a supply shortage that leads traders to compete to acquire the product immediately.
Balance of payments
The balance of payments is a record of a country’s transactions with the rest of the world, capturing imports and exports of goods and services in the current account, as well as investment income and transfers. The capital account records financial transactions, such as foreign direct investment or purchases of bonds and equities. The current account and capital account balances must offset each other.
A balance-sheet is an accounting statement that summarizes the assets and liabilities of a business. The assets are resources such as cash, equipment, and inventory, while liabilities show how those assets were funded, whether through debt (owed to creditors) or equity (owed to shareholders). A balance-sheet must balance in the sense that assets equal liabilities.
A term used in Britain to describe the official interest rate set by the Bank of England when it pays interest to commercial banks for holding their deposits. The Bank of England can manipulate this rate to affect the level of interest rates that businesses and consumers pay to borrow money.
A situation in which bank depositors start to doubt they will get their money back and begin to demand withdrawals. Since banks have lent out most of the money, it is impossible for them to repay all depositors instantly, which may lead to a bank failure. To prevent this, most countries have deposit insurance schemes that provide protection to depositors in case of bank failure.
Institutions at the core of the financial system that accept deposits and make loans, creating money in the process. Commercial banks provide banking services to individuals and businesses, while investment banks offer advice on financial transactions and trade in financial assets such as stocks and bonds. Many institutions act as both commercial and investment banks.
The direct swap of goods and services for other goods and services, without the use of money. This is normally a less efficient form of trade, since the wants and needs of buyers and sellers rarely match exactly.
One hundredth of a percentage point. The term is often used to describe interest rate changes. A quarter-percentage-point rise or fall in rates is described as 25 basis points.
Baumol's cost disease
Baumol’s cost disease refers to the phenomenon of wages rising in less productive sectors of the economy due to competition for labor, despite there being little to no increase in productivity. This is because workers in less productive sectors have alternative employment options in more productive sectors that pay higher wages, forcing employers to increase wages to attract and retain workers. The term was coined by economist William Baumol in the 1960s and is often used to explain the persistent rise in the cost of labor-intensive services such as healthcare, education, and the arts, relative to the price of goods that can be produced more efficiently with technology and automation.
A bear is an investor who predicts that the price of an asset or the entire market will fall, and thus may take short positions or sell assets in anticipation of such a decline.
Behavioural economics is a branch of economics that studies how psychological biases and emotions affect economic decision-making. It suggests that individuals are not always rational in their decision-making, and their choices can be influenced by non-economic factors such as emotions, social norms, and cognitive limitations.
Beta is a measure of an asset’s volatility in relation to the market. A high beta asset tends to move more than the overall market, both on the upside and downside, while a low beta asset moves less than the market. It is commonly used by investors to assess the risk of an asset in relation to the market.
Big Mac Index
The Big Mac Index is a humorous measure created by The Economist in 1986 to determine whether currencies are overvalued or undervalued. It is based on the concept of purchasing power parity, which suggests that exchange rates should eventually balance the prices of goods in different currencies. The index is regularly updated, and you can find the latest version, along with more information about how it works, here.
Bill of Exchange
Initially created to fund international trade, a bill of exchange is a short-term financial instrument. A buyer of goods would issue a signed bill to the seller, equal in value to the purchase price, which the seller could then redeem from a banker. In modern finance, the term “bills” refers to a range of short-term debts, such as commercial bills and Treasury bills.
A distributed ledger technology used to create a digital record of asset ownership, particularly for cryptocurrencies.
Bonds are a type of debt instrument issued by a borrower that guarantee repayment of the borrowed amount on a fixed date (the maturity), along with regular interest payments. Bonds with higher risk tend to offer higher interest rates or yields. Governments issue bonds to fund their spending needs while companies issue bonds to finance their investment activities.
Book value is the net value of an asset, calculated by subtracting the accumulated depreciation from the original cost. This value is recorded in a company’s accounting records and is used to determine the value of the asset in financial statements.
Boom refers to a period of rapid economic growth characterized by a significant increase in economic activity and production, as opposed to a bust or recession.
A theory about decision-making that suggests individuals are limited in their ability to process and absorb information, which can lead to seemingly irrational choices.
The location in New Hampshire where an international conference was held in 1944 to establish the post-World War II economic order, resulting in the creation of the International Monetary Fund, the World Bank, and a system of fixed exchange rates linked to the U.S. dollar, which could be exchanged for gold at a set rate.
The phenomenon in which asset prices become disconnected from their underlying fundamentals, leading to prices that are unsustainable in the long run. While some economists argue that markets are efficient and bubbles do not occur, identifying bubbles in real time can be difficult.
The yearly process during which a government outlines its planned spending and tax policies. A budget is considered balanced when the anticipated revenue is equal to the projected expenses. Usually, government spending surpasses its revenue, resulting in a budget deficit. In certain cases, intentionally creating or increasing a budget deficit can help stimulate an economy (see Keynesian economics).
An investor who has a positive outlook on the future value of an asset or the general market and is therefore inclined to purchase in the hopes of profiting from the asset’s appreciation.
A geographical area where businesses operating in the same sector or industry are concentrated. When companies within a cluster form, it becomes easier for them to attract high-skilled workers, workers have more employment opportunities, innovations can spread more quickly, and start-ups may have better access to financing.
The natural fluctuation in economic activity that an economy experiences over time, characterized by alternating periods of expansion (boom) and contraction (bust). Although the length and intensity of cycles may vary, they are an inevitable part of any market economy.
A period of significant economic decline characterized by a contraction in economic activity, a rise in unemployment, and falling prices. Typically, busts follow a period of economic expansion, or a boom, and are often accompanied by recessions or depressions.
In economics, the term “capital” has multiple uses, including referring to the initial investment made by an entrepreneur in a new business, the lump sum amount saved by an individual, and the people and institutions that invest in global financial markets. Additionally, it may also represent a bank’s equity capital.
The financial transactions involving investments and loans between countries are recorded in the capital account component of the balance of payments. The capital account on a company’s balance sheet is primarily comprised of the equity capital provided by its shareholders and the profits it has retained.
Capital asset pricing model
A financial model used to establish a relationship between the risk and return of an asset class is referred to as the capital asset pricing model. This model is based on the concept of a risk-free asset such as government bonds. Riskier assets like stocks are expected to have a higher return than risk-free assets to account for the greater potential loss. The asset’s risk is determined by its beta.
Regulations put in place to limit the flow of money across borders. These measures are often implemented in countries with a fixed exchange rate to protect their currency from depreciation. Capital controls were an essential part of the Bretton Woods system, and they can be used to prevent speculative attacks on a currency.
When investors move their assets out of a country to avoid high taxes or the risk of currency devaluation. Governments may try to prevent this flight by imposing capital controls, but investors can anticipate these measures and act quickly. Capital flight can harm a country’s economy, and it may indicate a lack of confidence in the government’s policies.
Capital gains tax
A tax imposed on the profits made by investors when they sell assets at a higher price than they paid for them. The rate of this tax varies depending on the jurisdiction, and some economists argue that it discourages risk-taking. However, if capital gains are exempt from tax and only income is taxed, it may create a loophole for accountants to reclassify income as capital gains.
The movement of capital from one country to another in search of higher returns or safety. This often occurs when investors are concerned about high taxes or currency devaluation. Governments may try to prevent capital flight by imposing capital controls, but this can be difficult to enforce as investors may anticipate these measures and move their money before they are put in place.
Capital gains tax
A tax on profits made from the sale of assets. Some economists argue that capital gains taxes discourage risk-taking, while others believe that they should be implemented to prevent tax evasion. There is a potential incentive for investors to convert income into capital gains if capital gains are tax-free and income is taxable. Tax laws can be complex, and creative accountants may find ways to exploit these incentives.
These are physical assets used by companies in the process of manufacturing. They are not sold as consumer goods, but instead are used in the production of goods and services.
These markets are where companies, governments, and other institutions raise long-term funds through the sale of securities such as equities and bonds. They are often contrasted with money markets, which deal with short-term borrowing and lending.
A system where private individuals use their money to start businesses and finance economic activity. Entrepreneurs hire workers, buy equipment and rent property to create goods and services. Any profit made from these ventures is kept by the entrepreneurs or investors who financed them. In contrast to capitalism, communism is a system where the state controls all economic activity.
A tax imposed on carbon dioxide emissions with the objective of discouraging high-emitting activities and encouraging low-carbon alternatives. The tax is designed to incentivize the reduction of greenhouse gas emissions, which contribute to climate change, by putting a price on carbon. The effectiveness of carbon taxes is a matter of debate, but they have been implemented in several countries as a way to address climate change.
A group of producers or companies that cooperate to control the price, output, and supply of a particular product or service, often to their advantage. Cartels are usually illegal under antitrust laws because they result in reduced competition and higher prices for consumers. They can also negatively impact small or new market players who are unable to join the cartel.
The primary monetary authority of a country responsible for managing the nation’s money supply, interest rates, and foreign exchange rate. It is also responsible for implementing policies that aim to achieve stable economic growth, low inflation, and financial stability. Central banks also serve as the lender of last resort to support commercial banks during financial crises. They are typically independent of the government, but their policies and decisions are subject to government oversight.
Chicago School of Economics
A group of economists who emerged from the University of Chicago in the mid-20th century and emphasized the power of free markets and individual rationality. The school, whose leading figures include Milton Friedman, Gary Becker, and Ronald Coase, gained influence in the 1970s as policymakers embraced their ideas and moved away from the Keynesian consensus. The Chicago School is associated with monetarism, public choice theory, and other conservative economic ideas.
A school of economic thought that dominated in the late 18th and early 19th centuries. Its most famous proponents were Adam Smith and David Ricardo. Classical economics emphasized laissez-faire policies and believed that the economy was self-regulating. This school of thought also popularized the idea of free trade through the theory of comparative advantage, which was developed by Ricardo.
A theory developed by Ronald Coase that addresses the problem of externalities, such as pollution. Coase argued that if property rights are well-defined and transaction costs are low, parties can negotiate with each other to reach an efficient outcome. For example, if a factory’s noisy machinery is bothering its neighbors, the neighbors can negotiate with the factory to reduce the noise or compensate them for the inconvenience. Coase’s work on externalities and the theory of the firm earned him a Nobel Prize in Economics in 1991.
An item that a borrower pledges as security for a loan. For example, when homeowners take out a mortgage, the house or flat can be used as collateral. In financial markets, traders and investors often use safe securities like Treasury bonds as collateral.
Banks that take in deposits and lend money to individuals and businesses. However, they have a vulnerability because most deposits can be withdrawn instantly while loans take time to recall. This can lead to a bank run.
A raw material, such as oil or copper, that is traded in large quantities. Changes in commodity prices can have significant effects on the economy by impacting consumer prices. For instance, a sudden increase in energy prices can reduce consumer demand because people have less money to spend on other things after paying for energy.
Commodity cycle refers to the pattern of fluctuating commodity prices and production. When prices of commodities rise, consumers reduce their consumption and producers increase their output. As a result, there is an oversupply of commodities, leading to a fall in prices and production until they become so cheap that consumption increases again.
Communism is a system developed by Karl Marx that advocates for the state to control nearly all economic activities. The concept eliminates private property and aims to reduce income inequality. Although communism’s theory is idealistic, in practice, communist regimes have been highly authoritarian.
Comparative advantage is one of the fundamental concepts in economics. It suggests that if a country can produce a certain product more cheaply than another country, it makes economic sense for them to trade. Even if one country is more efficient in producing all goods, it is still more beneficial for them to trade, with each country specializing in the goods where it is more competitive. This way, both countries can gain economically.
Firms compete to sell the best goods and services to consumers, and to attract the best workers. The aim is to allocate resources in the most efficient manner.
A large company that has diversified across a range of countries and business areas, normally through making acquisitions.
A measure, taken from a survey, of the public’s attitude towards the economic outlook. If people are worried about their jobs, or political unrest, or a pandemic, they will be less likely to spend money.
Consumer prices index
A measure of the cost of a “typical” assortment of goods and services, used to calculate the rate of inflation. Statisticians first calculate the composition of the basket of goods and services bought by the average consumer: eg, bread, petrol and electrical goods. They then compare the cost of those goods in one period with that in another, weighting the goods and services to reflect the amount the average consumer spends. The change in this consumer prices index over the period (eg, a year) is the inflation rate.
The spending of money on goods and services by households. Consumers can either spend their income, or save it. When consumers are cautious, they spend less and save more. This can have adverse economic effects as consumption is usually the largest component of aggregate demand, ahead of public spending and investment.
A market situation in which the futures price of a commodity is higher than the spot price. It reflects the cost of holding the physical commodity until the future date and can occur when market participants expect the price to increase over time.
A systematic approach for evaluating the pros and cons of a particular project or decision by comparing the potential costs with the potential benefits. The process involves identifying all relevant costs and benefits, estimating their values in monetary terms, and comparing them to determine if the benefits outweigh the costs. While cost-benefit analysis is a useful tool for decision-making, it has limitations, such as difficulties in quantifying non-monetary factors and uncertainty in estimating costs and benefits.
The term given to the interest rate on a bond, which stems from a time when physical coupons were attached to bond certificates. On a fixed-rate bond, the coupon does not change but the price of the bond does; the yield of the bond is determined by the relationship between the coupon and the price, plus any capital gain or loss that would result from holding the bond until it matures.
An exchange-rate system in which a currency is tied to another, but can fluctuate within a range, or band, depending on certain conditions. See also currency peg and fixed exchange rate
A concept developed by Joseph Schumpeter to explain economic innovation. Old inefficient companies must go out of business to release capital and workers so they can be used in new, more innovative ways. This process of “creative destruction” ultimately leads to increased productivity, economic growth, and the emergence of new industries and businesses. However, it can also cause short-term pain and dislocation for workers and communities.
Credit refers to the extension of loans to individuals, companies, or organizations. The term is also used to describe the total amount of debt in an economy, including the concepts of credit crunch and credit expansion. In simpler terms, a credit is a sum of money added to a bank account.
A credit crunch is a sudden reduction in the willingness of banks and other financial institutions to lend money. This reduction leads to adverse economic consequences that may impact businesses, individuals, and the overall economy.
Credit default swap
A credit default swap is a derivative contract between two parties. In this contract, one party insures the other against the default of a bond or loan. Credit default swaps were at the center of the 2007-09 financial crisis, along with other types of swaps.
Credit expansion refers to an increase in the willingness of banks and other financial institutions to lend money. This often occurs during an economic boom, but if credit expands too quickly, it can be a sign of excessive speculation, particularly in the property market.
Ratings assigned to borrowers based on their creditworthiness, which reflect the likelihood of them defaulting on their debts. Credit ratings are assigned by credit rating agencies, such as Moody’s or Standard & Poor’s, and are used by investors to determine the risk of lending to a particular borrower or company.
