User's blog

Author: Parul

  • What is a 529 plan in the U.S.?

    In my earlier post, I wrote about ways to fund your child’s college education. One of them was opening a 529 account. In this post, I will talk about what these plans are.

    529 plan is a tax advantage account, where people invest money to fund the college education of their kids. You can open an account for your education as well.

    529 plans are state government-sponsored plans and each state has its plans.

    Advantages of 529 plans

    The first advantage is that you invest your post-tax money and it grows tax-free. This is similar to a Roth IRA or 401 K. The other advantage is that there is no maximum contribution limit.

    Additionally, if the original beneficiary can’t use his account for any reason, there is an option to change the beneficiary anytime.

    Who can open the account?

    Mostly parents or grandparents open this account to fund money for their child or grandchild’s higher education.

    Anyone with a Social Security Number (SSN) or Individual Taxpayer Identification Number (ITIN) can open this account. Though non-U.S. citizens living outside the U.S. can’t open the account, they can still contribute to a child’s 529 plan.

    Also, anyone can contribute to a 529 plan, a grandparent, a friend, or a relative.

    Only U.S. citizens or resident aliens with a Social Security Number or Individual Taxpayer Identification Number can be the beneficiary.

    Also, you don’t have to be a resident of that state to apply for that plan. Most states offer it to both residents and nonresidents. However, there are six 529 plans that are only available to in-state residents:

    Two types of 529 plan

    • Savings plans: This is where you are building up money, which you can use toward almost any college tuition and related expenses in the US. This can also be used for K-12 education as well.
    • Prepaid tuition plans: This lets parents lock in today’s tuition rates for a child’s future education (but may limit where a child can go to school). The money can’t be used for room and boarding.

    Choosing the right 529 plan

    Savings plans tend to be more popular than prepaid tuition ones, as they are less restricting. Not all states offer prepaid tuition plans.

    Many families choose their state’s plan because their state can offer more tax benefits to them. However, you are free to choose any state’s plan. One tip is to compare different plans and choose the one with a low expense ratio.

    Disadvantages of 529 plan

    Since the money invested should only be used for education purposes, if you use it for anything else, you pay a 10% penalty and will owe taxes on the capital gains.

    Also, you can’t control which assets these plans invest in.

    Should you invest in 529 plan?

    Despite these limitations, it is still a great plan for funding college education if you think your child will go to college.

    Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice.

  • How to fund higher education in the US?

    Before I answer this question, I want you to look at the income of people with a college education vs people who don’t. Publicly available data and our observation show that people with a bachelor’s degree or a master’s degree get higher-paying jobs.

    Below chart, I copied from the U.S. BUREAU OF LABOR STATISTICS. It shows the median earnings by education level in the United States from the 2021 population survey.

    People with bachelor’s degrees earned 48% more than people who don’t complete their degrees. Clearly, completing the degree has a huge positive impact on median earnings. Also, people with professional degrees such as doctors, engineers, and lawyers earn even higher amounts.

    Ways of funding college education

    How to fund their child’s higher education is an important decision all parents will have to make at some point. Planning early for a college education is better than planning later and it is esp. true when you have more than one child.

    In the US, there are several ways you can do that:

    529 plan

    You can create a college fund using a 529 plan. A 529 plan is a tax-advantaged college savings account offered by either your state government or college.

    The tax advantage is the main benefit of it. Tax advantage means you invest your post-tax money, but it grows tax-free. Also, when you withdraw your money for college, you don’t have to pay taxes on it, as long as it is used for education purposes.

    If you are aware of 401k plans, 529 plans are similar to those. However, this money you withdraw can only be used for education. There is a penalty of 10% for non-educational use and you will have to pay income tax on it.

    To know more about this option, you can look at this website for all the details.

    Loans

    If you can’t afford to pay for your child’s college education from your own savings or investment, you can borrow.

    I am going to get a little sidetracked here, but from what I learned from various finance books and legit websites is worth sharing. I feel borrowing for good investments pays off in long run.

