Why is economics important to investors?
Economics and the stock market. That’s like asking why the skeleton is so important to the human body; it’s the support and framework for everything. Economics frames the core principles of financial markets – things you learned in high-school: supply & demand, elasticity, creation of money…etc (don’t worry we’ll dig into those later). Needless to say, understanding economics is incredibly important. Here are three of the most basic (yet important) elements of economics.
Economics Basics # 1: Why prices move up and down
Your high school teacher was right: economics is built on two principles – supply and demand. As demand increases, price increases and as supply increases, the price decreases.
Think of bubble gum. If bubble gum suddenly became incredibly popular (read: demand up), bubble gum sellers could charge more (making Willy Wonka very happy). On the other hand, if no one wants bubble gum, they would have to charge much less for them to entice people to buy them. Now think about oranges. Imagine the world’s supply of oranges decreased. Oranges would become more rare, therefore more valuable. Grocery stores and markets could therefore charge more for them.
Let’s look at how prices move on the stock market. Think about IBM stock. If there are more people buying IBM (demand up) than there are people selling it (supply down), IBM shares will become more valuable driving the price up (just like the oranges).
If there are more people who to sell IBM shares (supply up) than there are people who want to buy them (demand down) IBM shares will drop. Feeling dizzy yet? Just remember: Each upward movement means more people are buying then selling, each downward movement means more people are selling then buying.
Economics Basics # 2: Why Interest Rates affect the market
Check your mortgage, your student loan or your credit card statement – interest rates are everywhere! But interest rates and the market are much less understood. So that begs the question, why and how do interest rates affect the stock market?
If the Government increases interest rates, keeping your dough in a savings account becomes a whole lot more appealing simply because the interest that you’ll earn will be that much higher. However, there are economic implications:
- People will invest less. Saving and investing are linear. The more you save, the less you invest and vise-versa.
- Investing less means that companies have less access to cash. That can sometimes make it harder for companies to grow.
- When interest rates go up both people and companies tend to borrow less because the cost of paying the loan back is higher. If people borrow less they spend less and if companies spend less they tend to grow less too - essentially, it takes money to make money, right?
Economics Basics # 3: Why Unemployment affects the market
Unequivocally, unemployment is the biggest topic in the United States right now. And the ripple effect of unemployment trickles down onto many things, including the stock market. Simply put, as unemployment goes up, there are fewer jobs in the economy.
If the government needs to put more money into unemployment funds, it will have less to spend elsewhere (like on computers, building material and other infrastructure projects). Similarly, people on unemployment have less disposable income and are spending less on consumer goods.
As you can see, companies will also suffer in both those scenarios, along with their stock price.
Remember, higher unemployment affect stock prices negatively.
It’s all connected…
The stock market, like economics, is vast, volatile and interconnected. One thing out of place and the whole ecosystem can suffer (Think of the market as giant game of Jenga)
Read more about the different topics in Economics on Wall Street Survivor to see how else economics affects the markets.