An individual or organization that lends money to another party and is owed money in return. The creditor is typically entitled to receive interest payments and has the right to take legal action to recover the money owed in the event of default.
An economic system in which businesses succeed due to their connections with political leaders rather than their ability to compete in a free market. The Economist introduced a crony-capitalism index in 2014 to rank several big economies. This system is often associated with rent-seeking behavior.
A situation where increased government spending leads to higher interest rates, making it more expensive for private sector borrowers to access credit. This can result in reduced investment by private firms, as they may not be able to secure the necessary funding.
Digital tokens created using cryptography and decentralized ledger technology, such as blockchain. Some proponents view cryptocurrencies as a means of evading government and bank oversight and avoiding fiat currency. Cryptocurrencies are highly volatile, making them unreliable as stores of value or mediums of exchange. Some central banks have begun to issue their own cryptocurrencies.
Currency refers to the monetary unit of a nation state or a group of states such as the American dollar, the euro, or the Japanese yen. These currencies are allowed to fluctuate in value against each other and are traded in the foreign exchange market.
Currency peg is a system in which a national currency is fixed to another currency, typically the US dollar. Developing countries with a history of inflation and currency depreciation use this system to impose some discipline. However, maintaining the peg can lead to high-interest rates and recession, resulting in the link’s abandonment. This system is also known as a fixed exchange rate.
The current account measures all non-financial transactions between a country and the rest of the world, including imports and exports of goods and services, as well as transfers such as remittances and financial aid. As the balance of payments must balance, a current account deficit requires a capital account surplus (an inflow of money) to balance it.
Debt is the money that someone borrows from a bank, a company, or a person.
Default is when someone who borrowed money fails to pay it back. This can become a problem if many people default, as it can lead to a collapse in the banking system.
Deflation is when prices for goods and services in an entire economy are falling. Deflation was more common in the past when prices were stable over the long run, but it can be a problem in the modern era because it tends to be associated with falling incomes. This can be especially difficult for people who have borrowed money because they are obligated to pay back a fixed amount of money, which becomes more difficult to do when their income is falling. It’s important to note that deflation is different from disinflation, which is a decrease in the rate of inflation.
Demand refers to the desire or willingness of people to purchase goods or services. This can be further described as aggregate demand, which is the total demand for goods and services in an entire economy.
Demographics are the characteristics of a population, such as size or age composition. Demographics and changes in demographics can have an impact on economic growth. For example, if there are more people of working age, there may be stronger economic growth.
The dependency ratio is the proportion of the population that is not of working age, compared to those who are of working age. Typically, dependents are defined as those under the age of 14 or over the age of 65. Sometimes, this ratio is separated into youth dependency and old-age dependency. A higher dependency ratio means that there are more dependents who rely on the working population to support them, which can lead to a higher tax burden for workers. This can be a challenge for many developed economies, especially as more people are living into old age.
Deposit insurance is a program where a government agrees to compensate depositors if a bank fails, helping to prevent panic and bank runs.
Depreciation can have two different meanings. In foreign exchange markets, it refers to a decrease in the value of a currency, such as when the pound declines by 10% against the dollar. In accounting, depreciation is the gradual decrease in the value of an asset due to wear and tear, and companies account for this by reducing the asset’s value on their balance sheet over its lifetime. This reduction in value is recorded as a deduction on the company’s income account.
A depression is a severe and prolonged economic downturn, often accompanied by high levels of unemployment. The Great Depression of the 1930s is a well-known example of this.
Deregulation is a policy of reducing or eliminating government regulations,often referred to as red tape, that are seen as hindering economic growth. However, the public often demands new regulations to ban or restrict things that are considered harmful, leading to more regulations being introduced.
Derivatives are financial assets that derive their value from another asset, such as a stock market index or commodity price. Examples include futures, options, and swaps. Derivatives are often used to hedge against sudden changes in the value of a key variable, but they can also be used for speculation, leading some investors to refer to them as “financial weapons of mass destruction.”
Devaluation is a formal reduction in the value of a country’s currency. This occurs when a country with a fixed exchange rate decides to alter the rate, such as when sterling was devalued in 1949 and 1967. Depreciation, on the other hand, refers to a day-to-day decline in the currency’s value.
Developed countries are nations where incomes per person are high compared to the global average. They tend to have industrialized early and are mainly located in Europe, North America, Australasia, and some Asian countries such as Japan and South Korea.
Developing countries are nations where income per person is lower than in developed countries. These countries have usually industrialized later than those in Europe or America. The World Bank uses the terms “lower-middle” and “low-income” to classify countries based on their economic status.
Diminishing returns refer to a phenomenon in production where adding more inputs, such as labor, machinery, or raw materials, will initially improve productivity significantly. However, the marginal gains from adding more inputs will eventually decrease, resulting in diminishing returns. For example, adding more waiters to a restaurant will increase productivity, but only up to a certain point where each additional waiter will have fewer customers to serve.
Direct taxes are taxes that the government collects directly from individuals and businesses, such as income tax and corporate tax. They are different from indirect taxes, which are collected by intermediaries like retailers and passed on to consumers through prices.
Discount rate is a tool used by the government and investors to calculate the value of future cash flows in today’s dollars. Money in the future is worth less than money today, so the discount rate is used to reduce or “discount” the value of future cash flows. The discount rate is typically based on current interest rates or bond yields and can significantly affect the net present value of future cash flows.
Discouraged workers are individuals who are no longer actively seeking employment because they believe there are no job opportunities available to them. They are often considered economically inactive, which means they are not included in the labor force statistics.
Disinflation: When the overall prices in the economy are still rising, but at a slower rate than before. For example, if inflation was 10% last year and is now 5%, this is disinflation. It is different from deflation, which is when prices actually decrease.
The act of removing the middleman or intermediary, and allowing customers to directly connect with producers. This is often done to reduce costs. However, in practice, new forms of middlemen may emerge. For example, travel agents may be replaced by online travel agencies such as Expedia or Booking.com.
Spreading one’s interests widely. In investment, diversification is considered best practice. For example, a large pension fund may own shares in a wide range of companies across many countries, and also own bonds and property. Companies may also diversify across nations. However, diversifying across too many business activities to form a conglomerate is controversial, as some commentators believe that focusing on a small range of activities is more efficient.
A regular payment made by a company to its shareholders. It comes from the company’s profits and is typically increased over time. When a company reduces or cuts its dividend, it may be a sign of financial trouble.
Dividend discount model
A way to estimate the value of a share of stock based on the expected future stream of dividends that an investor will receive, adjusted for the time value of money.
Division of labor
A basic principle of economics proposed by Adam Smith in “The Wealth of Nations”. It states that work can be performed more efficiently if it is broken down into smaller tasks. It is also more efficient for individuals to specialize in their own jobs and use their wages to buy goods and services rather than producing everything themselves.
Dumping is the practice of selling goods or services at a price that is lower than the cost of producing them. This can be done by dominant suppliers to eliminate competitors or gain market share. Governments may use protectionist measures such as tariffs to prevent dumping by foreign producers.
Duopoly is a market situation where only two producers control the market, which can lead to a lack of competition and potential price-fixing. It is similar to monopoly, oligopoly, and cartel, where a small number of producers control the market.
ESG investing refers to investment strategies that take into account a company’s environmental impact, social responsibility, and governance practices. The popularity of ESG investing has increased in recent years due to a growing belief in stakeholder capitalism. Some argue that companies that neglect ESG issues will face negative consequences such as regulation, consumer backlash, or scandal, while others criticize the lack of clear criteria for ESG investing and claim that companies pay only lip service to these issues.
Econometrics is the application of statistical methods to study economic relationships and quantify them.
Economic rent refers to the extra income earned by the owner of a limited asset or resource. For example, a skilled worker may earn more than the lowest wage they are willing to accept, and a landlord may earn higher rent if the local authority builds a railway station nearby.
Economically inactive refers to individuals of working age who are not currently seeking employment or engaged in full-time education, but may be involved in other activities such as caring for family members or unable to work due to illness or disability.
Economies of scale
Economies of scale refer to the cost advantages that result from increased production or operation of a business, where fixed costs are spread over more units and average costs decrease as a result.
Efficient market hypothesis
The efficient market hypothesis suggests that market prices already incorporate all public information, making it impossible to achieve higher returns through trading based on that information. This theory explains why many fund managers fail to beat the market after accounting for costs, and has led to the popularity of index funds as a low-cost alternative.
Elasticity refers to how much one variable changes in response to a change in another variable. For example, if the price of a product increases by 10%, the demand for that product could either decrease by less than 10% (price inelastic) or more than 10% (price elastic). Goods that are essential, such as food and fuel, tend to be price inelastic.
Emerging markets are developing countries that may have high growth prospects and offer potentially higher returns for investors. However, they can also be risky, and investors may pull their investments out of these markets if they become risk-averse.
Endogenous growth theory
Endogenous growth theory is a hypothesis that suggests economic growth arises not only from external factors, such as new inventions, but also from government policies that encourage research and development and protect intellectual property. Paul Romer developed this theory, which earned him a Nobel prize. However, economists still do not fully understand the intricacies of how and why economies grow.
Endowment effect is a bias that affects how people value objects they own compared to objects they don’t own. Essentially, people tend to overvalue the objects they possess, leading to irrational decision-making.
An entrepreneur is someone who starts a new business by bringing together the necessary resources, including labor, capital, and management. They are often recognized for their ability to take risks and contribute to economic growth.
Equilibrium refers to a state of balance between the supply and demand for goods at a market-clearing price, although economists also study equilibria across the entire economy and in situations where markets do not clear. Despite its importance in economics, some argue that too much emphasis has been placed on equilibrium theory.
Shares of ownership in a company that investors can buy to become partial owners and share in the profits and assets of the company. Shareholders have the power to vote on certain decisions and may receive dividends.
A group of 20 European Union countries, at the time of writing, that use the euro as their currency, along with six non-EU countries. The European Central Bank is responsible for setting monetary policy for the euro zone.
European Central Bank
The institution responsible for monetary policy in the euro zone, which is a group of European countries that use the euro as their currency. The European Central Bank is headquartered in Frankfurt and supervises banks in the euro area. The governing council consists of six executive board members and the governors of the 19 central banks of euro zone countries. Its main goal is to maintain price stability.
Exchange rate refers to the rate at which one currency can be exchanged for another. It can either be a fixed rate or a floating rate, and can have various other forms.
Exports are goods and services that are sold to foreign buyers. When a foreign tourist buys a meal in Spain, that is an example of a Spanish export.
An externality is a cost or benefit that is experienced by a third party due to the actions of someone else. Externalities lie outside of the market system and can be positive or negative. For instance, polluted air caused by a chemical plant’s emissions is a negative externality, while beehives next to an orchard can be a positive externality because the bees pollinate the trees.
Factors of production
Factors of production refer to the key resources required for economic activity to take place, which are land, labor, capital, and entrepreneurship.
Fair trade is a concept that advocates for ethical considerations such as working conditions and wages, in addition to the cost of the goods.
Fat tails refer to a statistical phenomenon where extreme events happen more frequently than predicted by a normal distribution, which can lead to incorrect predictions in financial models.
Federal Reserve System
The central bank of the United States that controls the country’s money supply and monetary policy. It is made up of 12 regional banks overseen by a board of governors in Washington, DC. The key decisions on monetary policy are made by the Federal Open Market Committee.
A type of currency that is declared legal tender by a government and is not backed by a physical commodity like gold or silver. The value of the currency is based solely on the government’s backing and the trust of the people who use it. Most countries have fiat currencies and they are widely accepted as a medium of exchange.
The places where financial instruments like stocks, bonds, and derivatives are bought and sold. They provide a platform for people to invest their money and for businesses to raise capital. Financial markets are often referred to in the media as if they are a living, breathing entity that reacts to events and news.
First mover advantage
This is the advantage that a company can get when it’s the first to introduce a new product or idea in the market. They may be able to establish a strong reputation for that product, making it difficult for competitors to enter the market.
When inflation causes wages to increase, but tax allowances remain the same, workers end up paying more in taxes. This is known as fiscal drag.
These are the decisions a government makes about how much money to raise in taxes and how much to spend on public services. If the government is reducing spending or raising taxes, it’s called fiscal tightening. If the government is increasing spending or lowering taxes, it’s called fiscal easing. If the government is neither increasing nor decreasing spending or taxes, it’s known as a fiscally neutral budget.
Fixed costs are expenses that do not change as the level of production or sales changes. For example, the rent paid on a factory is a fixed cost as it remains constant regardless of how many units are produced.
Fixed exchange rate
A fixed exchange rate is a system in which the value of a currency is tied to another currency or a commodity such as gold. This system was popular until the 1970s as it provided stability in international trade. However, it became difficult to maintain due to the increasing flow of capital across borders.
A fixed rate refers to an interest rate that remains constant throughout the life of a financial instrument such as a bond.
Floating exchange rate
When the value of a currency fluctuates freely in response to market forces and supply and demand. Since the 1970s, most currencies have had floating exchange rates. This means that the exchange rate is not fixed and can fluctuate due to factors such as changes in economic conditions, interest rates, and geopolitical events.
Floating rate note
A type of financial instrument where the interest rate varies over time according to a set formula. Unlike fixed-rate instruments, the interest rate on a floating rate note is adjusted periodically, typically every six months, in response to changes in a benchmark interest rate.
The process by which a company sells its shares to the public for the first time. This is also known as an initial public offering, or IPO. When a company floats its shares on a stock exchange, it allows members of the public to buy a stake in the company, which can help to raise capital for growth and expansion.
Foreign direct investment
Foreign direct investment (FDI) is when a foreign investor sets up a new business in a country or acquires an existing one. It differs from portfolio investment, which involves buying a small stake in a business. FDI can improve a country’s productivity by introducing new technology and improving the skills of local workers. However, governments may be wary of foreign companies taking over strategic industries.
Foreign exchange market
The foreign exchange market, also known as FX or forex, is where currencies are traded.
Foreign exchange reserves
Foreign exchange reserves refer to assets held by a central bank, which can be used to manage the country’s exchange rate or address financial crises. Central banks typically hold reserves in major currencies like the dollar or euro, as well as gold. Reserves were essential under fixed exchange rate systems, but the scale of daily currency trading today makes it challenging for any country to hold enough reserves to counter market forces.
Forward exchange rate
Forward exchange rate refers to the rate at which two parties agree to trade currencies at a future date. This rate is determined by the difference in the interest rates between the two countries’ currencies.
Forward rate agreement
A forward rate agreement is a contract between two parties that determines the interest rate to be paid in the future. This is often used by borrowers to fix their interest costs in advance.