    Loans taken for higher education, starting or growing a well thought business, or real estate are all good investments. As there is a very high chance of you earning more from these investments. It is like you are investing for your future. So even if you have to pay interest on your loan, your earnings increase much more in comparison, to compensate for it.

    However, borrowing to pay for things that will ultimately depreciate, such as cars, furniture, and vacation isn’t worth it.

    Coming back to the topic, alternatively, you can also borrow for higher education if your savings or investment can’t cover the cost.

    Take loans from either the Federal government or from private banks

    These student loans can be used for tuition, accommodation, books, and other miscellaneous costs related to college. The interest rates on Federal loans are usually lower compared to private banks.

    As of today, interest rate on federal unsubsidized loan is 4.99% for bachelor’s degree and 6.54% for professional and graduates degrees. The repayment period defaults to 10 years but can be extended up to 30 years. For more info, you can refer to the Federal student loan website.

    On Aug. 24, 2022, the U.S. Department of Education (ED) extended COVID-19 emergency relief for student loans through Dec. 31, 2022. Please see here for more details.

    https://studentaid.gov/help-center/answers/article/what-is-current-interest-rate-for-direct-unsubsidized-loans

    How much can I borrow for a student loan?

    For the undergraduate level, you can borrow each academic year between $5,500 and $12,500 depending on your year in school and dependency status. For graduate or professional level, you can borrow up to $20,500 per year.

    Types of Federal loans

    The main difference between Direct Subsidized Loans and Direct unsubsidized loans is the financial need element. Direct subsidized loan are available to undergraduate students with financial need, so the US government pays interest on your behalf.

    Direct unsubsidized loans are not based on financial need and hence you pay the interest on the loan. On these loans, interest accrues (adds up) every day.

    Borrow from private banks

    The other option is to borrow from private banks. Usually, the rates are higher than Federal student loans.

    With private loans, the payments get due while you are still in college. In the case of a Federal direct unsubsidized loan, payments are not due until after you graduate.

    My two cents

    Get higher education even if it requires borrowing. Also, you have to understand how much money you should borrow. The main aim is that it should cover your tuition and basic living expenses, if you are staying away from home.

    It may be tempting for you to go to a great location, a beautiful campus, and choose a college with the best athletics. But, you should decide if taking a bigger loan for these extra amenities is even worth it, esp. when you have to pay interest on your loan.

    Another option is to check with a nearby college. From my experience, degree from UCLA or USC counts equally well as a degree from UC Berkeley, if you are applying for jobs in and around LA. If your nearby college has a decent rating, living at home and attending local universities will save a lot money on accommodation.

    Some kids also join two years of community college and then attend two years at their local public university This is a much cheaper option and can save you thousands of dollars.

    Also, make sure to submit your student loan FAFSA (form) as early as possible for the best grant and loan opportunities. You can also check for grants or scholarships from your local civic organizations, your local community colleges and universities, and even your parents’ employers.

    I hope you found this information useful. Adios, until next time!

    Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice.

  • Some ways to save money and cut expenses

    Who doesn’t like to see some extra money in their savings without having to sacrifice their living standard?

    Saving is the money left after subtracting all our expenses from all our income. This is, after all, the money you can ultimately invest and grow. Well, there are two ways to save money.

    Yes, you guessed it right, either you increase your income or reduce your expenses. In this post, I will focus on the latter.

    I will share some easy ways for you to reduce your monthly expenditures, without even feeling it. While some of these may seem common sense, it is still good to read this article. Maybe, you will find one particular option, which I am going to list below.


    I am combining personal finance and human psychology with my favorite economics knowledge to come up with some doable changes we all can implement. So without further ado, let’s get into it!

    Cut Down on Streaming services

    To start with, please cancel any unnecessary online streaming subscriptions. Many times, we take too many streaming services that we don’t even use much. Honestly, on average, if you are working or studying full time, how much TV do you get to watch every day? Maybe a couple of hours, max?

