Understanding the Foreign Exchange Market

What is the foreign exchange market? How is the value of a currency determined?

If you have ever traveled outside of the country, you have likely dealt with the process of exchanging your national currency for that of the country you are traveling to. You have also probably noticed that the price tag on an item from your home country might look very different from that of the country you are visiting. For example, a new pair of sneakers that costs 50 dollars in the US might cost 500 Swedish Krona in Stockholm. So what determines the values of these currencies? The answer lies in the foreign exchange market.

What is the foreign exchange market?

Often referred to as simply FOREX, the Foreign Exchange market is a decentralized financial marketplace where traders can buy and sell different currencies. Unlike some marketplaces and stock exchanges, the decentralized nature of this network is significant, as it is not tied down to a physical location. The FOREX market is also interesting in that it can be split into two different levels. The first level is that of the interbank market. This top-level of the FOREX market is primarily composed of private banks that conduct significant transactions, often experiencing trillions of dollars in transactions every day. On the second level of the FOREX market is the Over-The-Counter (OTC) market, where individuals and companies have the opportunity to participate. Together, the supply and demand forces of the foreign exchange market determine a currency’s floating exchange rate and help indicate the value of said currency.

How does the value of a currency change?

To understand how the value of a currency changes, it is worth knowing that when the value of a currency increases or decreases, these changes are always relative to that of another currency. This means that if the US Dollar increases in value (or appreciates) relative to the Euro, the Euro has lost value (and depreciated) with relation to the USD. Additionally, the basic laws of supply and demand can be applied to understand exchange rates. For instance, if something causes the supply of Yen on the foreign exchange market to increase (or the demand for it decreases) then the Yen will, relatively, drop in value. An increase in demand or decrease in supply would cause the opposite to occur.

What factors affect a currency’s supply and demand?

There are a number of factors that affect the supply and demand of a currency on the foreign exchange market. A change in any one of these factors will cause a reciprocated change in that currency’s value. While these factors are numerous and complex, on a basic level, they often include price level, interest rates, tastes, income, and political stability. If, for example, Country A is experiencing heavy inflation and has a higher price level than Country B (which has a lower inflation rate), there will be an observed increase in demand for currency from Country B. Or, in contrast, if Country A has a higher interest rate than Country B, foreign investors will move their capital to Country A, and its currency will appreciate. Changes in income also affect the quantity of goods and services that a country imports, and as good and services must be paid for in the currency of the country where they are being sold, supply and demand will be affected. Finally, an increase in political turmoil or instability is associated with an increase in risk, and will cause a currency to depreciate.

What is the difference between floating and fixed exchange rates?

The values of many currencies are controlled by floating exchange rates. These exchange rates are dictated entirely by the supply and demand forces of the market and are said to be self-correcting. However, many currencies are not free-floating, and instead deemed to be fixed, or pegged. These fixed exchange rates differ from floating exchange rates in that the government or central bank of a country is responsible for setting and maintain that currency’s value. Although central banks don’t normally trade currencies, they do have the ability to control foreign exchange reserves and interest rates in a way that can significantly affect a currency’s value.

Historically, the values of many countries’ currencies were determined by the gold standard. Following the Great Depression, however, this system began to disappear. Then, in 1944, the Bretton Woods Agreement fixed the values of international currencies to the US dollar, which was still being determined by the price of gold. In 1973, Nixon ended this system and the Foreign Exchange market developed into what it is today.

While many countries transitioned to floating exchange rates, fixed exchange rates (as controlled by a Central Bank) are not uncommon. Sometimes, for example, countries, such as Saudi Arabia, with economies heavily reliant on exports, will choose to peg the value of their currency to the US dollar. Although there are certain advantages to these fixed exchange rates, especially with regard to trade, there are also some negatives. Fixed exchange rates can be expensive to maintain and require a large amount of foreign exchange reserves. This constant maintenance of a currency’s value can have large economic repercussions, such as increases in price level.