In the field of behavioral economics, framing refers to the idea that how a proposal is presented can impact how individuals react to it. For instance, presenting the cost of an annual subscription as $6 a month may attract more customers than stating the total cost as $72 a year.
A person who enjoys the benefits of a product or service without paying the full price or anything at all. For example, someone who rides on public transportation without paying for a ticket. This is a problem when it comes to public goods, such as clean air or water, which have positive externalities.
A belief in the unrestricted exchange of goods and services between countries, which is thought to lead to more efficient economies and greater prosperity for all. This idea has been advocated by The Economist since its founding in 1843. Critics of free trade argue that domestic industries may lose jobs when faced with international competition, and governments often respond with tariffs and protectionist policies.
Free trade area
A region that has eliminated tariffs, quotas, and other restrictions on imports and exports. Examples include the European Union, which has deep economic integration, and the North American Free Trade Agreement (NAFTA), which has been replaced by the United States-Mexico-Canada Agreement (USMCA).
Free-market economists are people who believe that the market is better at allocating resources than governments. They think that excessive regulation and high public spending tend to diminish growth in the long run. There are different groups of free-market economists, including the Austrian school, Chicago school, laissez-faire, and neoliberalism.
Frictional unemployment is the joblessness that results when people quit their jobs in search of better opportunities or when struggling firms lay off workers while rising firms look for new workers.
Full employment is when everyone who wants a job at prevailing wages can find one. Zero unemployment is not possible because companies can go bankrupt or lay off workers, and it can take time for workers to find new jobs (see frictional unemployment). Central banks and governments may aim to achieve full employment, but it is difficult to define the rate at which it is achieved (e.g., 2% or 3%).
A future is an agreement made between two parties to buy or sell an underlying asset, such as a commodity or a financial instrument, at a specific price and at a future date. Futures are traded on an exchange, and they can be used for two purposes: hedging and speculation. A hedger is someone who uses futures to offset the risk of price changes in an asset they already own, while a speculator is someone who tries to make a profit by predicting the future price of an asset.
Gross Domestic Product (GDP)
The total value of goods and services produced in a country in a given period, usually a year. It is used to measure the size and growth of an economy.
A way to study how people or organizations make decisions in situations where the outcome depends on what other people do. It helps predict how different players may behave and how to make the best decisions in competitive situations.
This term refers to the amount of debt a company has compared to its equity. It is also known as leverage, and a company with high gearing has borrowed a lot of money to finance its operations, while a company with low gearing has a smaller amount of debt.
General Agreement on Tariffs and Trade (GATT)
An international agreement signed in 1947 with the aim of reducing trade barriers and promoting free trade between countries. It was succeeded by the World Trade Organization (WTO) in the 1990s.
Basic goods for which the normal relationship between supply and demand does not apply. When the price of a Giffen good goes up, so does the demand because the increased cost lowers real income and makes it difficult for consumers to afford alternative products. Examples are rare, but staple products like bread and rice can occasionally have Giffen characteristics.
A term for a type of work arrangement where people work part-time or temporary jobs, often for platform companies such as Uber or Deliveroo. These workers are often considered independent contractors and lack job security and benefits such as holiday pay or pensions. However, courts have ruled that some of these workers must be treated as conventional employees. See also precariat.
Gilts are bonds issued by the British government that are known for their high credit quality and are a form of debt securities.
The Gini coefficient is a measure of income and wealth inequality that ranges from 0 to 1, with 0 indicating perfect equality and 1 indicating absolute inequality.
Globalization is the process by which national economies become increasingly interconnected through the movement of goods, services, capital, and people across borders. It has occurred in two waves, with the first ending after World War I and the second emerging during the late 20th century.
Gold is a valuable metal that has been used in the past as a form of money. Even though it is not commonly used as currency anymore, central banks still hold gold as part of their reserves. Some people see gold as a way to protect themselves against rising prices, although its effectiveness in this regard is not consistent.
The gold standard was a system used in the past where a country’s currency was linked to its gold reserves. This meant that the amount of money in circulation was tied to the amount of gold the country held, which limited inflation. However, this also meant that any changes in the economy were very painful, often resulting in deflation.
Government bonds are a way for governments to borrow money from investors. They are seen as a safe investment because most governments are considered reliable in repaying their debts. Government bonds are commonly held by insurance companies and pension funds. The yield on government bonds also affects the cost of borrowing for companies, who usually have to pay a higher yield due to the higher risk of default.
Gravity model of trade
The idea that the amount of trade between two countries depends on how big their economies are and how far apart they are geographically. For example, in 2021, America traded the most with Canada and Mexico (its neighbors) and China (the second-largest economy in the world).
A period in the mid-20th century when income differences between people became smaller because of the growth of the welfare state and high tax rates on wealthy individuals.
A time in the 1930s when the world’s economy declined sharply, and international trade decreased significantly. The Great Depression challenged the traditional economic theory that the market would eventually recover on its own, which led to the adoption of a new theory called Keynesian economics after World War II.
A period from the mid-1980s to 2007 when developed countries experienced few recessions, low inflation, falling interest rates, and rising asset prices. This came to an end with the 2007 financial crisis, which was a Minsky moment when asset prices crashed.
The idea that when there are two types of currency in circulation, people tend to hoard the good currency and use the bad currency for transactions. For example, if there are two coins in circulation with the same value, but one is made of pure gold and the other is only 90% gold, people will hold on to the pure gold coins and spend the less valuable coins. Over time, the less valuable coins will become the only ones in circulation.
Gross national product (GNP)
GNP is a measure of the total value of all goods and services produced by the citizens of a country, both within and outside its borders. It takes into account the income earned by citizens abroad but deducts income earned by foreigners within the country. For example, if a multinational company is based in a country with a low corporate tax rate and generates a significant portion of its profits there, it can lead to a higher GDP than GNP since the income earned by foreign residents is deducted.
When a bank borrows money, it may have to give collateral as a security to the lender in the form of financial securities such as bonds. In case the borrower defaults, the creditor has the risk that the collateral’s value may decrease at that time. To protect themselves, the creditors apply a discount, or a “haircut,” to the value of the collateral. For instance, if the market value of securities is $100 million, the collateral value might be considered as $90 million. The more risky the securities, the higher the discount, or “haircut,” that is applied.
Hedge funds are investment vehicles that gather money from institutions, wealthy individuals, and sometimes even retail investors. They follow a range of investment strategies, which can include borrowing money (leverage) and selling assets they don’t own (short selling) to benefit from price movements in different markets. In addition to the annual management fee, they charge a performance fee, which can make individual hedge fund managers very wealthy.
Hedging is a strategy used by individuals, companies, and institutions to protect themselves from negative market movements such as changes in commodity prices, currencies, or interest rates. It involves taking a position in the opposite direction of a market exposure, reducing the risk of loss if the market moves against the initial position. It is similar to buying insurance against market volatility.
Hedonic adjustment is the practice of adjusting inflation rates to account for improvements in the quality of goods over time, such as advances in personal computer technology.
Hot money refers to short-term capital that flows into a country seeking quick returns. This influx of capital can lead to a lending boom that drives up property prices, but it also causes the country’s currency to appreciate, making its exports more expensive. When this hot money leaves the country, the currency can drop, leading to financial instability. Countries prefer more stable foreign direct investment rather than relying on hot money.
Human capital refers to the skills and knowledge possessed by workers. Improving human capital through education and training is thought to increase productivity, but measuring the effectiveness of such programs can be difficult.
Hybrid working refers to a work arrangement where employees work both in the office and from home. This concept became popular during the pandemic as it reduces commuting time while allowing employees to interact with their colleagues and attend meetings in the office.
Hyperinflation occurs when the rate of inflation gets out of control, which happened in Germany in 1923. Prices increased so rapidly that a loaf of bread cost 200 billion marks in November 1923. Hyperinflation is typically caused by a rapid expansion of the money supply.
Hypothecated taxes refer to taxes that are earmarked for a specific purpose, such as road-building or healthcare. Hypothecation can make tax rises more politically acceptable, but governments may still divert the revenues to other departments.
Hysteresis is a term used in economics to describe a persistent effect, such as high unemployment rates that continue even after an economy has recovered from a downturn. This can occur when workers lose skills or motivation, making it difficult for them to find jobs even when the economy is growing.
Illiquid assets are assets that are difficult to sell quickly for cash or can only be sold at a substantial discount. These assets can create problems for financial institutions, such as banks, if they have more long-term loans (which are illiquid) than deposits from customers (which can be withdrawn instantly). Illiquid assets often offer a higher return because of the higher risk involved.
Imports are goods and services that are purchased from other countries. For example, when a German tourist buys a meal in Spain, that is considered an import for Germany.
Income refers to the regular flow of money that is received by the different factors of production. For example, labor receives wages, land receives rent, and capital receives profits, interest, and dividends.
Income tax is a fee that people and businesses pay to the government based on their earnings. The tax is often deducted from salaries by employers. The more someone earns, the more income tax they have to pay.
Indexation is when a variable, like wages or prices, is linked to the inflation rate. This can happen with government benefits or transportation costs, among other things. It can also refer to a type of investment management that aims to match the performance of a specific stock market index.
Indirect taxation is a tax that is collected by someone other than the government, such as retailers or airlines. Examples include sales tax and taxes on alcohol and tobacco. Governments might use indirect taxes to raise revenue without changing the rate of direct taxes like income tax.
Industrial policy is when a government promotes certain industries that it considers important for the country’s economy. This can involve giving subsidies, using tariffs or other measures to support these industries. The COVID-19 pandemic, concerns about Chinese economic power, and the Russian invasion of Ukraine have all renewed interest in industrial policy in the West. However, the use of protectionist policies can also lead to renewed protectionism, which is a concern.
Inequality refers to the difference in income or wealth between different groups of people. Economists often use the Gini coefficient or other measures to quantify inequality. The Kuznets curve hypothesis suggests that industrialization initially increases inequality, but eventually decreases it. However, inequality has increased in developed countries since the 1980s. There is ongoing debate among economists about how much inequality is acceptable and what policies can decrease or increase it.
An infant industry is a new industry that a government protects from foreign competition with tariffs, subsidies, and other measures. This is often done by developing countries to help their economies grow. However, developed countries also use this argument to justify protectionist policies.
A general increase in the price of goods and services over time. To measure inflation, economists compare the cost of a fixed “basket” of goods and services at different times. Central banks often try to control inflation using various tools like changing interest rates or quantitative easing. Inflation can affect the cost of living for people and impact the economy as a whole.
Inflation targeting is a policy where governments ask central banks to aim for a specific rate of inflation and give them independence to control it. Central banks use tools like changing interest rates or quantitative easing to try to achieve the target rate. The debate around inflation targeting is whether central banks should aim for a higher or lower target rate.
Economic activities that are not registered with the authorities of a country, such as selling goods on the street or providing informal services. These activities have value but are not included in official economic statistics. The informal economy is estimated to involve around 2 billion people worldwide.
Infrastructure refers to the physical systems and facilities that a country or region needs to function properly. This includes things like roads, airports, railways, and ports. While they are important for economic growth, they can also have negative effects like noise and take up a lot of space. Building infrastructure can be difficult in democracies because it takes a lot of time and resources, whereas autocracies like China can build it more quickly. In some cases, infrastructure is built by private companies, but usually, it is the government that builds it.
Inheritance taxes are taxes that are paid on the assets of a person who has died. The idea behind inheritance taxes is to help ensure that societies stay meritocratic, which means that people are rewarded based on their abilities rather than their family’s wealth. However, these taxes are often unpopular with middle-class voters who want to pass on their assets, like homes, to their children. To prevent small businesses and farms from being broken up when the owner dies, governments create exemptions. Inheritance taxes are not a significant source of government tax revenue.
Initial public offering (IPO)
An initial public offering, or IPO, is a process by which a company goes public and sells shares of its stock for the first time. This is also called a flotation. When a company wants to raise money, it can sell shares of its stock to the public. The process of going public requires the company to disclose financial information and other details about its business. The shares are sold to investors who are looking to invest in the company and make a profit.
Innovation means coming up with new ideas, products, or ways of doing things. It’s important for making businesses more productive and for driving economic growth. Sometimes innovation means inventing new technologies or gadgets, but it can also mean finding better ways to organize work or make products. Innovation can come from entrepreneurs who have new ideas, or from research and development that’s funded by governments.
Insider trading happens when someone uses secret information to make money in the stock market. This is against the law in many places because it’s not fair to other investors, and it can make people lose trust in the stock market.
These are big investors in financial markets, like insurance companies, pension funds, and governments. They have a lot of money to invest, and their decisions can have a big impact on the stock market.
Insurance is the practice of protecting oneself against the financial impact of risk. Traditionally, it was developed to cover events such as fire, the sinking or seizure of a ship, or the death of the family breadwinner. Insurance companies attempted to calculate the likelihood of such events occurring and protected themselves by diversifying their risks. In modern times, insurance is also commonly used to protect against risks such as changes in market prices or interest rates. In some cases, speculators assume the other side of the risk in the hopes of making a profit.
An intangible asset is something that does not have a physical form but can still create value. Examples include patents and brand names.
Intellectual property is an asset that is created solely through human intelligence and creativity. Examples include copyrights, patents, and trademarks.
Interest on reserves
Interest on reserves is the payment made by central banks to commercial banks for holding their reserves. These payments help to ensure that market interest rates stay at the desired level.
Interest rates are the amount of money paid for lending money or the cost of borrowing it. The level of interest rates is determined by factors such as the time value of money, the credit risk of the borrower, and the level of inflation. Short-term interest rates are usually set by, or closely linked to, the decisions of a country’s central bank. Long-term interest rates, such as long-term bond yields, are influenced by the balance between the supply of savings and the demand for credit.
Internal rate of return
The internal rate of return is a measurement used by businesses to determine the profitability of a potential investment. In general, the higher the internal rate of return, the better the investment. Businesses will typically establish a minimum rate before starting a project. See also rate of return.
International Monetary Fund (IMF)
The International Monetary Fund (IMF) is an institution created after the Bretton Woods agreement of 1944. Originally, its aim was to help countries facing balance-of-payments crises. It is the international organization that countries turn to when they encounter financial difficulties. Its advice has sometimes been controversial because some people think it favors rich creditors at the expense of workers, imposing austerity measures. The IMF’s recommendations during times of crisis, such as deregulation, privatisation, and openness to international trade, are known as the “Washington consensus” since the organization is headquartered in Washington, D.C.
The internet is a system that connects electronic devices such as personal computers, and it has significantly transformed the global economy by changing the way people work, communicate, and shop. However, its rise has corresponded with a slowdown in productivity growth in the developed world. Economists debate whether this is due to issues with measuring productivity or whether the internet is a less transformative technology than earlier innovations such as electrification and the internal combustion engine.