    So, yes most people do not get the time to watch that much TV and we often end up paying too much for each service. So you should consider how many of these you can’t live without. Even though their monthly fees don’t seem that much individually, together they all add up.

    Is Gym membership worth it?

    Think about marginal benefit vs. marginal cost of Gym membership

    Unless you use the gym 4-5 times a week, paying $20 or so per month isn’t worth it. We get tempted by their deals and may use them for some time in the beginning, but most of us are not able to continue for whatever reason.

    I am totally in favor of exercising and maintaining a healthy lifestyle. And there are free resources for that. You can always start with walking or jogging outside or jump roping. You can also do yoga and make use of many free online exercise videos or free cardio classes. These will all give you the same results if done 3-4 times a week for 30 minutes a day.

    Do you still use Cable TV?

    How to cut your expenses without affecting your living standards?

    In a world where there are so many streaming services, I honestly think we don’t need cable TV anymore.

    I find that a lot of time is taken by the ads shown, and we don’t have the option to skip ads, in cable TV. Honestly, most people just flip between channels waiting for the ads to finish. What a waste of time!

    Consume less electricity during peak hours

    For most places, peak hours are between 4 to 9 PM. This is when you get charged the most. So try not to use your dishwashers and washers during this time if you can. Also, Having an app like Nest will help you monitor how much your AC is running and how to control it. I found some additional ways to reduce your electricity bill in this post in case you are interested.

    Refinance your loans

    If you follow my posts and the news, you must be aware that the Fed has (indirectly) raised all the interest rates that affect us. This includes our home loans as well. The Fed has clearly stated that to fight inflation, it will further raise interest rates. So there is still time for you to refinance some of your loans for a lower rate.

    So anytime, you find interest rates lower than usual, don’t miss the opportunity to refinance your mortgage.

    Eat out less

    Well, this goes without saying, right? I understand everyone can’t have a home-cooked meal every single day. We also need a break and eating out provides us with that happy feeling. But if you can, try to slowly decrease the number of times you go out to eat. For example, start by reducing it by 25% and gradually increase it.

    There will be two advantages to it. Not only you will save money on restaurant bills, but you will also be able to have a healthier life. To get to this, you will certainly need better meal planning (esp. since we all live very busy lives). Nevertheless, it is doable if you incorporate simple and healthy options to cook. One way to do it, which I sometimes do is to make extra servings of the food in an instant pot and use my freezer to save it for the future.


    Avoid instant online shopping temptations

    When we pay with credit card or debit card, often times we don’t know how much money we have spent. We easily fall prey to online shopping deals and offers. Studies have found that the pleasures of online shopping release dopamine, a happy hormone.

    Oftentimes, we just want to buy something because we see others using it. Here, we need to stop and think if we really need it. Is this really adding value to our life?

    An additional tip is while buying clothes, shoes, and accessories, try not to do too many one-time-use purchases. Buy something that you can use more often. We all need a few party wear and special occasions outfits but just choose the number wisely. We work hard for the money and we need to use our judgment while making any purchase.

    Most of the time the pleasure we get by making any purchase is very short-lived. We suffer from something called “shiny object syndrome”. So always think before giving to this instant online need to splurge. One tip is to leave the item in a shopping cart for a few days and then decide if you still need to buy it.

    Return options

    Many of the companies we buy from these days, offer return services, some up to 90 days or more with a receipt. We procrastinate returning because of this long window and may forget to return the item. I am sure it has happened to some of you. So either set up reminders or do it as quickly as you can to avoid sitting with that item.

    Be cautious of free trial magazines and other services

    Sometimes, we take a service, which is free for a trial period. Usually, these services require us to give the payment information even though they don’t charge for the trial period. They also give the option to cancel the service anytime during the trial period. But life happens and we may forget to cancel it.

    Then unknowingly, we get charged for a whole year. Be cautious of these. I would suggest not falling for these offers unless you are very disciplined and can keep track of all your free trial subscriptions. One way to avoid getting charged is to set reminders on your phone to cancel before the free trial period ends.