Conclusion
Although the modern foreign exchange market has only really developed in the last half century, the concept of exchanging currencies with fluctuating values is by no means a new concept. Today, the foreign exchange market is the biggest financial market in the world and plays a significant role in the maintenance of our increasingly global economy.

What is the Phillips Curve?

Just as heart rate and blood pressure are used to measure well-being, economists rely on a number of indicators to help them understand the health of the economy. Although economic indicators can meet a wide range of definitions, certain indicators like the rate of unemployment or the price level are often seen as some of the most important measures of economic health.

Not only do these indicators provide us with important individual measure of economic health, but equally as informative is the relationship shown between these indicators. Specifically, in this lesson, we will focus on the Phillips curve which depicts the inverse relationship between the levels of inflation and unemployment within an economy.

Image result for the phillips curve

History

After a comprehensive study of many decades of data from the British economy, economist A.W. Phillips published a paper on his discovery of an inverse relationship between rates of unemployment and changes in money wages. The graph below is taken directly from the original publication of Phillips’ study and clearly shows the negative correlation he observed.

Related image

A couple years later, and following independent studies that had reached similar conclusions, economists Paul Samuelson and Robert Solow officially established the inverse relationship that is known today as the Phillips curve. This economic advance led to the formal acknowledgment of the tradeoff between unemployment and the rates of inflation. Although this Phillips curve was initially thought to represent a stable and structural relationship, economists would later conclude that the model was not reflective of the long run behaviors of an economy. Therefore, the inverse relationship first depicted by Phillips is commonly regarded as the short run Phillips curve.

Short Run Phillips Curve

An important component of the relationship that the Phillips curve depicts is the concept of tradeoffs. We face tradeoffs all the time in our everyday lives, whether deciding how to spend our time or what to eat for our next meal, we are constantly giving up one option in exchange for another. Economic trade-offs are very similar to those we face in our daily lives and the Phillips curve is the perfect example. At any given point of the Phillips curve, the rate of unemployment within an economy is correlated with a certain rate of inflation. So if an economy is facing high rates of unemployment, leaders might attempt to decrease rates of unemployment at the cost of increasing the rate of inflation. In contrast, an economy with high inflation rates might work to decrease the price level, at the risk of increasing the rate of unemployment.

Movements Along the Curve

We have now established that a given point on the Phillips curve shows the levels of unemployment and inflation within an economy and that there are trade-offs between different points on the curve. So how does an economy actually move from point to another along the curve? The answer is through changes in aggregate demand. Aggregate demand is similar to demand, except it represents the sum of all demand (by consumers, businesses, governments, and foreign nations) in an economy. When there is an increase in aggregate demand, the price level and output of an economy increases. This is shown by a leftward movement on the Phillips curve, as both inflation and production have increased (increased production means lower levels of unemployment). Similarly, a decrease in aggregate demand will lower levels of inflation and decrease production (increasing unemployment), causing a rightward movement along the Phillips curve.

Image result for aggregate demand and phillips curve

Shifts of the Curve

Not only can changes in the state of the economy cause movements along the Phillips curve, but the Phillips curve itself can also shift. Shifts of the Phillips curve are caused by the result of changes in aggregate supply. Aggregate supply is a measure of the supply of all goods and services offered within an economy at a given price level. An increase in aggregate supply causes a decrease in the price level, but an increase in output. This is seen by a leftward shift of the Phillips curve, as each point of output is now correlated with a lower price level. Similarly, a decrease in aggregate supply increases the rate of inflation at each amount of output, shifting the Phillips curve to the right. An easy way to remember this is that a shift of the aggregate supply curve will cause the Phillips curve to shift in the opposite direction.

Criticism

Although initially welcomed by many of the most renowned economists and established nations of the world, the relationship that the Phillips curve presented eventually proved unsustainable in accounting for long run economic trends. As many nations welcomed the idea of decreasing unemployment in exchange for higher levels of inflation, economists were beginning to notice varying levels of inflation at given levels of unemployment. In particular, America’s economic stagflation of the 1970s presented the Phillips curve with a new bout of scrutiny. Stagflation is the name given to an economy facing both increasing levels of inflation and unemployment. By nature, this occurrence is a direct rejection of the relationship presented by the short run Phillips curve. The phenomenon was eventually explained by the adoption of the long run Phillips curve.