Investment is a term used in two related ways, both referring to putting money to work, usually for the long term. Business investment occurs when companies purchase new machinery, build new factories, or conduct research and development, all with the goal of increasing profits. Portfolio investment occurs when individuals or institutions invest money in long-term assets such as bonds, stocks, and real estate.
Investment banks are financial institutions that earn their money by providing advice to corporate clients and trading assets, instead of taking in deposits and giving out loans like a regular bank. In the past, commercial and investment banks were separated by law, but nowadays, they are often combined into one entity.
Investment management is a sector that specializes in managing other people’s money. Most of these companies charge an annual fee for their services, while some may also add a performance fee. This field includes active and passive management, hedge funds, pension funds, and private equity.
The term “invisible hand” was introduced by Adam Smith to describe how an individual may be unknowingly motivated to promote a goal that wasn’t initially intended. Today, this metaphor is interpreted to mean that individuals who act in their own self-interest may inadvertently promote the greater good of society as a whole.
Invisible trade refers to trade that involves non-physical things such as services (e.g. banking and insurance).
Involuntary unemployment happens when people who are willing to work for the current wage rate can’t find a job. This type of unemployment can occur due to various reasons, including a lack of demand for goods and services, or difficulties in finding a job in the labor market. Involuntary unemployment is an essential concept in Keynesian economics, which emphasizes the role of government intervention in managing the economy.
The J-curve is a pattern that a country’s balance of payments typically follows after its currency has been devalued or sharply depreciated. Initially, the country’s imports become more expensive, while exports become cheaper, resulting in a widening trade deficit. However, over time, foreign demand for the country’s exports increases, and domestic consumers buy fewer imports, leading to an improvement in the balance of payments.
Job vacancies are a measure of the number of job openings in the labor market. During an economic expansion, the number of job vacancies typically increases, which can lead to upward pressure on wages. In contrast, during an economic contraction, the number of job vacancies usually decreases. The quit rate, which measures the percentage of employees who voluntarily leave their jobs, is another important indicator of labor market conditions.
Joint supply refers to a situation where the production of one product results in the simultaneous production of another product. For example, when crude oil is distilled, it yields not only gasoline but also other products such as kerosene and asphalt.
Junk bonds are a type of bond that is considered to be high-risk, as there is a chance that the borrower will fail to pay interest or be unable to pay back the full amount borrowed. They offer high returns to investors as compensation for the risk they are taking. See bond ratings for more information.
Just-in-time manufacturing is a strategy that aims to reduce costs and minimize waste by producing goods only when they are ordered, rather than keeping large inventories on hand. While this approach can be efficient, it can also be risky if supply chain disruptions occur, such as those caused by natural disasters or pandemics like COVID-19. Lean manufacturing is a similar concept that focuses on minimizing waste throughout the production process.
Keynesian economics is an economic theory introduced by John Maynard Keynes, which suggested that during times of economic hardship, governments should increase spending rather than balancing their budgets to stimulate demand and revive the economy. This approach was adopted by many governments after World War II and is known as fiscal policy.
Knightian uncertainty is a concept coined by American economist Frank Knight. It refers to the situation where economic actors cannot accurately predict the probability of potential outcomes due to a lack of information. This uncertainty is different from risk, which is quantifiable, and only certain outcomes are known, as in games of chance like roulette.
A term that can refer to both the workforce and organized representatives of workers like trade unions and political parties. The availability of labor is a crucial factor in economic growth, and the decrease in working-age populations in developed countries may limit growth in the future. Improving the skills of the workforce and encouraging people to re-enter the workforce may be necessary.
Labour market flexibility
Refers to the ease of hiring and firing workers. Supporters of flexibility believe that too much job security can discourage employers from hiring new workers and create a “two-tier” job market, with secure workers and a large number of long-term unemployed. Flexibility also facilitates the process of creative destruction, allowing workers to move from unproductive industries to innovative ones. However, opponents argue that flexibility leads to insecure, low-paid jobs and a precariat.
Labour theory of value
The concept, popularized by Karl Marx and mentioned by Adam Smith, that the value of a good is determined by the labor required to produce it. However, a good’s value is also dependent on demand, meaning that an item may require a lot of labor but still have little market value if no one wants to buy it.
The Laffer curve is a graphical representation of the relationship between tax rates and tax revenue. It suggests that as tax rates increase, tax revenue initially increases but eventually starts to decrease at a certain point because high taxes discourage work and investment. The curve is often cited by conservative politicians to argue for lower taxes, but it is not clear where the curve bends, and it may not always hold true.
The lagged effect refers to the time it takes for changes in economic policy to have an impact on the economy. For example, changes in interest rates can take up to 18 months to affect the economy fully because loans may only be renegotiated at certain times. The risk is that economic circumstances may change by the time the policy starts to work.
Lagging indicators are economic data that reveal the past and are less useful for predicting the future. For instance, Gross Domestic Product (GDP) numbers are released well after a quarter has ended and are often revised later. Similarly, unemployment tends to be slow in falling when an economy recovers. Contrastingly, leading indicators and real-time indicators are more helpful in predicting the future economic trends.
A French term that suggests governments should keep their hands off the economy as much as possible, allowing for free trade to take place. This idea is associated with the classical school of economics, which advocates for minimal government intervention in economic affairs.
One of the essential elements that contribute to the production of goods and services. The supply of land is relatively fixed, and while some new land can be created or discovered, it is limited. Historically, land expansion and the increased productivity of agricultural land were crucial drivers of economic growth. In modern times, zoning and land-use restrictions may inhibit productivity gains, while taxes on land values are popular among economists but not always embraced by politicians.
Economic data used to anticipate future trends in the economy. For example, surveys of consumer confidence may offer insights into future retail sales, while changes in producer prices may forecast future changes in consumer inflation. Some analysts view the stock market as a leading indicator of the economy, although it is not always accurate. Leading indicators are contrasted with lagging indicators, which reflect past economic trends, and real-time indicators, which show current economic conditions.
A business approach popularized by Toyota that aims to reduce waste and continuously improve the production process. This approach is also known as “just-in-time” manufacturing.
A term coined by economist George Akerlof to describe a scenario in which markets do not operate efficiently due to asymmetrical information. In the used car market, for example, sellers have more information about the car’s condition than buyers, leading to buyers being wary of purchasing a faulty car, or “lemon,” and reducing the price they are willing to pay.
Lender of last resort
An important function performed by central banks during financial crises. When depositors and creditors lose faith in the banking system, the central bank can provide funds to solvent banks that are experiencing liquidity problems, thus minimizing the economic damage.
A financial strategy that involves using borrowed funds or a small amount of capital to invest or speculate on an asset. For example, a company may buy another company using mostly borrowed funds, which is known as leverage or gearing. Another example is buying stocks on margin, where the investor puts down only a small percentage of the stock price and borrows the rest. Leverage can amplify returns when prices rise but can also result in significant losses if prices fall. Excessive leverage is often a cause of financial crises.
A type of corporate takeover, often by a private equity group, that uses a significant amount of borrowed funds to finance the purchase. The goal is to reduce costs and sell assets to pay down the debt, eventually generating a profit for the investors in the private equity group.
Debts or obligations owed by a company to others, often in the form of money. This is the opposite side of the balance sheet from assets. Liabilities can also take other forms, such as warranties to repair or replace a product or legal costs associated with compensating customers for a faulty product.
The theory that people tend to borrow when they start their careers, save as they approach retirement, and then spend their savings after they stop working. This is because their need to spend money is relatively constant, while their income tends to increase over time. The idea was proposed by Franco Modigliani, an Italian-American economist and Nobel laureate. See also permanent income hypothesis.
A key concept in modern capitalism that protects investors from losing more than their initial investment if a company goes bankrupt. This means that investors who own equity in a company can only lose the money they initially invested, and their personal assets (such as their homes) cannot be seized by creditors. This helps to encourage more entrepreneurs to take risks and start businesses, and more investors to back them.
The ease with which an asset can be converted into cash. Some assets, like Treasury bills (short-term debt issued by the American government), are very liquid, while others are less so. The liquidity of an asset can depend on the nature of the instrument or the volume of trading in the market. In times of crisis, investors tend to prefer liquid assets, while during boom times, illiquid assets may seem more attractive.
Liquidity trap refers to a situation where the monetary policy is not effective in stimulating economic growth because people and businesses would rather hold onto cash than spend or invest it. In such cases, fiscal policy measures need to be taken to revive the economy.
Loss aversion is a psychological tendency where investors are averse to accepting losses. They may hold onto losing positions instead of selling them because they do not want to accept the mistake they made. Depending on how a situation is presented, people may behave differently. For example, a penalty for paying taxes late would be more effective than a discount for paying taxes early.
Lump of labor fallacy
Lump of labor fallacy is the belief that there is a fixed amount of work to be done and new entrants into the job market would take away jobs from existing workers. This fallacy is used to argue against women joining the workforce and against immigration. However, this belief ignores the fact that new workers earn wages and spend them on goods and services produced by other workers. Despite the global population increasing over the past century, most people have found jobs.
The study of how the entire economy functions, including how the decisions made by consumers, businesses, investors, and governments affect important economic indicators like inflation, unemployment, and gross domestic product (GDP). Governments can use tools like fiscal and monetary policy to try and steer the economy in a certain direction.
Rules put in place to try and prevent a widespread financial crisis, such as the one that occurred during the 2007-09 recession. Examples include requiring banks to have a certain minimum amount of equity capital or mandating that homebuyers put down a larger deposit when getting a mortgage. The goal is to reduce systemic risk in the financial system.
The process of using labor and machines to turn raw materials into finished physical products. While it used to be a dominant sector of developed economies, it now makes up a smaller share of GDP compared to the services sector, and this trend is not expected to reverse.
Margin refers to the difference between the cost of producing a product and the revenue generated from its sale, often expressed as a percentage. Investors can also purchase shares on margin by putting up only a fraction of the total cost, which is an example of leveraging. The marginal product of labor is the additional output a company can produce by adding one more worker or having an existing worker put in extra hours. Other terms associated with margin include marginal cost, marginal propensity to consume, marginal tax rate, and marginal utility.
Marginal cost refers to the cost of producing an additional unit of a product. When production is increased, the marginal cost of producing each additional item can be significantly lower than the average cost of production due to economies of scale.
Marginal propensity to consume
Marginal propensity to consume is the proportion of an additional dollar earned that an individual would spend rather than save. Those with lower incomes have a higher marginal propensity to consume than those who are wealthy. As a result, fiscal policies aimed at boosting consumption are more effective when targeted at those who are less well off.
Marginal tax rate
Marginal tax rate refers to the percentage of an extra dollar earned that goes to taxes. When marginal tax rates are high, it can reduce people’s motivation to work. At both ends of the income scale, marginal tax rates can be high: at the lower end, welfare benefits can be withdrawn once individuals’ income exceeds certain levels, while at the upper end, societies often impose higher marginal tax rates on those with high incomes. This system of progressive taxation aims to promote fairness in the distribution of wealth.
Marginal utility is the extra satisfaction or benefit that consumers get from consuming one additional unit of a good or service. Typically, as consumption increases, the marginal utility decreases. For example, a hungry person may feel a lot of satisfaction from the first slice of toast, but the satisfaction may decline after the seventh or eighth slice.
Mark-to-market is the practice of valuing an asset in a company’s accounts at its current market price, rather than the price at which it was purchased. While this approach makes sense in theory, it has been criticized for encouraging short-term thinking. If the market value of an asset is uncertain, a company can manipulate its figures to suit its interests. Mark-to-market accounting was at the center of the Enron scandal.
Market failure is a situation where a market is unable to efficiently allocate resources or take into account all the costs involved. This can happen due to external factors such as pollution, which can impact people with no connection to the industry. Public goods like defense or road building are also examples of goods that can only be provided by the public sector. Market failures can occur due to monopolies, monopsonies, or information asymmetry.
Marxism is a social, economic, and political theory developed by Karl Marx. It believes that the working class, or the proletariat, is exploited by the capitalist class, or the bourgeoisie, and that this leads to inequality and class conflict. Marxism advocates for a socialist system where the means of production are owned and controlled by the workers, rather than by capitalists, in order to create a more equal society.
Mass production is a manufacturing method that involves the use of specialized machinery and standardized products, allowing for economies of scale that can reduce costs and increase the market for goods. It is often associated with the Ford Motor Company and was a significant breakthrough in 20th-century manufacturing.
Maturity refers to the amount of time remaining before a debt needs to be repaid or refinanced. This term is used in the context of debt.
Medium of exchange
Medium of exchange is one of the primary functions of currency, which means it is easily used to buy and sell goods. Modern fiat currencies have succeeded in performing this function, but cryptocurrencies have yet to do so.
Mercantilism is an economic theory that was popular in the 17th and 18th centuries, which advocated that countries should aim to accumulate gold and silver by restricting imports and boosting exports. This theory rejected free trade and viewed trade as a zero-sum game. Adam Smith criticized mercantilism and argued against state intervention in the economy.
Mergers and acquisitions
Mergers and acquisitions (M&A) refer to corporate takeovers, where a larger company buys a smaller one. While genuine mergers are rare, agreed takeovers are more common. These deals can be very lucrative for investment banks and advisers, but there is a risk of overpaying for the target and cultural incompatibility.
Microeconomics is the branch of economics that studies the decision-making of individual entities such as individuals and businesses. It analyzes how these agents will respond to incentives or changes in prices, regulations or taxes. In contrast, macroeconomics looks at the economy’s behavior as a whole.
Middle income trap
The middle-income trap is a problem that can affect developing countries as they get stuck at a certain level of GDP per person. Such countries can have success in manufacturing low-value goods but may struggle to develop higher value-added sectors in services or technology.
The minimum wage is an hourly pay rate for workers set by law to reduce poverty and protect workers from exploitation. Historically, many economists were skeptical about the benefits of a minimum wage, believing it would reduce demand for labor and increase unemployment. However, the evidence suggests that there has been little impact on employment, possibly because higher wages attract better-skilled workers and reduce staff turnover, or because using minimum-wage labor is still cheaper than using machinery in some sectors.
A sudden drop in the stock market or a financial market due to the loss of investor confidence. The term is named after Hyman Minsky, an economist who believed that as asset prices increase, investors become increasingly confident and borrow more money to buy them. Eventually, investors become overconfident and ignore underlying valuations, leading to a market crash when sentiment shifts.
A measure that combines the rates of inflation and unemployment to give an idea of the economic hardship experienced by a population. It was developed in the 1970s by American economist Arthur Okun as a way to understand the impact of stagflation, a period of high inflation and high unemployment.
Mathematical or graphical descriptions of economic relationships used to test theories and make predictions. While models can help clarify and add rigor to economic statements, they often oversimplify complex real-world relationships and may rely on unrealistic assumptions. Economists are sometimes criticized for using complex mathematical equations in the belief that economics should resemble a precise science.