    So, these were some of my tips for reducing your expenses without substantially affecting your lifestyle. I am sure there are many more, so feel free to share those in the comments section below. In my other post, I will also cover some ways to increase your income.

    I hope you learned something from this personal finance post series. Please leave your comments on what type of posts you would like to read, it will help me connect with my readers more. I hope you are having an amazing day and I will be back soon with another topic. Thank you for reading till the end!

     

  • Did inflation fall to 0% in the US in July?

    Yesterday, in the news, I read President Biden saying the US had 0% inflation in July. The BLS, the official source of inflation numbers, reported no change in the CPI (Consumer price index) from June.

    So did inflation suddenly disappear? Well, it depends on how you measure it.

    Sometimes, the way politicians report some facts could give us misleading conclusions. So, the economist in me had to write something today to help my readers understand it better.

    How do we measure inflation?

    As I said above, the official inflation number in the US comes from the BLS every month. BLS calculates price inflation both monthly and annual.

    If you want to know more about inflation in simple words, you can read my previous posts. I described how we can calculate inflation using some simple examples. I also explained what policy measures the central bank takes to control inflation – my most favorite post.

    So was Biden lying when he said 0% inflation?

    There was indeed no general average price increase from June 2022 compared to July 2022. This meant a 0% monthly inflation.

    However, the year-to-year inflation ending July 2022, was 8.5%. This is still very high, compared to the average US inflation of around 2%. Inflation is the percentage price increase of a basket of goods and services people in the urban United States use. This is of course, over a specific period.

    But, the good news is that it was somewhat less than the June 2022-to-2021 inflation of 9.1%.

    A picture is worth a thousand words

    Here is a chart showing category-wise inflation. The food prices continued to rise. Few others, such as electricity, new vehicles, and shelter also rose.

    The main reason behind 0% monthly inflation was the falling gas prices. It offset the increase in food and shelter indexes. The lower gas prices finally come as a relief to millions of Americans. We have been experiencing a sharp rise in gas prices for a long time and wanted a break.

    Hopefully, Fed’s tight monetary policy will bring inflation down further in the coming months. But, there might be a cost to it- the possibility of a recession. As we say in economics, there is no free lunch. Let’s just hope that even if the R word happens, it is not significant.

  • The jobs market in the US is still going strong

    Two days ago, President Joe Biden proudly posted that the unemployment rate in the US was 3.5% in July. This matched the lowest rate in the last 50 years. He also said that since he started, 10 million jobs have been created in the US economy.

    Praising the fastest-growing job market, Biden mentioned that 528,000 jobs were added in the US in July itself. “Today, we also matched the lowest unemployment rate in America in the last 50 years: 3.5%,” he said.

    The Bureau of Labor Statistics (BLS) in the US publishes data for the unemployment and labor force statistics every month. These are based on the data collected from household surveys and establishment surveys on sample-based estimates of employment.

    I got this Civilian unemployment rate graph from the BLS. You can see that the US unemployment rate is now at its lowest level at 3.5%. This had happened three times before in Sep 2019, Jan 2020, and Feb 2020, when it hit 3.5%.

    But have you ever wondered what is the unemployment rate anyway?

    Well, the unemployment rate is the percentage of people who don’t have a job but can work and have actively looked for a job in the past 4 weeks. This is relative to people in the labor force.

    According to the BLS, The labor force is the sum of employed and unemployed people ages 16 and older at a given period.

    Their recent report about July’s unemployment rate was contrary to what many people would have expected. People were expecting a somewhat slowdown in the job market, but clearly, this hasn’t happened yet. The Fed has been raising interest rates to control inflation. The Fed’s policy aims to cool the overheated economy by reducing overall spending by individuals and businesses.

    So what does a low unemployment rate mean for you?

    If you are looking for work or want a change of job, right now could still be a good time for that. There’s a huge likelihood of you finding it sooner than later and as per your terms. With many employers paying higher salaries, it is a good time to ask for a raise if you think you deserve it.