Long Run Phillips Curve

The rejection of the Phillips curve as spearheaded by monetarists like Ed Phelps and Milton Friedman terminated with the conclusion that the negative relationship presented by the Phillips curve was only applicable in the short run. In the long run, however, it was determined that there was no such tradeoff between unemployment and inflation. The long run Phillips curve, instead, was established to be a vertical line, with the economy at the natural rate of unemployment for any level of inflation.

Image result for long run phillips curve

Today’s Economy

Since its conception, the Phillips curve and the relationship that it presents seems to have undergone constant examination in economic fields. In fact, in recent years, economists such as Larry Summers have argued that the curve is flatlining, and may be breaking down altogether. As for now, however, there is still consensus that the curve holds, and the relationship it presents can be very helpful in understanding the current state of the economy.  

Opportunity Cost: The Economics of Decisions

You may have heard someone say “There is no such thing as a free lunch”. This phrase was commonly said by Milton Friedman, a Nobel Prize winning economist. What Friedman meant is that even if someone else takes you out to lunch, there is still a cost, such as the time and energy you spent in order to be there. You could have used that time to do something else, such as golfing or studying. Whenever people make a decision, they are illustrating the concept of opportunity cost. This concept of opportunity cost enables economists to realize how their choices have consequences and it leads to better decision-making.

What is opportunity cost?

Opportunity cost is the next best alternative to any decision you make. For instance, you might decide to go fishing one day. Instead of going fishing, you could have been going to a movie or studying. However, you enjoy movies better than studying. As a result, your opportunity cost is the movie, not studying, as the opportunity cost is the next best alternative, not the next few alternatives.

How do I calculate opportunity cost?

Opportunity cost is the value of the next best option that is given up when making a decision. Say you were going to either eat a sandwich or eat a burger. If the satisfaction gained from the sandwich is 100 utils, while the satisfaction from the burger is only 80 utils, your opportunity cost while eating the burger would be 80 utils, or the value of the next best alternative.

Opportunity Cost in Real Life

Opportunity cost can help businesses make better decisions. By considering opportunity costs, businesses are able to assess the risks of each options as well as the potential returns. Furthermore, opportunity costs can help individuals see what they are giving up when making decisions. One example of a decision is going to college. If you decide to go to college, the opportunity cost is the four years of income you would have earned if you got a job instead. When deciding whether or not to go to college, you should see if the opportunity cost is worth it. For most people, going to college is better in the long run as their college degree would lead them to have a higher paying job that would make up for the loss of four years of income.

Another real life example is investing in the stock market. The stock market is very volatile so investors have to constantly weigh the opportunity costs of investing in stocks. For instance, let’s say you have $10,000. You could leave that money in a savings account with 5% interest or invest in a stock. If you decide to invest in the stock and the stock returns 7% then you have benefited. However, if the stock returns 1%, then the opportunity cost would be the additional 4% you could have earned if you put your money in the savings account. This is why you have to be careful when investing in stocks and look at the risks and benefits in order to ensure that you will gain a profit from the stock. Opportunity cost is a cornerstone concept of economics, and something that applies to all decisions, whether personal or in the complex business world.

How Opportunity Cost Affects You

Let’s say you wanted to start a business. You can either mow lawns or become a babysitter. Using the concept of opportunity cost, you can calculate and conceptualize what would be most profitable to you based on the price you charge for those jobs. If there is a lower opportunity cost for being a babysitter and you could earn more, then you would do more babysitting jobs than lawn jobs. Visualizing the opportunity costs between two decisions is important and has a real impact on your life.