Modern Monetary Theory
Modern Monetary Theory (MMT) is a type of economic thinking that argues a government with its own currency can borrow as much as it wants and run as large a deficit as it likes, as long as it doesn’t lead to higher inflation. The government doesn’t have to worry about paying back its debt because the central bank can buy it or create the required money. Supporters of MMT believe that the government should use fiscal policy to manage the business cycle instead of adjusting interest rates. However, this view is not widely accepted by traditional economists.
The belief that changes in the amount of money in circulation are the main driver of inflation, popularized by Milton Friedman. While hyperinflation has been associated with rapid increases in the money supply, implementing monetarist policies in the late 1970s and early 1980s proved challenging for governments, who struggled to control the money supply and determine the most effective measures to target. As a result, many countries have abandoned monetarist policies in favor of inflation targeting.
The direct financing of government spending by the central bank. Historically, this practice was viewed with great suspicion after being associated with hyperinflation in Germany in 1923. Some commentators have viewed quantitative easing (QE) after the financial crisis of 2007-09 with similar suspicion, although technically QE is not considered monetary financing since central banks only buy government bonds in the secondary market and pay interest on reserves.
The use of interest rates and other tools by the central bank to influence the economy. Typically, interest rates are raised when the central bank is trying to control inflation and lowered when inflation is low and the central bank is trying to stimulate the economy. However, the financial crisis of 2007-09 led central banks to face the “zero lower bound,” prompting the development of new tools like quantitative easing to bring down long-term interest rates or bond yields.
Money is the fuel that keeps the economic system moving, serving as a unit of account for economic activity. In the past, money took various forms, including seashells and stones. However, modern money is mostly electronic and fiat currency. Regardless of its form, money needs to be a stable store of value and a reliable medium of exchange.
The tendency to ignore the impact of inflation when evaluating economic transactions. For example, workers may be more likely to accept a pay rise of 4% when inflation is 6%, instead of a pay freeze when prices are decreasing. Savers should prefer earning a return of 2% when inflation is zero, rather than the possibility of earning 4% when inflation is 6%.
Money markets refer to the lending and borrowing of money on a short-term basis, usually for less than a year. Banks regularly require short-term borrowing to finance themselves, so when money markets freeze, as in 2008, a crisis is likely to occur.
Money supply refers to the total amount of money circulating in an economy, including notes and coins, current account balances, unused credit card balances, and holdings of money-market funds. The measurement and determination of which components are most significant can be challenging.
A monopoly is a company that controls a significant portion of an industry or sector. While the traditional concern was that monopolies would exploit their position to overcharge customers, in the internet age, the focus has shifted to technology companies. These companies may stifle competition by denying new firms access to their platforms or by acquiring them to add the product to their range, increasing their dominance. Antitrust regulations are used to prevent this.
Monopsony refers to the presence of a dominant buyer in a market. For example, a food producer may be the primary purchaser of coffee beans or fresh chickens from farmers. A monopsonist can use its position to demand lower prices.
Moral hazard is the risk that individuals or organizations may behave differently when they are insured, as they may take more risks, assuming they will be covered in the event of a loss. This is particularly relevant to insurance providers, but also applies to central banks acting as lenders of last resort to banks, which may encourage them to take more risks.
Most favoured nation
Most favoured nation is a principle in international trade, requiring countries to treat all members of the World Trade Organization (WTO) equally, without granting preferential treatment to any one country over others.
The multiplier effect is a concept in economics that refers to the amplification of demand that occurs as a result of an initial injection or withdrawal of spending. For instance, an increase in government spending on roadbuilding creates more jobs, which increases the amount of money spent in the economy, creating further jobs and stimulating more spending.
NAFTA (North American Free Trade Agreement)
NAFTA is an agreement signed in 1993 between the United States, Canada, and Mexico that aimed to eliminate trade barriers and create a free trade area among the three countries. The deal was criticized by many politicians across the political spectrum, and it was renegotiated by former President Donald Trump during his term in office. The new agreement, called the US-Mexico-Canada Agreement (USMCA), introduced changes, including increasing the proportion of a car’s components that must be manufactured in the US to qualify for tariff exemption.
Nairu (Non-Accelerating Inflation Rate of Unemployment)
Nairu stands for Non-Accelerating Inflation Rate of Unemployment, which is the lowest rate of unemployment that does not result in an increase in wages and inflation. The concept is based on the natural rate of unemployment, which states that a certain level of unemployment is inevitable as workers switch jobs or take time to upgrade their skills. Attempting to reduce unemployment below this level can lead to inflation. However, calculating Nairu is challenging and varies over time. Other related concepts include frictional unemployment and the Phillips curve.
Nash equilibrium is a concept of equilibrium devised by John Nash, an American mathematician, in the late 1940s. It is one of the most influential ideas in economics. In Nash equilibrium, every agent chooses their optimal strategy, taking into account the strategies of everyone else. It represents the best outcome that can be achieved given the strategies of other players, but it may not be the best for society as a whole. Nash’s work on game theory and Nash equilibrium earned him a share of the Nobel Prize in Economics in 1994.
National debt refers to the total amount of debt owed by a government, usually expressed as a percentage of the country’s GDP. The significance of this proportion is a topic of debate, especially in the context of quantitative easing and central banks owning significant portions of government bonds. Factors such as interest rates, debt maturity, currency denomination, and creditors also play a role in determining a government’s ability to manage its debt. Governments with a large amount of short-term foreign currency debt face the greatest challenges.
National income refers to the total income generated within a country’s borders, including income earned by both domestic and foreign residents. It is commonly measured by gross domestic product (GDP) and gross national product (GNP).
Nationalisation occurs when a government takes control of privately-owned businesses. In communist systems, all large businesses are state-owned, often without compensation for previous private owners. In social democracies, the state may focus on specific industries, such as utilities or strategically important and/or loss-making businesses that employ many workers. Nationalisation was a common practice after 1945, but many countries reversed this trend through privatization programs in the 1980s and 1990s.
Economists usually cannot conduct controlled experiments on real economies like scientists can in a laboratory. However, sometimes opportunities arise that offer similar conditions known as natural experiments. These may include situations like a minimum wage increase in one location but not another. The pioneering work in this field was carried out by Nobel laureates David Card and the late Alan Krueger.
Natural rate of unemployment
The natural rate of unemployment, also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), is the lowest level of unemployment that does not lead to an increase in wages and inflation. Economist Milton Friedman developed the concept of the natural rate of unemployment, which assumes that a certain level of unemployment is inevitable as workers switch jobs or upgrade their skills. Trying to push unemployment below this level could cause inflation. However, calculating the NAIRU at any given moment can be difficult as it varies over time.
Negative equity is a situation that arises when the value of a property falls sharply after a borrower has purchased it, resulting in the loan’s size being greater than the property’s value. This was a significant issue in the American housing market in the mid-2000s, as negative equity meant that borrowers would, at best, be unable to move and, at worst, default on their loans, resulting in losses for both the borrowers and the lenders.
Negative income tax
A payment made to individuals with low incomes in order to alleviate poverty. Instead of complex welfare programs, the state provides a direct payment to those below a certain income threshold.
Negative interest rates
A modern phenomenon in which investors effectively pay for lending or depositing money. This emerged after the 2007-09 financial crisis as central banks sought new ways to ease monetary policy. Despite the seemingly counterintuitive concept, investors may accept negative yields on government bonds for various reasons, such as potentially larger losses investing elsewhere or impracticality of holding cash.
A school of thought that emerged in the late 19th and early 20th centuries, associated with Alfred Marshall. Unlike classical economics, which focused on the cost of production to determine price, neoclassical economics focused on consumer preferences and utility. By maximizing utility for both producers and consumers, neoclassical economists built models of how the economy functions.
Neoliberalism is a term that refers to the economic reforms pursued in the 1980s by Margaret Thatcher and Ronald Reagan, including lower taxes, constraints on public spending, privatisation, and deregulation. It is often used by opponents of these policies, as neither politician used the term to describe their own policies. See also supply-side economics.
Net present value
Net present value is a standard approach used in business investment. It involves estimating all the future revenues that will come from a project and then discounting them to reflect their value in today’s money. This calculation is highly sensitive to assumptions about future revenue growth and the discount rate applied, and there is a risk of overoptimism. See also time value of money.
The network effect refers to the benefits that consumers and producers receive when more customers buy a product. For example, it’s not very useful to be the only person who owns a telephone. Network effects have been significant in the development of the internet, where platforms like eBay and Airbnb benefit from attracting more consumers and suppliers. See also first mover advantage.
Nobel Prize in Economics
Established in 1969 in memory of Alfred Nobel, this award recognizes outstanding contributions to the field of economics. The prize is funded by Sweden’s central bank and notable winners have included Paul Samuelson, Simon Kuznets, and Milton Friedman, among others.
Nominal Interest Rates
These are the interest rates that are stated without adjusting for inflation. For example, a nominal interest rate of 5% may seem attractive, but if inflation is 8%, the actual value of the money is decreasing by around 3%. To account for inflation, real interest rates are used.
Also known as the bell curve, this is a statistical phenomenon in which most data points tend to cluster around the average, with few outliers. Human heights are a classic example of a normal distribution. While financial models often use the normal distribution, there is a risk of being caught off guard by extreme events or fat tails.
The Organisation for Economic Co-operation and Development, established in 1961, is a group of developed nations that produces reports on individual economies, conducts research on policy options, and collects economic data. It serves as a forum for cooperation and policy coordination among its members.
The Organisation of Petroleum Exporting Countries is a cartel of oil-producing nations that seeks to influence the supply and price of oil. OPEC was most successful in the 1970s when it quadrupled the price of oil, contributing to the stagflation of the era. Its influence has declined since then due to the emergence of new oil producers like Norway and the development of America’s shale oil reserves. However, OPEC’s decisions, now taken in consultation with other producers like Russia, still have an impact on global oil markets.
An economic situation where a small group of firms dominates a market, potentially leading to collusion and anti-competitive practices such as price-fixing or blocking new competitors. This concentration of market power can have negative impacts on consumers and the wider economy.
The cost of a choice or action is not just the immediate price or expense, but also includes the value of the next best alternative that must be foregone. For example, the opportunity cost of going on vacation may be the wages or income that could have been earned if that time was spent working instead. Understanding opportunity cost is essential for making informed economic decisions.
Optimal currency area
A concept in economics that refers to the geographic regions where it would be most efficient, in economic terms, for countries to share a single currency. Factors that contribute to optimal currency areas include highly integrated economies, flexible labor markets, and the ability for fiscal transfers between nations. Developed by Nobel laureate Robert Mundell, this theory is used to evaluate the pros and cons of currency unions such as the eurozone.
A financial instrument that grants the right, but not the obligation, to execute a transaction at a predetermined price within a set timeframe. A call option gives the holder the right to buy, while a put option gives the right to sell. The holder pays a premium to the option writer for this privilege. Share options are a common type of option.
The end result of economic activities, measured by metrics like GDP, which quantifies the total output of a country’s economy.
The difference between the actual output of an economy and its potential output. A positive output gap suggests that the economy is operating above its potential, and there is upward pressure on prices due to a shortage of resources. However, estimating potential output is a complex task, so the accuracy of output gap estimates can be limited.
Over-the-counter (OTC) markets are trading forums where financial instruments are bought and sold outside of a recognized exchange, such as the New York Stock Exchange. These markets see trillions of dollars in daily currency trading.
Overheating occurs when an economy grows too quickly, causing bottlenecks in the acquisition of resources and labor, resulting in higher costs and wages and ultimately leading to rising inflation.
Overshooting is a phenomenon in financial markets when a trend is taken too far. For instance, when a currency depreciates, investors may lose confidence and sell, causing the currency to become undervalued. Similarly, investors may overreact when central banks start to tighten monetary policy, driving up rate expectations beyond the intended level. However, in certain conditions, exchange rates can naturally overshoot, as demonstrated by German economist Rudi Dornbusch.
The Pareto distribution, also known as a power law, is a statistical pattern that describes how often events of a certain size or impact occur. It is named after Vilfredo Pareto, an Italian economist who observed that 80% of the wealth in Italy was owned by 20% of the population. This distribution is commonly found in various fields, such as finance, economics, and biology.
Pareto efficiency is a state of economic allocation where resources are distributed in such a way that no one can be made better off without making someone else worse off. This concept is named after Vilfredo Pareto, who developed the idea while studying wealth distribution. In theory, achieving Pareto efficiency means that resources are allocated optimally, and any attempt to further improve the welfare of one person would require making someone else worse off.
Passive management refers to the investment strategy of creating a portfolio that tracks the performance of a market index, rather than attempting to outperform the market through active stock picking. Passive management arose in the 1970s after studies revealed that many active fund managers failed to beat their respective benchmarks after fees. The goal of passive management is to achieve market returns at lower costs, and it has become increasingly popular in recent years.
Institutional investors that manage portfolios for current and future retirees. Final-salary (or defined-benefit) funds offer a pension linked to employees’ salaries; these are increasingly limited to the public sector. In the private sector, younger employees are typically only offered defined-contribution pensions, where retirement income depends on market performance.
A market model that assumes numerous, well-informed buyers and sellers, with no monopoly, monopsony, or oligopoly power. The model makes several idealized assumptions (such as no transaction costs) that do not apply in the real world.
Permanent income hypothesis
A consumption theory, proposed by Milton Friedman, that suggests people aim to spread their spending evenly over their lifetime. A sudden windfall will not be spent entirely; a significant portion will be saved. These savings will be used to supplement spending in the event of a loss of income, such as losing a job. Therefore, an individual’s spending will be less volatile than their income. See also life-cycle hypothesis.
A concept developed by economist William Phillips, which suggests that inflation and unemployment are inversely related: when inflation is high, unemployment is low, and vice versa. Phillips discovered this relationship in data from the British economy between 1861 and 1957. However, in the 1970s, both inflation and unemployment were high (see stagflation), and in the 2000s, both were low by historical standards. This indicates that the relationship is far from stable. Our Schools Brief provides a more in-depth explanation.
A phenomenon where economists try to model their theories based on the principles of physics, using mathematical equations and complex models. The idea is to create more precise and predictive economic models, but this approach has been criticized for being unrealistic and oversimplified.
A tax that is imposed on activities that have negative externalities, such as pollution, in order to reduce the overall harm to society. The tax is designed to discourage people and businesses from engaging in such activities by making them more expensive.
A company that creates an online platform to connect buyers and sellers, service providers and consumers, or any two groups that benefit from direct interaction with each other. The platform provides a marketplace for transactions and benefits from network effects that make it more valuable as more users join.
Products or services that are associated with high social status and serve as status symbols. These goods are often expensive and limited in supply, making them desirable to those who want to distinguish themselves from others. The concept of positional goods helps explain why people may continue to work hard even when they have achieved a certain level of material comfort.