    When the effects of tightening monetary policy start showing up and we see a reduction in jobs created, it might be a little late to negotiate.

    As always, if you enjoyed reading my post and learned something, please feel free to write your views in the comment section below. Thank you, till we meet again next time!

  • How to always make money in the stock market? What is a Dollar Cost Averaging?

    Today, I will introduce you to a very useful concept called Dollar-cost averaging. It is an investment strategy where you invest a fixed amount of money every period, such as every month, despite the stock market trend. You could invest your money in an index or mutual fund, or electronically traded funds (ETF).

    So, no matter how the stock market behaves if you keep putting in a fixed dollar amount every period, over the long run, it will surely give you good returns.

    Let’s understand this with a help of an example. The dollar amount you contribute each period, divided by the stock price, gives you the number of stocks you buy for that period. So, when you invest a fixed dollar amount (let’s assume you contribute every month), you end up buying fewer stocks when the stock price is high.

    Conversely, when the stock price falls, you buy more stocks for the same dollar amount you invested during that month. This way, your average purchase price per stock stays low over time.

    There is an excellent example explaining dollar cost averaging that I found on the Charles Schwab website.

    To be a successful investor, you need to have patience and invest for the long term. People expect their money to grow overnight and this certainly doesn’t happen.

    Why people need to use this strategy?

    People try to buy stocks when their prices are falling and sell when they are rising to make profits. But it is very difficult to time the market. There is no foolproof way to know how the stock price will behave the very next day or coming days.

    Sometimes, you may buy a stock thinking it is selling at a low price and will rise in the future. If the stock price rises and continues to rise, you made a good investment decision until you sell it at a higher price and make a profit. However, if the stock price falls further for the next few days, and you end up selling it at a lower price than you bought it for, you made a mistake.

    Dollar-Cost Averaging

    In reality, people panic and start selling individual stocks when the stock prices are going down. This is actually the wrong thing to do.

    Also, people, sometimes, don’t buy those underpriced stocks thinking they are not performing well and will continue to fall.

    We, as individual investors don’t have enough information about a specific company and other economic events. Hence, our guesses about market stock price and index movements are not always correct.

    How does Dollar cost averaging help?

    This can be avoided when we invest a fixed dollar amount. With dollar cost averaging, you can stick with a good investment schedule and will not overthink about when to buy or sell stocks.

    I like to invest worry free

    Thus, a big advantage of dollar-cost averaging is that it is a worry-free method of investing. The emotions and anxiety associated with investing are taken out and you just invest a fixed amount at a fixed time (such as every month), ignoring the market ups or downs.

    An example of dollar-cost averaging investing would be the investments done through your employer’s 401k plan. Here you and your employer contribute a fixed amount of money towards your retirement income.

    I hope you learned something from my post today. If you haven’t already, you will start making use of this useful technique in making your investment decisions. Also, please start early, as time is the key. After creating the emergency fund in your savings account, invest your money so it can grow.

    Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice. I recommend you consult a qualified financial advisor to make investment decisions.

  • Saving vs Investing

    What is saving?

    Saving is the extra money we are left with after meeting our expenses from our income. It is the difference between our total income and our total expenditures.

    There are several things we can do with that extra money. We can either leave it at home (the worst option) or keep our extra money in a bank, such as in a savings account or invest it.

    In this post, I will cover how much money we should save in a bank vs investing it to grow it.

    Advantages of having a savings account in a bank

    First, and foremost, we need to understand money loses its value over time because of inflation. So, even though the interest paid on a savings account is not very high, we still get some interest to compensate for loss happening from inflation. Thus, it is certainly better than keeping it in your house, as you don’t earn any interest when you keep it at your house and will lose its value due to inflation.

    However, the best part about a savings account is that your money is safe in a bank, as most commercial banks in the US are insured by FDIC. FDIC is Federal Deposit Insurance Corporation that insures that will not lose their money if that bank goes bankrupt.