Final Thoughts

In a world of scarcity, everything has an opportunity cost since there is always a trade-off involved in all the decisions you make. Instead of reading this article right now, you could’ve been reading, exercising, or learning a new skill. From now on, evaluate the decisions you make and ask yourself if the opportunity cost is worth the decision.

What is Supply?

In an earlier lesson, we introduced one of the most fundamental relationships in economics: supply and demand. In order to best make sense of the relationship between supply and demand, it is important to understand each element individually. Previously, we covered demand, which is defined as the level of desire for a good or service by consumers. In this lesson, we will look at the market from the perspectives of producers, focusing on supply.

Supply  

What exactly is supply? The definition of supply is similar to the definition of demand, but instead of looking at consumers and their desires and abilities to purchase goods, supply is controlled by producers. Specifically, supply is defined as the desire by producers to provide a good or service. The supply curve, which is the graphical representation of supply, shows supply as a direct relationship between the price of an item and the quantity supplied of that item.

Price (6).png

Law of Supply

Just as the Law of Demand can be used in understanding why the demand curve is downward sloping, the Law of Supply explains the upward sloping nature of the supply curve. Simply put, the Law of Supply explains that as the price of a good or service rises, the quantity of said item will rise as well. The Law of Supply makes sense when better understood from the perspective of a producer. As prices increase, producers are eager to maximize their profits, so they provide a greater amount of goods or service in question. This is demonstrated by the curve below.

Quantity Supplied

When the price of an item increases, the quantity supplied of that item will increase. Similarly, if the price of an item, the quantity supplied of that item will decrease. However, just because the price of an item changes, it does not mean that the supply of that item will also change.  

Price (5).png

Changes in Supply

Supply itself can also increase and decrease, but not as the result of a change in price. These shifts in supply occur as the result of one of the “determinants” of supply, which include changes in production costs, number of sellers, technology, or future expectations. An increase in supply is shown by a rightward shift of the supply curve, while a decrease in supply is depicted by a leftward shift.

Price (7).png

The Determinants of Supply

Cost of Production

There are a number of factors that can impact the costs of production, both positively and negatively. Such production costs include the costs of raw materials or other items used in the production of the final good or service (input prices), wages, taxes, and government-controlled rules and regulations. If any of these costs increase, it will be more expensive for a company to produce final goods, so supply will decrease. Likewise, if costs decrease, producers will be able to make more final products than before, and supply will decrease.

Technology

Changes in technology always affect supply positively, making for a more efficient production process. Such technological advances can span a range of developments, including everything from the invention of a new pesticide to improve harvest yield to improved systems of business management. Rarely, however, are practices adopted in which technological progress is reversed. Thus, changes in technology will (almost) always cause an increase in supply.

Future Expectations

Changes in future expectations of producers can have complicated effects on supply, depending on whether those supplying the product are the sellers or manufacturers of the products. At its simplest, when producers believe that they can sell their products for higher prices in the future, they will withhold their inventory. In the present, this results in a decrease in supply. The opposite occurs when suppliers expect that prices will drop.

Number of Sellers

If the number of sellers in a market increases, so will the supply. Likewise, when the quantity of producers decreases, supply does as well.

There are a few other determinants of supply, including the prices of related or joint goods and services that can impact supply both positively and negatively.

Summary

In conclusion, supply is the level at which producers want to provide a good or service at varying price levels. The Law of Supply helps illustrate the direct relationship between price and quantity supplied. Additionally, the determinants of supply can be used to explain shifts in demand.

Now that you have understood both supply and demand, you are ready to understand the interaction between the two, and how together, they form the market mechanism.  

Sources:

https://www.investopedia.com/terms/l/lawofsupply.asp

https://staffwww.fullcoll.edu/fchan/Micro/1determinants_of_supply.htm

https://xplaind.com/790162/determinants-of-supply

What is Demand?

Have you ever noticed that swimsuits are cheaper in the winter than in the summer? Or that it will cost you less to go to the movies on a Tuesday morning than it will on a Saturday evening? These everyday observations can be explained by one of the most fundamental concepts in economics: supply and demand. At the most basic level, supply and demand can be explained as the relationship between how much of an item is desired (demand) and how much of an item can be offered (supply). In order to fully understand supply and demand, however, it is necessary for us to look at each component individually.