Post-neoclassical endogenous growth theory
Post-neoclassical endogenous growth theory is a branch of economic theory that builds on endogenous growth theory, which suggests that technological progress and human capital accumulation are key drivers of long-term economic growth. Post-neoclassical endogenous growth theory also takes into account factors such as institutions, social norms, and government policies that can influence the rate and direction of technological progress.
Poverty refers to a state of deprivation or lack of material resources, such as food, shelter, clothing, and access to healthcare and education. Measures of poverty can be absolute or relative, with absolute poverty indicating an inability to afford the basic necessities of life, and relative poverty measured against a proportion of median income. Extreme poverty, as defined by the World Bank, is when an individual’s income is less than $2.15 per day. The global proportion of people living in extreme poverty has declined from over 35% in 1990 to less than 10% today.
A poverty trap occurs when institutional barriers prevent individuals or households from improving their circumstances. This can be due to factors such as high effective marginal tax rates, which discourage people from earning more income, or limited access to education and healthcare, which can limit individuals’ ability to realize their full potential.
A statistical distribution that follows a particular mathematical formula, where a small number of observations have very high values, while the majority have much lower values. This distribution is also known as the Pareto distribution, after the economist Vilfredo Pareto.
A term used to describe workers who are employed in low-paid jobs, often part-time or on zero-hours contracts, and have little job security or financial stability. Such workers may rely on government welfare payments to supplement their income. Critics argue that the prevalence of the precariat is a consequence of labor market deregulation in recent decades.
The desire to hold cash or other liquid assets to guard against unexpected events or emergencies. Economist John Maynard Keynes identified this as one of three reasons for holding cash, along with the speculative motive (holding cash to take advantage of investment opportunities) and the transactions motive (holding cash for day-to-day transactions).
The amount of money that a customer is willing to pay for a good or service, which is determined by the balance of supply and demand. The price can be influenced by factors such as production cost, market structure, and the nature of the product, with positional goods and monopolies often charging a premium above production cost. In some cases, prices may be sticky and not adjust quickly to changes in supply or demand.
A measure of how sensitive the demand for a good or service is to changes in its price. Products that are highly elastic have demand that is sensitive to price changes, while those that are inelastic have demand that is less affected by price changes.
A popular method used to value individual stocks or the stock market as a whole, which compares the current market price of a stock to its after-tax earnings per share. The price-earnings ratio can be based on either historical or forecasted earnings, and a high ratio may indicate that a stock is overvalued. The cyclically adjusted price-earnings ratio (CAPE), developed by Robert Shiller of Yale University, is a method of valuing the entire stock market based on an average of the past ten years’ earnings, adjusted for inflation.
The difference between a government’s revenue and expenditure in a given year, excluding interest payments on its existing debt. This measure is often used to evaluate a country’s financial sustainability, as a primary surplus can help reduce the debt-to-GDP ratio over time. However, the primary balance can be influenced by factors such as interest rates and the size of existing debt.
The market where new securities are issued, such as the initial public offering (IPO) of a company’s equity or the issuance of a bond. In a crisis, the primary market may freeze, making it difficult for companies to raise new capital. The primary market is distinct from the secondary market, where existing securities are bought and sold among investors.
Principal-agent problem refers to the situation where an agent, who is acting on behalf of a principal, has a misaligned incentive structure that may lead to actions that are not in the best interest of the principal. This occurs because the agent may have better information or may prioritize their own interests over those of the principal. For instance, shareholders may hire managers to run a company, but the managers may focus on increasing their own salaries or perks rather than maximizing shareholder returns. This can result in agency costs and asymmetric information.
Private equity is a type of investment management that specializes in investing in companies that are not publicly traded on a stock market. Private equity firms often acquire public companies using borrowed money, and then work to improve the company’s financial performance with the aim of selling it for a profit in a few years. They may offer management incentives in the form of share options.
The private sector refers to all economic activities that are not controlled by the government, ranging from small businesses to large corporations.
Privatization is the process of transferring assets or companies from the public sector to the private sector. This was a popular policy in the 1980s and 1990s, as it raised money for governments and was seen as a way to increase operating efficiency. However, the benefits of privatization are less clear when it comes to utilities, such as water companies, which are natural monopolies.
Productivity is a measure of the efficiency with which a company or an economy utilizes its resources to produce goods and services. It is often measured as the amount of output per unit of input, such as output per worker or output per hour. Productivity growth is essential for sustainable economic growth, as it increases the output of goods and services while keeping costs under control.
Profits refer to the financial gain made by a company after deducting its expenses from its revenues. They are a key measure of a company’s financial performance and provide an incentive for businesses to invest in research and development, innovation, and expansion. Profits can be used to pay dividends to shareholders, reinvest in the business, or repurchase shares. However, excessive profits can also raise concerns about market power and inequality.
Progressive taxation is a tax system where the tax rate increases as the income of the taxpayer increases. The idea behind progressive taxation is to achieve greater income redistribution and reduce income inequality. The tax rates are set in such a way that those with higher incomes pay a higher proportion of their income in taxes than those with lower incomes.
Property refers to anything that a person or business owns, including land, buildings, equipment, and other assets. Private property ownership is a cornerstone of most economic systems and provides individuals with an incentive to invest in and use property productively. Property rights protect individuals and businesses from unauthorized use or appropriation of their assets and encourage them to use their resources efficiently.
Protectionism refers to a set of policies that are designed to promote domestic companies by creating barriers to trade with foreign companies. These barriers can take the form of tariffs, taxes, or regulations that make it difficult for foreign competitors to operate in the domestic market. While protectionism can be seen as a way to safeguard domestic jobs and industries, it can also lead to inefficiencies and higher prices for consumers.
Public choice theory
Public choice theory is an economic approach that studies the behavior of individuals and groups involved in government, such as politicians and bureaucrats. This theory suggests that these individuals may act in their own self-interest, rather than in the best interest of the public they serve. They may use their power to build up their own departments, or to create regulations that favor their own constituents. As a result, government failures can occur in addition to market failures.
Public goods are goods or services that are available to everyone in society and cannot be excluded from anyone who wants to use them. Examples of public goods include clean air, national defense, and radio broadcasts. Because public goods are subject to the free-rider problem, where individuals can benefit from them without paying for them, they are often provided by governments and funded through taxation.
The public sector refers to that part of the economy that is owned or controlled by the government. This includes government agencies, public utilities, and other entities that are established to provide goods and services to the public. The public sector is distinct from the private sector, which is owned and controlled by individuals or businesses.
Public spending refers to the amount of money that the government spends on goods, services, and programs. It is a significant part of most economies, accounting for 30% to 50% of GDP across OECD countries. While periodic efforts to reduce public spending through austerity programs have been made, they are often followed by prolonged rebounds due to increasing needs to spend on healthcare, pensions, and welfare. Economist John Maynard Keynes argued that public spending should be increased during recessions as a way to boost demand.
Purchasing-power parity (PPP)
Purchasing-power parity is a method used to adjust exchange rates to account for the different levels of prices in different countries. In theory, prices of goods and services in different countries should be roughly equivalent, allowing for transport costs, in the absence of trade barriers. However, in practice, this is rarely the case. Economists calculate PPP exchange rates to assess whether currencies are undervalued or overvalued.
A monetary policy tool used by central banks to stimulate the economy during periods of economic downturn. QE involves purchasing government bonds and other assets in the secondary market, which injects liquidity into the economy and lowers borrowing costs. Critics argue that QE can be difficult to reverse and can lead to monetary financing.
The opposite of quantitative easing, quantitative tightening involves reducing the central bank’s bond portfolio by selling bonds back to the private sector or letting them mature without reinvesting the proceeds. This reduces liquidity in the economy and increases upward pressure on bond yields.
Quantity theory of money
A theory in monetarism that suggests that the money supply is the primary driver of inflation. The theory is based on the equation MV=PT, which states that the money supply multiplied by the velocity of money is equal to the price level multiplied by the number of transactions. However, increases in the money supply may not always lead to higher prices due to fluctuations in money velocity.
A metric that measures the number of employees who voluntarily leave their jobs, as opposed to being fired or laid off. An increasing quit rate indicates that workers are more optimistic about finding new employment opportunities, which is often a sign of a growing economy. See also job vacancies.
A policy that restricts the amount or monetary value of goods that a country can import. Quotas are a form of trade barrier that can limit competition and protect domestic industries. See also protectionism.
A business that has offered and listed its shares on a stock exchange, making them available for purchase by investors. Being a quoted company can provide benefits such as access to capital and increased visibility, but also requires compliance with exchange regulations and transparency in financial reporting.
The real interest rate, adjusted for inflation, that would exist when the economy is performing at its potential level. Economic models suggest that monetary policy is providing stimulus if the real interest rate set by the central bank is lower than R*. However, this important variable cannot be directly observed.
Randomized control trials
A type of experiment where a policy change is implemented on a randomly selected group of individuals in order to isolate its economic impact. These trials have been primarily conducted in developing countries. Abhijit Banerjee, Esther Duflo, and Michael Kremer were awarded the 2019 Nobel Prize in Economics for their work on RCTs. However, some have raised ethical concerns regarding the use of such trials.
Rate of return
The annual profit, income, and increase in value from a project, expressed as a percentage of the capital invested. The internal rate of return is a related concept that calculates the discount rate that makes the net present value of a project equal to zero.
Indicators of the level of risk associated with a financial instrument, provided by ratings agencies like Standard & Poor’s, Moody’s, and Fitch. A higher credit rating indicates lower risk, which translates to lower interest rates for debt instruments. Ratings below a certain level are considered high-risk, as with junk bonds. During the 2007-09 financial crisis, ratings agencies faced heavy criticism for overrating financial instruments that ended up losing value.
The concept that people base their decisions on the best information available to them and learn from their mistakes. This led free-market and monetarist economists to argue that consumers would anticipate government policy changes and adjust their behavior accordingly. For instance, if the government implements a large budget deficit to boost demand, consumers will anticipate future tax increases and save some of the windfall to cover these future expenses (known as Ricardian equivalence). Consequently, Keynesian fiscal policy would be counterproductive in the long run.
Fundamental commodities such as oil, metals, and cotton that companies require to manufacture goods.
A measure that takes into account inflation when analyzing economic data or financial metrics. Real terms adjustments allow for a more accurate assessment of changes in purchasing power or value over time. For example, a salary increase of 3% may appear to be a gain, but if inflation is at 4%, the increase is actually a loss in real terms.
Economic data that provides timely and up-to-date information on current economic conditions, rather than relying on lagging indicators that are published after a delay. Real-time indicators may include data from sources such as online job postings, credit card transactions, or traffic activity, and are used by policymakers and analysts to track economic trends in real-time.
A period of declining economic activity, typically characterized by a decrease in gross domestic product (GDP), rising unemployment, and falling consumer and business confidence. A recession is usually identified as two consecutive quarters of negative GDP growth, although other factors such as employment and production levels are also taken into account. The National Bureau of Economic Research is the official arbiter of US recessions.
The discriminatory practice of denying financial services, such as loans or insurance, to individuals based on their race or the location of their residence. Although regulations have been passed to prevent redlining, cases of this practice still occur today.
Policies aimed at stimulating the economy by increasing government spending, cutting taxes, or reducing interest rates. These measures may increase the rate of inflation but are typically employed during times of low inflation or deflation.
Taxes that take a larger percentage of income from lower-income earners than higher-income earners. Sales taxes are typically regressive, while income taxes are generally not. Flat-rate taxes, such as the “poll tax” in the UK during the late 1980s, are also regressive.
Regulatory arbitrage refers to the practice of exploiting the differences in regulations between different jurisdictions to gain a competitive advantage. Companies may relocate or restructure themselves to benefit from more favorable rules or to avoid unfavorable ones. For example, a bank may choose to operate in a country with less stringent capital requirements. However, this can lead to a race to the bottom in terms of regulatory standards.
Regulatory capture is when regulators become too closely aligned with the interests of the industries they are supposed to regulate, often to the detriment of consumers. This can happen because of lobbying efforts by the industry or because of a revolving door between the regulator and the industry. As a result, the regulator may be less willing to take tough action against the industry, or may be more sympathetic to the industry’s demands.
Remittances refer to the money that migrants send back to their home countries to support their families. They are an important source of income for many families in developing countries and can help to reduce poverty. Remittances can come in the form of cash, bank transfers, or other means. The World Bank estimates that low- to middle-income countries received $626 billion in remittances in 2022.
The payment made for the use of land or buildings to the owner. In economics, the term is also used to refer to economic rent.
A term used to describe the practice of gaining a larger portion of the profits without creating more value. This practice may involve lobbying the government to receive favorable treatment or imposing regulations that limit competition. Examples include crony capitalism and protection rackets.
A repurchase agreement, in which a seller of securities agrees to buy them back from the buyer at a specific time and price.
A financial arrangement where one party sells a security, such as a government bond, to another party with a promise to repurchase it at a slightly higher price at a future date, typically the following day. This is a form of borrowing, and the difference between the selling and repurchasing price represents the interest on the loan. The repo market is vast, estimated to be over $4 trillion in the US alone, and is used by many market participants to finance themselves in the short term.
The process of restructuring the terms of a debt when the borrower is struggling to make repayments. This usually involves reducing the interest payments in the short term and extending the life of the loan or bond. The negotiations for rescheduling often take time and involve discussions between the borrower and the creditors.
Research and development
Also known as R&D, this is the essential work that creates innovation and increases productivity in the economy. Governments can fund R&D directly, especially during times of war, or encourage it through tax breaks. OECD countries typically spend, at the time of writing, around 2.5% of GDP annually on R&D, with some countries like Israel, South Korea, and Taiwan investing much more.
The minimum wage at which a worker is willing to accept a job offer. Alternatively, it is the wage level at which a worker is indifferent between working and not working, taking into account the opportunity cost of leisure time.
A currency that is widely held by central banks and used in international trade and finance. Reserve currencies are typically perceived as stable and reliable, and are therefore held as a store of value. The US dollar is currently the dominant reserve currency, followed by the euro and Japanese yen.
The amount of funds that commercial banks are required to hold in reserve, typically as deposits with the central bank. Reserve requirements are set by the central bank and are used as a tool for regulating the money supply and controlling inflation. In some cases, central banks may adjust reserve requirements to influence the availability of credit in the economy.
The curse that some countries with abundant natural resources, such as oil, gas or minerals, experience. The excessive profits generated by such activities can lead to corruption and rent-seeking behavior among politicians and other powerful figures, stifling economic diversification and leaving the country vulnerable to the boom-and-bust cycle of commodity prices.