    In other words, people who deposit money in a savings account protected by FDIC for up to $250,000.

    So, when looking for a savings account, make sure your bank has FDIC insurance. Also, if you want to select a bank for a savings account, you should look for one that charges the minimum fee for you to hold an account.

    Another important use of keeping money in a savings account is that you can withdraw it for expenses such as a down payment for a car or a house.

    Get that Emergency fund established first

    People also keep money in their savings accounts for emergencies. I strongly feel everyone should create an emergency fund. If something were to happen to our income, we should have at least 6 months’ worth of money to survive.

    So, keeping money in a savings bank doesn’t make you rich, but it helps in creating an emergency fund and meeting some big expenditures. So before, we start investing, we should have at least 6 months’ worth of money in a savings account for emergencies.

    This can change based on the size of the family and sometimes people need up to 12 months’ worth of expenses if the family size is big.

    Anything after that, we should invest if we want our money to grow.

    What do we mean by investing?

    In finance, investing means when you invest your extra money with the hopes to grow it. The most common forms of investment are stocks, bonds, an index or a mutual fund, commodities like gold and silver, and real estate (property).

    If you are interested in learning more about these options, you can check out my post here.

    Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice. I recommend you consult a qualified financial advisor to make any investment decisions.

  • IMF predicts further slowdown for the world economies

    The International Monetary Fund in its latest World Economic Outlook report, published on July 26, 2022, has lowered its estimate of Economic growth for the world economies. This is a downward revision from their April 2022 projections of GDP growth rate for both 2022 and 2023. Below is the chart I took from the IMF website showing their growth projections by region.

    I have tried to summarize the main points of the report for you. If you are interested in reading the full report, please click here. https://www.imf.org/en/Publications/WEO/Issues/2022/07/26/world-economic-outlook-update-july-2022

    Lower GDP growth but higher inflation globally in 2022-23

    The GDP of the World is now expected to grow at 3.2% this year and 2.9% next year, compared to what they had predicted in April to be 3.6% in both 2022 and 2023.  While they predicted lower GDP growth across the globe, they raised their inflation estimates. The report predicts a 6.6% inflation in advanced economies and 9.5% in emerging and developing economies.

    What are the main factors behind this?

    The report cited various reasons for its downgrade revision. On top of the pandemic after effects, higher-than-expected inflation has been a major cause of worry worldwide, especially in the US and major European countries. This has caused the central banks of these countries to raise interest rates, making financial conditions tighter.

    Additionally, China’s economic slowdown has been worse-than-expected due to its zero covid policy. This has caused longer lockdowns, affecting their exports to the major US and European economies, and causing supply chain issues. This has also led to a supply-induced inflation.

    The report fears that given the current scenario, the Russian – Ukraine war could continue for long and sanctions associated with it could go up further. This will, unfortunately, cause more problems in energy and food markets’ supply.

    They also ran an alternative scenario of a possibility of a full shutdown of Russian gas flows to Europe by the end of 2022. If that happens, GDP global growth might fall further to 2% next year. The report also stated that since 1970, global growth has only been lower five times, so this does look very gloomy.

    What should the countries do to overcome this?


    The report suggests that controlling elevated inflation should remain the priority of policymakers around the world. This requires tightening monetary policy, and many central banks have started to do that already, both in advanced economies and emerging markets.

    They also noted the role of Fiscal policy is important here to protect the vulnerable population. But it is important that the fiscal policy (like in the form of subsidy or stimulus payments) should only target the weaker population and should not interfere with the overall disinflationary motive of monetary policy. Because a lot of inflation in the advanced economies was caused by this issue, where too much money was chasing too few goods. In other words, people got the money to spend, but not that many goods and services were getting made, causing excess demand and inflation.

    The report concluded that policymakers must continue to work on increasing vaccination rates to protect against future outbreaks. Lastly, countries must collaborate to address climate change and speed up the green transition to avoid their dependence on oil.

    Please let me know in the comment section your feedback on what topics you would like me to write about.