Demand

First, let’s start with demand. Demand is defined as the willingness and ability of buyers to purchase a product or service. The demand curve, which is the graphical representation of demand, depicts demand as a relationship between price and quantity demanded.Price (1).png

The Law of Demand

The model above of the demand curve shows that as the price of a good decreases, the quantity demanded of the good will increase. By the same means, a higher price is correlated to a lesser quantity demanded. This relationship is called the Law of Demand. And it is more simple than it might seem. Let’s say a store is selling a candy bar for 100 dollars. Chances are very few people will be willing and able to spend the money to buy that candy bar. But if the prices of the candy bar fall to ten cents, a much larger portion of the population will have the means and desire to buy it.

Quantity Demanded  

It is important to note that as the price of an item drops, the quantity of the item demanded increases, but demand as a whole does not increase.  The quantity demanded is the exact amount of an item that buyers are willing to purchase, as represented by any unique point on the demand curve. A movement along the demand curve is due to a change in price, which will cause quantity demanded to change accordingly.

Price (4).png

Changes in Demand

Just as the quantity of an item demanded can change, there are a number of factors that can affect demand as a whole. A change in demand is represented by a shift of the demand curve and means that buyers are both willing and able to purchase a different amount of a good or service at each price.

Price (3).png

Determinants of Demand

Determinants of demand are the factors that can cause demand for a good or service change. Such determinants include consumer tastes and preferences, changes in income, related goods such as substitutes or complements, and market size.  

Tastes

Consumer tastes are highly impressionable and can affect demand both positively and negatively. If consumer tastes change favorably, then more of an item will be demanded at each given price, and demand will increase. For example, if a new study comes out declaring that drinking orange juice increases life expectancy, then demand for orange juice will likely increase. But consumer tastes can also have a negative impact on demand. So if an influential celebrity like Beyoncé tweets that she finds a certain shoe brand ugly, then the demand for that shoe brand might decrease.

Income

To understand the role a buyer’s income plays in demand, it is important to recognize that not all goods are the same. Typically, goods can be categorized as normal, inferior or luxury goods. When incomes rise, people have more available to spend, so the demand for luxury goods increases, while the demand for inferior goods decreases. The opposite happens when incomes decrease.

Substitutes

Substitutes are goods and services that are similar enough to other goods and services that can effectively act as a replacement. A common example of substitutes is Coca-Cola and Pepsi. If the price of one soda rises, then demand for the other will increase.

Complements

Complementary goods refer to those goods that often accompany the purchase of other goods. For instance, if marshmallows go on sale at your local grocery store and the quantity of them demanded subsequently increases, then demand for graham crackers and Hershey’s chocolate will likely increase as well. Similarly, if hot dogs suddenly get more expensive and quantity demanded decreases, then demand for hot dog buns will also decrease.

Number of Buyers

When the size of a market increases, then the demand for goods will also increase. Simply put, a bigger population means that there are more potential consumers. For example, if the birth rate rises dramatically, so will the demand for baby cribs and car seats.

In summary, demand can be thought of as the willingness and ability of buyers to purchase a good or service. The Law of Demand helps illustrate the inverse relationship between price and quantity demanded. Additionally, the determinants of demand can be used to explain shifts in demand.

Understanding demand is only the first step. In this lesson, we have focused on buyers and their actions. In the next lesson on economics, we will look at supply, and how producers can also play a critical role in markets.

Sources:

https://primeyourpump.com/2018/07/09/supply-and-demand-real-life-examples/

https://www.investopedia.com/university/economics/economics3.asp

https://www.intelligenteconomist.com/determinants-of-demand/

http://www.econport.org/content/handbook/Demand/Factors.html

https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/basic-economics-concepts-macro/demand/a/lesson-summary-demand-and-the-determinants-of-demand

The Power of Compound Interest

Introduction

I might be biased since he is my namesake, but I think Albert Einstein was a really cool guy. Many of you may know him as the genius physicist, but did you know he was also a money-savvy guy? My favorite quote from Einstein, in which he refers to compound interest, is this:

“He who understands it earns it, he who doesn’t pays it.”