A theory proposed by David Ricardo that suggests that debt-financed expansion of the public sector will not stimulate demand because citizens understand that government debt will ultimately have to be repaid through future taxes, leading them to save money to cover these future obligations. This means that Keynesian-style government stimulus programs may not be effective in boosting demand in the economy. See also rational expectations.
The possibility that events may not unfold as anticipated. All economic participants, including workers, consumers, producers, and investors, face some degree of risk, which may take many different forms. While some risks can be quantified and managed, others, such as those associated with Knightian uncertainty, are more difficult to assess due to the lack of available information.
The additional return investors require for holding assets that have a higher risk than risk-free assets such as cash or government bonds. This premium needs to account for the potential of absolute loss, such as a company going bankrupt or defaulting on a debt, and the volatility of the asset’s price. During times of crisis, risky assets may experience a significant decline in price, which could force investors to sell them at a loss.
A measure that considers the differing levels of risk between portfolios. It compares the return of a fund or portfolio with its risk as measured by volatility or other factors. For example, a fund manager who achieved a 20% return over a year may have done so by taking on greater risk than the market as a whole, such as by investing in only a few stocks. Therefore, there is no guarantee that the manager’s performance will continue in the future.
A state of being cautious, which can lead to subdued economic activity. In a risk-averse environment, businesses may be hesitant to invest in new production facilities, banks may be reluctant to lend, and investors may prefer the safety of government bonds to equities. Analysts sometimes describe uncertain financial conditions as “risk-off” markets. See also animal spirits.
The return on assets that are considered to have very low risk of default, such as government bonds or high-grade corporate bonds. While these assets are generally considered to have a low level of risk, they can still be impacted by inflation and interest rate fluctuations. Therefore, the term “risk-free” is somewhat misleading.
Rules of origin
Regulations that specify the country or region of origin for a product in order to determine how it will be treated for trade purposes. This can have significant implications for the product’s eligibility for preferential treatment under free trade agreements or for customs duties. These rules can be complex and can vary by country and industry.
Sales tax refers to a type of indirect tax that is collected by retailers and other intermediaries on behalf of the government. It is a major source of revenue for governments worldwide. In the European Union, the sales tax is in the form of a value-added tax (VAT), which is levied at every stage of the supply chain.
Sanctions are measures that are imposed by governments or international organizations to restrict economic activity with a particular country, group or individual. They can include trade embargoes, travel bans, and asset freezes, among others. Sanctions have become a widely used tool of foreign policy.
Savings refer to income that is set aside for future use instead of being consumed. There are three motives for saving: the precautionary motive, speculative motive, and transactions motive. While savings are important for long-term economic growth as they provide funds for investment, a sudden increase in saving can lead to a fall in aggregate demand, potentially causing a recession. In a closed economy or the world economy, saving and investment must be equal.
Say’s law is the economic theory that suggests supply creates its own demand. This means that as businesses produce goods and services, the income they generate in the process will create demand for other goods and services in the economy. This theory was popularized by French economist Jean-Baptiste Say in the 19th century, and was used by classical economists to argue that recessions would naturally correct themselves without the need for government intervention.
Seasonal adjustment is a statistical technique used to account for variations in economic activity that occur depending on the time of year. For example, retail sales may increase dramatically in the lead up to Christmas, so economists adjust the data to accurately reflect these seasonal fluctuations.
The secondary market is the platform where existing securities, such as bonds and equities, are bought and sold. The turnover in the secondary market is enormous, with trades worth trillions of dollars taking place every day. When the media reports on “volatile markets,” they are usually referring to the fluctuations in the secondary market. The primary market, in contrast, is where new securities are issued for the first time.
Securities are financial instruments that are traded on financial markets. This can include stocks, bonds, and other types of assets.
Securitization is the process of bundling together certain types of assets, such as mortgages, and selling them as securities to investors. This allows issuers to raise funds by tapping into the value of the underlying assets. However, securitization played a role in the financial crisis of 2007-2009, when the bundling of subprime mortgages led to the collapse of the housing market.
Seigniorage refers to the profit that governments make from creating and circulating their own currency. It is the difference between the cost of producing money and the value of the money itself. While historically seigniorage has been a source of revenue for governments, in some cases, such as with small denominations, the cost of production can outweigh the value of the currency.
Refers to the hierarchy in which creditors are entitled to be repaid in case of a company’s insolvency. Senior debt has a higher priority than junior debt, and therefore carries lower risk and lower yield.
Economic activities that do not involve the production of a physical product, unlike manufacturing. Services constitute a significant part of the GDP in most developed economies and encompass a broad range of activities, from architecture to zookeeping.
Financial institutions that operate outside the regulated banking system but still engage in lending and derivatives trading. The growth of shadow banks in the early 2000s contributed to the credit expansion that ultimately led to the 2007-09 financial crisis. Subprime mortgages were also a factor in this crisis.
Options that provide the right, but not the obligation, to buy company shares at a predetermined price. Companies use share options to incentivize executives and align their interests with those of shareholders. While share options have been effective at boosting executive compensation during times of equity market growth, critics argue that they may lead to short-term thinking and discourage long-term investment.
The idea that companies should prioritize maximizing returns for shareholders above all else. This concept gained popularity in the 1990s and early 2000s, but has since been criticized for promoting short-termism and neglecting social and environmental responsibilities.
A term used interchangeably with equities to refer to ownership in a company represented by units of stock.
The practice of selling borrowed shares in the hope of buying them back at a lower price and making a profit. Short-sellers are often unpopular due to the perception that they benefit from bad news, and the practice is typically restricted during times of market stress, when it is most profitable. However, short-sellers can serve as a valuable check on overheated markets and help to uncover fraud or mismanagement.
An excessive focus on short-term gains at the expense of long-term considerations. This can apply to businesses that prioritize quarterly profits over sustainable growth or to institutional investors who hold positions for only a few weeks. Short-termism is often criticized for impeding innovation and investment in research and development, as well as for its negative impact on stakeholder interests.
Skill-biased technological change (SBTC)
A theory that explains the rise of income inequality in developed countries as a result of the increasing use of new technology. This has led to a premium on wages for those who possess the necessary skills to use these technologies efficiently, while wages for lower-skilled workers have remained stagnant.
A political ideology that emphasizes collective ownership of some resources, typically those that are essential to society, but allows for a private sector to exist. Socialists advocate for progressive taxation and social welfare programs to promote social justice and reduce income inequality, but not to eliminate all income differences between individuals.
The possibility that a government may fail to honor its debt obligations or default on a loan, which could lead to financial losses for the lender or investor.
Sovereign wealth funds
Large investment funds created by national governments, often funded by revenue from natural resources. Examples include China, Norway, Abu Dhabi, and Kuwait. Sovereign wealth funds provide countries with a means to diversify their assets and hedge against economic risks, such as a decline in key industries or economic downturns.
Special drawing right (SDR)
The SDR is a reserve asset created by the International Monetary Fund (IMF) and defined in terms of a basket of five currencies, including the American dollar, euro, yen, yuan, and British pound. In times of crisis, the IMF can create new SDRs to help stabilize the global financial system. SDRs are distributed to countries based on their shares in the IMF, thereby providing them with additional foreign exchange reserves to use as needed.
Specialisation is the division of labor into specific tasks that can be performed by different individuals or groups. This idea was popularized by Adam Smith, who used the example of a pin factory to illustrate how breaking up a production process into a series of tasks can improve productivity. Specialisation allows individuals, businesses, and countries to focus on their areas of comparative advantage, leading to greater efficiency and increased economic output.
Speculation refers to buying or selling assets with the goal of making a profit from short-term price movements. Unlike investing, which involves a long-term focus on the underlying fundamentals of an asset, speculation relies on market trends and momentum. Speculation can involve leverage, which amplifies potential gains and losses, and may not be based on any fundamental analysis of the asset in question. While speculation is often criticized, it can play a role in providing liquidity and helping to manage risk in financial markets.
A reason for holding cash, identified by John Maynard Keynes, in addition to the transactions motive and the precautionary motive. The speculative motive refers to holding cash with the expectation of buying assets at a lower price in the future, in anticipation of a decline in asset prices.
The immediate price at which a commodity, currency or financial asset can be bought or sold in the current market. The spot price differs from the futures price, which refers to the price of an asset for delivery at a future date.
The difference between two prices or interest rates. In financial markets, the spread refers to the difference between the price at which a dealer buys and sells an asset. For example, in the stock market, the spread is the difference between the bid price (the price at which a dealer is willing to buy a security) and the ask price (the price at which a dealer is willing to sell a security). The spread can also refer to the difference in yields between two bonds or interest rates, often used to measure credit risk.
Stagflation is a rare combination of high inflation and high unemployment that defies the usual relationship between these two economic indicators. Typically, high unemployment signals weak demand, and high inflation suggests that demand is outstripping supply. However, stagflation occurred during the 1970s after the OPEC oil embargo caused a supply shock. Stagflation has also been a potential concern in the wake of the COVID-19 pandemic.
Stagnation is a period of extended economic stagnation, characterized by little or no economic growth. During a period of stagnation, an economy may experience high levels of unemployment, low productivity, and weak demand, leading to low levels of investment and innovation.
Stakeholder capitalism is an approach to business that emphasizes the interests of all stakeholders, including shareholders, employees, suppliers, and society at large. Advocates of stakeholder capitalism argue that businesses that prioritize the long-term well-being of all stakeholders, rather than focusing solely on short-term profits, are more likely to succeed in the long run. This is in contrast to the traditional focus on maximizing shareholder value.
A system in which the state plays a significant role in directing the economy, often through state-owned enterprises and strategic investments. This can take various forms, ranging from state ownership of major industries to government intervention in market activities. The term is often associated with authoritarian regimes where political power and economic power are closely intertwined.
The tendency for prices of goods and services to adjust slowly in response to changes in supply and demand, leading to market imbalances. This can be due to various factors such as the costs of adjusting prices, the difficulty of conveying information about price changes to consumers, or simply inertia in the pricing behavior of businesses.
A formal marketplace where securities such as stocks, bonds, and derivatives are bought and sold. In a stock exchange, investors can buy or sell shares in publicly-traded companies, and prices are determined by the forces of supply and demand. Trading can be conducted either physically or electronically, with the latter being more common in modern times.
A term used to refer to the trading of shares or equities within a formal market.
An industry deemed by the government to be of significant importance to the economy and therefore deserving of special treatment, such as subsidies, tax breaks, or protection from foreign competition as part of an industrial policy. The reasons for designating an industry as strategic may include promoting research and development, fostering an infant industry, national security, or self-sufficiency. However, this may also lead to protectionism.
A program of economic change aimed at improving long-term growth. The IMF and World Bank may require countries to undertake structural adjustment programs as a condition for receiving loans. Many economists and leaders also recommend structural reforms to achieve long-term economic growth.
Joblessness resulting from the structure of the economy, rather than from a shortage of demand. Causes may include foreign competition, technological change, overregulation, or a lack of labor market flexibility.
Home loans made to borrowers with poor credit ratings, often bundled together and sold to investors. During the 2007-2009 financial crisis, many subprime borrowers defaulted on their loans.
Financial assistance provided by a government to either consumers or businesses. Subsidies may be given to encourage the purchase of a specific product, keep prices low, prevent business failure, or create new jobs. However, subsidies may also distort market signals and are generally frowned upon by many economists, unless they correct externalities.
Substitution effect refers to the tendency of consumers to switch to a substitute product when the price of a product increases. For example, if the price of beef increases, consumers may opt for chicken instead. This effect is important to consider when measuring inflation.
These are costs that have already been incurred and cannot be recovered. Examples include the cost of developing a prototype or obtaining planning permission for a new project. The danger of sunk costs is that businesses may continue with a project, regardless of its potential for success, in order to avoid admitting failure and taking a loss. This is known as “sunk cost syndrome” and can lead to poor decision making.
Supply refers to the amount of goods and services that are available to meet demand in a given market.
Supply and demand curves
Supply and demand curves are a graphical representation of the relationship between the price of a product and the quantity of that product that consumers are willing to buy. The law of supply states that the quantity supplied of a good or service will increase as its price increases. The law of demand, on the other hand, states that the quantity demanded of a good or service will decrease as its price increases. The point at which the supply and demand curves intersect is known as the equilibrium price, at which the quantity demanded equals the quantity supplied.
Supply shock refers to the sudden disruption of economic activity caused by an unexpected interruption of important products’ supply or a sharp increase in price. In the modern era, supply shocks are often associated with energy, such as the oil embargo imposed by OPEC in the 1970s, Russia’s restrictions on gas supplies after its invasion of Ukraine in 2022, or the covid-19 pandemic, which caused many businesses to close. Supply shocks usually result in both higher inflation and lower output, and are thus difficult for policymakers to handle.
Supply-side economics is a school of thought that advocates stimulating output by improving productivity as the best way to boost economic growth. This can be achieved by tax cuts for the wealthy to encourage entrepreneurship, reducing regulations on business, and promoting labor market flexibility to make it easier to hire and fire workers. The approach was developed by free-market economists in the 1970s as a counter to Keynesian economics, which tended to focus on shortfalls in demand.
Swaps are derivative agreements in which two counterparties agree to exchange cash flows. For example, one party may agree to pay a fixed interest rate, and the other a variable rate linked to some benchmark. When payment is due, the two cash flows will be netted out, so only one party will pay the other. Swaps can be used for hedging against rising interest rates or for speculation, like other derivatives. See also credit default swaps.
Systematic risk refers to the risk that cannot be diversified away. An investor could buy 100 shares and reduce the risk that the collapse of a single company could harm their portfolio. However, the systematic risk of a collapse in the stock market would remain.
Systemic risk is the risk of damage to the entire financial system resulting from the collapse of an individual institution or group of them. Regulators had to reconsider this subject after the financial crisis of 2007-09 when some companies were deemed “too big to fail.” Large commercial banks certainly fall into this category, but the collapse of AIG, an insurance company, indicated that the potential for systemic risk was widespread. See also macroprudential regulation.
A jurisdiction with low or no taxes on transactions or profits, making it attractive to multinational corporations and financial firms for some of their activities. Wealthy individuals may also use tax havens to reduce their tax bills. According to the IMF, governments around the world lose an estimated $500 billion to $600 billion in revenue each year due to the use of tax havens.
Assets that have physical existence and can be touched, such as buildings, machinery, and inventory. Tangible assets are usually valued on a company’s balance sheet at their original cost less accumulated depreciation.
A tax levied by a government on imported goods. Tariffs are usually imposed to protect domestic producers and industries from foreign competition or to generate revenue for the government. However, they can also lead to higher prices for consumers and trade disputes between countries.
A trade policy mechanism that allows a specified quantity of a product to be imported at a lower tariff rate or duty-free. Once the quota is filled, a higher tariff rate applies to any additional imports of the product. Tariff-rate quotas are part of many countries’ trade agreements and are overseen by international organizations like the World Trade Organization.