  • Why did Fed raise interest rates again, making borrowing more expensive?

    Ending their two-day meeting, the Fed (central bank of the US) has once again raised interest rates. The reason for the hike is to control inflation. The United States Congress has given the Fed a dual responsibility – to achieve maximum employment and keep inflation around the rate of 2% over the longer run.

    The average consumer in the US has been feeling the burden of rising prices, especially since the start of this year, esp. in gas, housing (including rental), and food prices. The Consumer Price Index, which measures inflation in the US has been at an elevated level for quite some time. In their press release, as of July 13, 2022, the BLS published inflation at 9.1%.

    How does the interest rate affect inflation?

    Going back to today’s news, let’s understand how the interest rate mechanism works. The FOMC (Federal open markets committee) is responsible for determining the federal funds rate target range. This is the rate at which banks borrow from each other. The Fed doesn’t set this rate, but market forces determine it.

    The reason this rate is very important to us is through its linkages to other rates. This federal funds rate impacts all the other interest rates such as on credit cards, housing, auto, and education loans.

    How much did Fed raise interest rates?

    In today’s meeting, the Federal open market committee decided to raise the target range for the federal funds rate from 2.25% to 2.5%. This increase has moved the Federal funds rate to its highest level since December 2018. During their June 13, 2022 meeting, they increased the target range for the Federal funds rate to be 1.25% – 1.75%. You can see the graph of this rate over time here.

    So how does the Fed steer the federal funds rate?

    It uses “interest on reserves balance” as its main monetary policy tool for that. To understand it better, you can read my article here, which explains this in detail. When the Federal funds rate (borrowing costs of banks) is high, banks will pass on these added costs to their final consumers. These consumers include people like you and me, and businesses.

    In a nutshell

    The main idea behind this repeated increase in the interest rate is that expensive loans will discourage people from spending. When the cost of borrowing (interest rate) is high, general consumers (households) borrow less for a big purchase such as a car or a house. Similarly, businesses also invest less in the expansion of their plant, inventories, machinery, buildings, etc. All of this will reduce the demand for goods and services these businesses make and they will also hire fewer workers. And when the excess (increased) demand is lower, the prices will eventually start falling, which will control high inflation. Thus, interest rate hikes are the Fed’s main tool to control inflation.

    Inflation happens because of strong consumer demand, which supply can’t match. Supply bottlenecks with China during the Covid pandemic, Ukraine war, etc have all contributed to a weaker supply of many essential items we use every day. Since many of the supply chain issues will take a long time to fix, the Fed is trying to control the demand aspect of inflation. By raising interest rates, and making borrowing more expensive, the Fed is hoping to weaken Americans’ willingness to spend money and ultimately bring inflation close to its 2% target level.

  • Commonly used macroeconomic terms that you should know

    Today, I explain some of the most widely used macroeconomic terms relating to a country’s economic performance. These are the terms we often read in the news, so we need to understand what they are and how they affect us. My list is not comprehensive, but I feel it is a good start. In my future posts on Economic Glossary, I will be explaining the meaning of some other important economic terms, so please stay tuned for that. For now, let me explain the ones that are coming to my mind as I type.

    Interest rate: It is the cost of borrowing money or the return we get from saving our money. By changing interest rates, the Fed (central bank) can influence economic growth. Low-interest rates encourage spending and investments and make the economy grow. On the other hand, rising interest makes loans more expensive and lowers investment. This reduces firms’ hiring, employment, and thus total demand in the economy and can lower both inflation and GDP growth.

    GDP: It measures the size of the economy. It is the market value of everything (final goods and services) produced in a country, whether it is made by its citizens and companies or by the rest of the world. Market value is how much we pay for something, such as the market price for that bread we eat or the plumbing service we get. The US GDP number is published every quarter to see its trend. Economists at the U.S. Bureau of Economic Analysis estimate GDP by using a lot of data gathered by other federal agencies and private data collectors. As of Q1, 2022, the US Real GDP was $19.7 trillion. The US is the number one economy in the world when measured by real GDP.