So, let’s understand compound interest.

What is compound interest?

Compound interest is, most simply, “interest on interest.” When you take out a loan from the bank, you receive a sum of money equal to your principal amount owed. Then, your amount owed rises by a percentage of that principle as interest to the bank, in return for the risk they incur for loaning you the money. When this interest stacks with the principal and the following interest payments rise due to last year’s addition of interest, this is compound interest in action.

This will make more sense with some numbers to look at. For simplicity’s sake, let’s say you take out a loan for $1000, paying 10% per year. One year later, your amount owed is now at $1000 plus 10% of 1000. So in one year, you owe $1100. Fast forward another year, and you now owe $1100 plus 10% of $1100, equal to $1210. Notice how the interest payment of the second year, $110, is greater than $100, the interest payment of the first year. The reason you are paying more interest every year is that 10% of the amount owed rises as the interest stacks with the principal – compounded interest.

How powerful is compound interest?

Now, you may think that the difference between $110 and $100 isn’t all that bad, but keep in mind we are dealing with a small time period of 2 years so far, and a relatively small principle of $1000. In real life, many loans taken are in the hundreds of thousands for homes, and tens of thousands for cars.

Conversely, let’s look at a relatively realistic example, except when compound interest is working for you. Let’s say John has invested $30,000 in the stock market and for the sake of simplicity, enjoys a constant ROI, or return on investment, of 3% per year. 3% isn’t bizarre at all; some years the markets will be negative and other years will be much higher than 3%, so on average 3% is a fine number to work with here. Observe the following table:

As we can see in the table, our YOY difference, or year on year difference, increases every year due to the power of compound interest. Again, this is because 3% of the value in our Amount column is rising due to the interest from the previous years! Because these are percent changes, the power of compound interest is much more effective with respect to time with larger numbers. This is one of the biggest reasons the wealthy are able to create even more wealth; they have immense capital and can utilize the power of compound interest to its fullest capacity. In this example of $30,000, John earns approximately $40,967 over 30 years. With $300,000, he would’ve earned 10x that, or $406,970. Their average YOY difference would be approximately $1356.50 and $13,565 respectively. Either way, that is a lot of money, considering you are simply letting the money sit in an account!

As you can see, compound interest can be very powerful. This is precisely what someone means when they say to have money work for you, rather than you work for money.

What does this mean for me?

Seeing those numbers up above should both scare you and excite you. On one hand, your debt can quickly get out of hand, especially with credit cards, where the interest is approximately 15% on average – very scary considering our model above was based on merely 3%. On the other hand, the table also shows John’s account more than doubling with no work required. What does this all mean?

First, don’t shirk at the thought of any debt. Money is leverage. If you had the chance to take out a loan paying 3% interest but had the potential to use that money to make more than that interest in profits from a business deal, that is still a net profit. That being said, now that you know how powerful compound interest can be, shy away from debt that will almost never make you money, such as having credit card debt. We live in an increasingly materialistic world with social media and the Internet connecting us like never before. A quote from Dave Ramsey has always stuck with me and is very relatable to debt, particularly with credit cards: “We buy things we don’t need, with money we don’t have, to impress people we don’t like.” Never spend more than you have, and avoid credit card debt like the devil.

So if you’re taking out a loan, hopefully, it is only for business deals resulting in greater returns than the interest you pay, or large purchases in which you cannot make without the loan, like a house or a car.

On the other hand, have compound interest working for you immediately! That savings account in your bank account yielding 0.1% interest is effectively useless since the interest rate is too low. In addition, inflation is 3% on average, so your savings account actually loses real buying power every year. Keep some money in there as a rainy-day fund for emergencies, but place the rest in an investment account and start earning some compound interest! We’ll have another article soon detailing exactly how you can do this with financial investment vehicles such as ETFs, or exchange-traded funds.