The legal use of methods to reduce a taxpayer’s liability for taxes owed. This can include taking advantage of tax deductions, credits, and exemptions, as well as structuring business operations to minimize tax liability. While tax avoidance is legal, it is sometimes criticized as unethical or unfair, particularly when used by multinational corporations to avoid paying taxes in the countries where they operate.
The phenomenon in which two or more jurisdictions attempt to attract businesses and individuals by reducing their tax rates. While this can prevent governments from imposing excessive tax burdens on their populations, the extent to which it succeeds depends on the mobility of taxpayers. Capital controls under the Bretton Woods system made it difficult to move money between countries, and as a result, tax rates on companies and wealthy individuals were generally higher. Today, some argue that the combination of free capital movement and tax havens means that the corporate sector and the wealthy do not pay enough tax.
The act of paying less tax than what is legally required. Tax evasion is punishable with fines and, in some cases, imprisonment. However, catching evaders can be difficult. Tax evasion differs from tax avoidance.
A jurisdiction that imposes little or no tax on corporations and wealthy individuals. Tax havens benefit by attracting deposits to their banks and generating business for local lawyers and accountants.
The actual distribution of the tax burden, as opposed to the legal liability. When a company is taxed, the cost is passed on to shareholders (via lower dividends), customers (via higher prices), or workers (via lower wages). This chain of impact can be complicated, and sales taxes paid by consumers may result in lower demand and hit the profits of retailers. Tax incidence is sometimes referred to as the “effective” incidence of a tax, in contrast to its “formal” incidence.
Tax neutrality refers to the principle that tax rules should not influence economic decisions and should be designed to be neutral. However, due to political priorities and lobbying by corporations, tax neutrality is often not observed in practice.
The Taylor rule is a guideline proposed by John Taylor, an American economist, for setting interest rates by the Federal Reserve. The rule suggests a normal real interest rate of 2%, and interest rates should be adjusted based on the distance between actual inflation and the target rate, as well as the output gap. While central banks consult rules like the Taylor rule, they prefer to maintain their policy discretion.
Technical progress refers to innovations that have driven long-term economic growth, such as the steam engine, internal combustion engine, and electrification. Governments can play a role in generating technical progress through policies that support innovation, as suggested by endogenous growth theory.
Terms of trade
Terms of trade refer to the average price of a country’s exports relative to its imports. A fall in commodity prices can reduce the value of exports and worsen the trade balance for developing countries. A rise in commodity prices can increase the cost of imports and hit the trade balance for developed economies.
Time value of money
Time value of money refers to the concept that a dollar received today is worth more than a dollar received in the future due to the opportunity cost of waiting to receive the money. When evaluating an investment, the expected future income must be discounted by a rate to determine its net present value. The choice of the discount rate is important, as it affects the net present value calculation; the higher the rate, the lower the net present value.
A Tobin tax is a proposed levy on all currency transactions, designed to reduce market volatility and discourage speculation in foreign exchange. The tax was first proposed by James Tobin, a Nobel Prize-winning economist. Although the Tobin tax has yet to be imposed due to the difficulty of achieving international agreement, the idea continues to be debated.
Total factor productivity
Total factor productivity is a measure of output relative to inputs, calculated by dividing an index of output by a combined index of labor and capital. TFP captures productivity growth that is not accounted for by increases in input quantities, but rather comes from greater efficiency or the adoption of new technology.
Total return refers to the overall returns from an investment, including both capital gain and income.
A trade bloc is a group of nations that have agreed to reduce trade barriers, such as tariffs, among themselves. The European Union is a prominent example of a trade bloc. A trade bloc can also be referred to as a regional trade agreement.
Trade unions are organizations formed by workers to advocate for better wages, working conditions, and employment rights. While their influence was at its peak during the post-World War II era, the decline in manufacturing jobs and the rise of globalization has resulted in a reduction in union membership, with their greatest strength now found in the public sector.
Trade-weighted exchange rate
A trade-weighted exchange rate is a weighted average of a country’s exchange rate with its main trading partners, taking into account the proportion of trade with each partner. It provides a useful guide to a country’s competitive position in international trade.
Tragedy of the commons
The tragedy of the commons is a situation in which individuals have access to a public resource, which they exploit without considering the common good. For instance, small farmers may allow their animals to graze on the commons, eventually depleting all vegetation, or humans may overfish the oceans over time. This problem can be addressed through regulation or market pricing to discourage overuse.
The transactions motive is one of three reasons suggested by Keynes for holding cash. It refers to the need to hold cash in order to make purchases. The other two motives are the precautionary motive (holding cash for emergencies) and the speculative motive (holding cash to take advantage of investment opportunities).
A transfer refers to the act of giving money to another party without receiving goods or services in exchange. This type of transaction often takes the form of government welfare benefits or personal gifts to charities or individuals.
Transfer pricing involves the exchange of goods or services across national borders within a multinational corporation. This creates an opportunity for a subsidiary in a high-tax jurisdiction to sell or buy from a subsidiary in a low-tax area at an artificially low or high price, resulting in higher profits for the subsidiary in the low-tax nation. Although there are rules against this type of tax avoidance, it is still practiced by some companies.
Treasury bills are short-term government debt securities with a maturity of less than one year. These bills are issued by the American government and are highly liquid, meaning they can be easily bought or sold in the market. Other governments, such as the British government, also issue Treasury bills.
Treasury bonds are medium to long-term debt securities issued by the American government. The market for these bonds is one of the most liquid in the world and is often used as a basis for financial transactions such as repurchase agreements.
Trust is a crucial element in economic transactions where both parties rely on the other’s honesty and reliability. Inadequate trust can hinder business, trade, and financial activities. Trust can be built over time through repeated interactions and by implementing systems that reduce the risk of dishonesty or fraud.
USMCA (United States-Mexico-Canada Agreement)
USMCA is a free trade agreement between the United States, Mexico, and Canada that replaces NAFTA. It includes provisions related to intellectual property, digital trade, labor, and the environment. USMCA is intended to promote trade and investment among the three countries.
Uncertainty refers to a situation where there is a lack of knowledge or information about possible outcomes, making it difficult to estimate the likelihood of events or their potential consequences. It is different from risk, which involves the probability of known outcomes. Knightian uncertainty is a concept that describes situations where the likelihood of outcomes cannot be measured objectively, making it impossible to assign probabilities to different outcomes.
Unions refer to workers’ associations that aim to secure better employment rights and wages. In the past, union membership was high and manufacturing jobs were plentiful. However, globalization and the decline of manufacturing employment after 1980 weakened union membership, leaving their greatest strength in the public sector.
Universal basic income (UBI)
Universal basic income (UBI) is a term used for a variety of schemes aimed at reducing poverty. The schemes involve providing every citizen with enough income to support themselves, either as a replacement for all or part of the current benefit system. However, there are doubts about the potential effectiveness of UBI as it may require punitively high marginal tax rates and create a disincentive to work.
Usury is the practice of charging excessive rates of interest. In the past, many ancient philosophers disliked the concept of interest payments, and in the Middle Ages, laws against usury were common. These laws discouraged trade expansion and business formation since lending was inherently risky during that era. In the modern era, some governments still have laws that discourage loan sharks from charging sky-high rates of interest.
In the property sector, vacancy rate is the proportion of rentable or lettable properties that are unoccupied at a given point in time. A high vacancy rate may indicate economic difficulties or excessive building of properties. For job vacancies, see job vacancies.
Value added is the difference between the price of a good or service and the cost of the inputs used in its production. It is a measure of the contribution that each firm or sector makes to the economy. Value added is also used as the basis for value-added tax (VAT).
Value at risk (VAR)
Value at risk (VAR) is a measure used by financial institutions to estimate the maximum potential loss they could face within a set period due to market movements. However, it has limitations as it may not accurately capture extreme events or “fat tails” that occur infrequently but can cause significant losses.
Variable costs refer to the expenses that change based on the level of output produced by a firm, such as raw materials or labor costs. In contrast, fixed costs do not vary with changes in output.
Veblen goods are luxury items whose demand increases with their price. These goods are often associated with conspicuous consumption and social status. They are named after economist Thorstein Veblen, who described the phenomenon in the late 19th century. The high price of these goods often makes them more desirable because they are seen as a symbol of elite status. The saying goes, “If you have to ask the price, you can’t afford it.”
Velocity of money circulation
A measure of the rate at which money circulates through an economy, calculated as the total value of all transactions divided by the money supply. It indicates how frequently a unit of currency is used in a given period of time and is an important component of the quantity theory of money.
A type of private equity investment that focuses on financing early-stage and high-growth companies with innovative ideas and products. Venture capitalists provide capital to start-ups and small businesses in exchange for equity ownership, with the expectation of high returns on their investment in the future. The industry has been instrumental in funding many successful technology and innovation-driven companies.
The exchange of physical goods between countries, including raw materials, commodities, and finished products. It is a component of a country’s balance of trade and is measured by the difference between the value of a country’s exports and imports.
The degree of fluctuation in the price of a financial asset over a specific period of time. It is often used as a measure of risk in the financial markets. High volatility indicates that the price of an asset is rapidly changing, and investors may be exposed to higher risk. Low volatility suggests a more stable price trend.
Refers to workers who choose not to work despite being able to and actively seeking employment opportunities. This includes individuals who may be taking time off work for personal reasons or are between jobs, and they are not considered unemployed as they are not actively seeking work.
A self-perpetuating cycle in which increasing inflation leads to demands for higher wages, which in turn results in higher costs for businesses and subsequently higher prices for goods and services. This cycle may continue until it is disrupted by external factors such as government intervention or a recession.
The compensation paid to employees for their labor, typically in the form of hourly wages or salaries. Benefits such as health insurance, retirement plans, and paid time off may also be included as part of an employee’s overall wage package. Wages are often subject to negotiation between employees and employers, but may also be governed by minimum wage laws or collective bargaining agreements.
A term coined by economist John Williamson to describe a set of economic policy prescriptions promoted by international financial institutions such as the International Monetary Fund and the World Bank in the 1980s and 1990s. These policies included market liberalization, privatization, fiscal austerity, and deregulation. The Washington Consensus has been criticized for being too rigid and failing to account for unique national circumstances.
The tendency for changes in the value of assets such as stocks, real estate, or other investments to affect consumer behavior. Increases in wealth may lead consumers to feel more confident and spend more, while declines in wealth may lead to reduced spending. The wealth effect can have significant impacts on overall economic activity.
A tax on an individual’s net worth or assets, which is proposed by some policymakers as a means of reducing wealth inequality. This can take the form of a one-time levy on large inheritances or an annual tax on high net worth individuals. However, critics argue that wealth taxes are difficult to enforce and could discourage investment and economic growth.
A term used to refer to social programs that provide assistance to individuals or families who are in need. This can include unemployment benefits, housing assistance, food stamps, and healthcare. These programs are designed to help vulnerable individuals and reduce poverty.
Programs that aim to help unemployed individuals find work and transition off of government assistance. These programs often include job training and education programs, as well as tax incentives for employers who hire program participants.
A sudden increase in income or wealth, such as an inheritance or a large bonus. Some individuals may choose to save these gains, while others may choose to spend or invest them. The response to windfall gains can depend on a variety of factors, including an individual’s financial situation and personal preferences.
Taxes imposed on companies that earn unexpectedly high profits due to economic changes. For example, energy companies were subject to windfall taxes following Russia’s invasion of Ukraine in 2022. Economists are skeptical about the effectiveness of such taxes as they may discourage future investment, and companies may require occasional windfalls to offset losses incurred during difficult times.
Markets in which only a few individuals receive significant rewards while the majority receive much less. For example, many people can sing or play football, but only those who can sell out concerts or play for top-flight clubs will receive high pay. Similarly, top accountants, lawyers, and fund managers can charge high fees because clients seek them out.
A tax collected before the recipient receives their money. Withholding taxes are often applied to interest and dividend income, and taxes are deducted from most workers’ wages before they receive payment.
Working from home (WFH)
A trend that became popular during the COVID-19 pandemic, particularly for office workers whose workplaces were closed. Although not feasible for employees in some sectors such as retailing and manufacturing, office workers were able to use technology such as video conferencing to work from home. Evidence did not suggest a significant impact on productivity, and as the pandemic subsided, hybrid working became common where employees work some days from home and some in the office.
The World Bank is an international organization established under the Bretton Woods agreement, alongside the International Monetary Fund. Its main objective is to provide loans and advisory services to developing countries to help them with their economic and social development. The World Bank also conducts research on issues such as poverty reduction, health, education, and climate change.
World Economic Forum
The World Economic Forum is a research and conference group that holds an annual meeting in Davos, Switzerland, bringing together world leaders, business executives, and other influential figures to discuss economic and social issues. The forum provides a platform for networking, knowledge-sharing, and collaboration. The event has been criticized for being elitist and disconnected from the concerns of ordinary people.
World Trade Organization
The World Trade Organization is an international organization that regulates international trade and resolves trade disputes between countries. It was established as part of the General Agreement on Tariffs and Trade (GATT) and replaced it in 1995. The WTO promotes free trade, sets rules for trade, and provides a forum for negotiation and dispute resolution. However, it has been criticized by some for impinging on national sovereignty and favoring developed countries over developing ones.
The return on an investment expressed as a percentage of its market value. For bonds, this is typically the coupon rate, which is based on the bond’s face value of $100, but may differ from the price at which it is currently trading, resulting in a different yield. For stocks, the yield is the dividend payout as a percentage of the stock price.
A graph that displays the yields of bonds with different maturities, usually plotted on the vertical axis against time to maturity on the horizontal axis. The yield curve generally slopes upward, with longer-term bonds yielding more than shorter-term bonds, due to the time value of money. However, an inverted yield curve occurs when shorter-term bonds have a higher yield than longer-term bonds, which may signal a potential economic downturn or recession.
Zero coupon bond
A bond that is issued at a discount to its repayment value and does not pay any interest payments. Instead, the bondholder makes a capital gain if they hold the bond to maturity. In some jurisdictions, this type of bond may offer tax advantages, as capital gains are often treated more favorably than interest income.
Zero lower bound
The lowest point to which central banks can lower interest rates to stimulate the economy. Economists once debated whether rates could be cut below zero, meaning depositors would be penalized for keeping their money in a bank. However, central banks demonstrated in the aftermath of the 2007-09 financial crisis that negative interest rates could be introduced for commercial banks, rather than for individuals.
A type of employment in the gig economy that provides maximum flexibility to employers but little security to workers. Employees are called in to work only when they are needed and cannot be certain about their income, availability for other jobs, or childcare commitments.
The belief that economic gain by one party can only be achieved at the expense of another. This philosophy underlies protectionism, which seeks to exclude the products of other countries. However, most economists believe that open trade is mutually beneficial.