    GDP Per capita is the GDP divided by the total population. It shows the standard of living of its people and this number is published once a year. Real GDP is the GDP at constant price or base year prices. This measure removes the effect of rising prices on GDP. GDP growth rate is a % measure that calculates real GDP growth as compared to the previous quarter or the previous year. This could be a positive or negative % depending on an increase or decrease in real GDP. To know more about US GDP growth, click here.

    Recession: A recession is a significant fall in the economic activity of an economy. It is mostly seen as a decrease in income and employment. During a recession, there is a significant drop in consumer spending. Some businesses can go bankrupt, people out of school don’t find good jobs and people might lose their homes when housing prices fall. If you want the exact definition of recession or expansion in the US, here’s a good source https://www.nber.org/business-cycle-dating-procedure-frequently-asked-questions

    Inflation: The inflation rate is a sustained rise in the average price level during a specified period, usually a month or a year. It is calculated as a % increase or decrease in prices from the previous period. Inflation exists when prices increase but our purchasing power reduces over some time. As seen in my post here, demand, supply, and future expectations about inflation affect inflation. 

    US Government and the Fed both measure and publish inflation numbers every month. They use CPI and PCE respectively for measuring inflation. Sometimes, the CPI can give us misleading information because it includes food and oil/gas prices. These numbers are usually more volatile. The core inflation rate excludes food and energy prices and thus is a better measure of the inflation rate. The Personal Consumption Expenditures price index is another measure of inflation. It includes more business goods and services than the CPI. For example, health care services paid for by health insurance companies are part of PCE and not CPI.

    Unemployment rate. Every country sets a target unemployment rate that it seeks to achieve. In most advanced economies it is a lower % compared to developing economies. In the US, The BLS publishes this % every month. The Fed aims to keep the unemployment rate around 4%. The unemployment rate represents the number of unemployed people as a percentage of the labor force. People in the labor force include people 16 years of age and older, who are either employed (have a job) or unemployed (those who have looked for a job in the past 4 weeks but couldn’t get one).

    As of June 2022, the unemployment rate in the US was 3.6%. The total number of unemployed persons was 5.9 million.

    Monetary policy or the Fed: Federal Reserve is the central bank of the U.S. The Fed performs many important functions such as supervising the nation’s commercial banks, conducting monetary policy and providing financial services to the U.S. government. It also promotes the financial system’s stability by taking measures to prevent crises like recession and bank failures.

    The Fed is not just one bank but consists of 3 main components.

    1. Seven Board of governors guide the entire monetary policy and set the discount rates for member banks
    2. 12 regional federal reserve banks are located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St, Louis, and San Francisco.
    3. FOMC, the Federal open market committee. It meets eight times a year and makes decisions that help promote the health of the U.S. economy and the stability of the U.S. financial system.   

    The Fed is an independent entity and is not affected by U.S. politics. Congress has given Fed a dual mandate of stable inflation and maximum employment. The Fed tries to keep prices stable with a long-term 2% inflation target and also promotes maximum employment. Please see my detailed post on how Fed in the US uses its monetary policy tools to keep inflation in the target range.

    Fiscal policy : Fiscal policy is the term used to describe the spending and taxation decisions of a government that can influence an economy. For example, the government can lower taxes and raise spending to boost the economy when needed. Governments often spend on infrastructure projects to create jobs and grow income to take the economy out of a recession.

    Similarly, the Fed increases business investment and spending by lowering interest rates. In a boom situation, when the economy is overheating with high inflation and very low unemployment, they do the opposite. The government reduces its spending and raises taxes. Alternatively or in addition, the Fed raises the federal funds rate which in turn increases all the other interest rates in an economy and thereby puts a break on overall economic activity. Thus, either fiscal or monetary policy or both can be used to expand or contract the economy.

    If you like my posts or think I can do better, please provide your feedback in the comment section below. I will be happy to research and write about any topics you might be interested in learning more about. Thank you!