Study of Economy

Talk to any stock analyst about investing and quite often they will tell you they use fundamental analysis as an integral part of their investigation. Fundamental analysis basically involves the study of three major areas: First the economy, second the economic sector of the security, and last the security (company) itself.

Study of the economy is probably the most abstract of the three disciplines. Analyst study the strength and direction of the economy knowing that a strong, prosperous economy bodes well for the stock market. The government controls the economy through manipulation of the money supply, in other words the amount of money its citizens possess. Federal government influences money supply using two methods: fiscal policy (the ability to tax) and government spending (may use deficit spending). To increase the money supply, the government can reduce taxes or increase government spending. To decrease the money supply they would do the opposite; increase taxes and/or reduce government spending. The Federal Reserve Bank also has the ability to control the money supply through application of monetary policy. The Federal Reserve Bank manages the money supply by increasing or decreasing the amount of deposits commercial banks must retain, may raise or lower the federal funds interest rate and can make sales/or/purchases of government securities on the open market. Any one or a combination of these activities will serve to manager the money supply.

The Federal Reserve Bank and the government generally appears to have a three pronged objective in the application of money supply changes. The first objective appears to be full employment of its citizens. The acceptable target (never published) appears to be about five percent (5%) unemployment. If unemployment increases above the acceptable rate say to seven percent (7%) then money supply would be expanded. Expansion gives people more money to spend, which means company sales will increase, which will put more people to work and ultimately unemployment should be reduced. The second objective is a sustainable expansion of the economy as measured by the gross domestic product. In this case the objective appears to be approximately a two to three percent annual growth rate of all the goods and services produced in the United States. A rate lower than three percent indicates the economy is not vibrant and healthy. The Federal Reserve and possibly the government would take action to expand the money supply. An increase in money supply should allow for an increase in the production of goods and services and put the economy back on track. The third objective is to control inflation, too much money circulating within the economy can be inflationary. Too much inflation erodes the value of savings, makes goods and services more expensive, and interest rates higher. Hyper high inflation could result in political instability and major changes in operation of a country. The Federal Reserve would like a zero percent inflation but appears willing to accept a three percent rate. A high rate of inflation could result in a reduction in the money supply and reduce business activity resulting in a possible recession.

Understanding how and why the economy fluctuates should help investors understand that every down turn (economic and stock market) is not dooms day. Investors should realize that there is always risk in any investment but knowledge, logical thinking and patience will be rewarded.