Final Thoughts

In summary, compound interest can be pretty terrible for you in the case of bad loans, but it can also work for you tremendously when investing. Let me leave you with this: the best time to invest and utilize the power of compound interest is 10 years ago, the second best time is now.

Introduction to Economics

If you don’t have much experience with economics, the subject might seem daunting and obscure. You might even assume that economics is all about money and finance, and that it has nothing to do with your daily life. This is far from the truth. First of all, it must be understood that economics is a social science. Although many economic principles are critical to finding success in business and finance, economics is also a tool that can be used to predict human behavior, understand the forces behind social issues, or simply, navigate everyday life. In fact, whether you are conscious of it or not, you are constantly making economic decisions, such as choosing how to spend your Friday evening or deciding if it’s really worth eating another piece of chocolate cake (it is!).

Scarcity

Fundamentally, however, economics is the study of scarcity: how to satisfy unlimited wants with limited resources. The world we live in is full people that have all kinds of needs and desires. The problem of scarcity is that there are a finite amount of resources— land, labor, and capital— that can be used to satisfy this infinite set of wants. This basic problem presents society with the following three fundamental questions to be answered: What goods and services will be produced? How will goods and services be produced? Who will consume goods and services? By resolving these questions, an economy can attempt to solve the issue of scarcity. Scarcity also gives way to a variety of key economic concepts, such as opportunity cost. Opportunity cost is one of the most basic economic principles, and demonstrates the idea of trade-offs: by making one decision, the benefits of all other alternatives are forgone. For example, by deciding to go to soccer practice after school, you might be giving up going to the movies with your friends.

Rational Behavior

Another critical idea to understand in the study of economics is the concept of rational behavior, which assumes that humans are constantly acting to optimize outcomes and maximize personal benefit (or, as it is referred to economics, utility). In other words, when given multiple options, people will always choose the option that provides them with the biggest economic incentive. Although the concept of rational behavior is important to understand since it forms the basis for many fundamental economic models and ideas, it can often be difficult to apply in the real world. Humans are impacted by a variety of different factors— ranging from cognitive to cultural— that cause them to behave irrationally. This overlap between the fields of economics and psychology forms the basis for behavioral economics.

Macroeconomics and Microeconomics

In understanding economics, it is also important to recognize the difference between macroeconomics and microeconomics. Microeconomics is the area of economics that focuses on the decisions and interactions of individual actors, such as buyers, sellers or business owners. Microeconomics, for example, might put emphasis on a specific product, firm or industry. On the other hand, macroeconomics focuses on the bigger picture. This can mean either the economy as a whole, or aggregates, which is the grouping of many smaller economic units. Examples of macroeconomics might include national economies and economic indicators such as GDP and unemployment rates. Despite their differences, however, both macroeconomics and microeconomics are interdependent.

Positive and Normative Economics

Another distinction to be made is the difference between positive and normative statements in economic analysis. Positive economic statements center on factual evidence, while normative economics emphasize value judgements and how things ought to be. For instance, to say that the unemployment rate in America is lower than the unemployment rate in Spain would be a positive statement. Conversely, to declare that taxes in Norway are too high would be a normative statement.

Now that you understand the basics of economics, start looking for these economic principles in your daily life. Can you find examples of scarcity and opportunity cost? Why do you make the decisions that you do? How do you choose to maximize your utility?

Sources:

https://www.economicshelp.org/blog/5628/economics/applying-economics-in-everyday-life

https://www.investopedia.com/terms/e/economics.asp

https://www.mbacrystalball.com/blog/economics/

https://www.investopedia.com/terms/e/economics.aspqhT

https://investinganswers.com/financial-dictionary/stock-market/opportunity-cost-2560

https://www.investopedia.com/terms/r/rational-behavior.asp

https://www.investopedia.com/terms/m/microeconomics.asp