This Is How The Economy Affects The Value Of Your Money

Timo de Groot Feb 2017 - 14 min read

Understanding how the economy affects the value of your money is vital for self-directed investing. In this article, you will learn how macroeconomic factors and monetary policy influence your money. And you’ll find out how to adapt your investing strategies to different scenarios.

‘United Kingdom reports record-low unemployment in December.’

‘Eurozone headline CPI surges to new highs on stronger energy prices.’

‘Federal Reserve hikes benchmark rate by 0.25%.’

‘China sets yuan trading band lower for another week.’

Financial and economic headlines affect your life more than most people realise. These macroeconomic forces influence a couple of things:

  • The value of your money
  • How much interest rates banks charge on your loans
  • The rate of return on your investments

But what are macroeconomics and monetary policy exactly? And how do these concepts affect the value of your money?

Understanding the difference between macroeconomics and microeconomics

Macroeconomics looks at the following aspects of an economy:

  • Performance
  • Structure
  • Behaviour
  • Decision-making

This refers to the study of national, regional, and global economic metrics. Such as gross domestic product (GDP), inflation, unemployment rates, consumption, and trade.

In short, macroeconomics is all about the bigger picture.

Microeconomics zooms into interactions between individuals and firms, by studying:

  • Production theory
  • Elasticities
  • Game theory

The field of macroeconomics focuses on the factors that shape long-run economic growth. And how you can sustain or improve the performance of an economy.

This is where monetary policy comes in. In charge of monetary policy is the monetary authority of an economy. Usually, that’s a central bank or a currency board. They adjust the money supply to maintain price stability or to control economic growth.

Do you understand the macroeconomy and the role of monetary authorities like central banks? Then you will be in a better position to manage your finances. This will help you to make strategic investment choices that align with macroeconomic forces.

What are the goals of monetary policy?

Monetary authorities like central banks seek to maintain price stability and support economic growth. In short, they hope to make their country more stable and prosperous.

In line with these goals are targets when it comes to:

  • Unemployment
  • Liquidity and exchange rates
  • Spending activity

Monetary policy can be expansionary or contractionary

Expansionary monetary policy includes measures to stimulate economic growth. Such as lower interest rates or increased money supply. When a central bank is in expansionary mode, you could say it acts in a ‘dovish’ manner.

In recent times, we have seen central banks act in an ultra-dovish manner. To save and support a global economy that was brought to its knees by the 2008 credit crisis. Many Western central banks took interest rates to zero. They also bought up their government bonds. Why? To further improve liquidity in the financial system. A process that’s known as quantitative easing (QE).

Contractionary monetary policy refers to the use of tools that slows the growth rate. How? Through higher interest rates or lower money supply. If a central bank uses contractionary methods, you can describe it as ‘hawkish’.

Expansionary monetary policy

Expansionary monetary policy seems straightforward. As central banks often use this strategy to pull an economy out of recession. They do this by encouraging businesses and consumers to ramp up spending and investing.

For instance, cutting interest rates makes loans cheaper. So companies and individuals find it more affordable to buy a home or a car. In effect, this leads to other smaller purchases. Such as furniture, appliances, auto insurance, and maintenance. This can translate to household spending and gas purchases down the line. And thereby propping up consumer spending. Magnifying this effect to the whole economy means stronger demand for products and services. Which is also positive for business production and employment.

Contractionary monetary policy

Contractionary monetary policy can be trickier and is used less. This is often implemented when:

  • Inflation is rising too fast
  • Wages can no longer keep up with the increase in price levels

In this case, higher interest rates encourage businesses and individuals to save more. Because banks offer greater returns on deposits and investments. In other words, this leads people to save rather than spend. And thereby reducing production and growth as well. Yet, you should apply this with care. Otherwise, this could increase unemployment. And push an economy into recession when consumers become tight-fisted with their hard-earned money.

How monetary policy affects the value of your money

Now, how do all these factors affect the value of your money?

Let’s start off with a brief review of the Law of Supply and Demand. In this case, it’s safe to assume that the demand for money remains almost the same. And only the central banks can change the supply of money.

Decreasing the money supply through contractionary monetary policy drives up its value. Because there’s less cash in circulation. While increasing the money supply through expansionary monetary policy lowers its value. Since there’s now more cash in circulation.

Exchange rates

The value of your money is also measured relative to other currencies. That’s why exchange rates are also important. Strong economic performance can lead a central bank to be hawkish. This means the central bank will probably increase interest rates to control inflation. Which then increases the return rate for holding that country’s currency. This drives up its value against other currencies in relative terms.

Weak economic performance can lead a central bank to be dovish. The central bank will now probably lower the interest rates to stimulate growth.

This:

  • Decreases the return rate for holding that country’s currency.
  • Drags down its value against other currencies in relative terms.

If you notice that your domestic currency is rising in value or appreciating against other currencies? You can presume that this may have something to do with the domestic economy’s improving performance.

And if you see your domestic currency falling in value or depreciating against other currencies? It’s likely to do with weakening economic performance.

This factors into your day-to-day activities when you are using foreign currency in:

  • Shopping online
  • Going on a vacation abroad
  • Receiving funds that are converted to your local currency

You probably have observed these factors in play. When you notice large swings in fuel costs or transportation fares for example. Especially when oil or natural gas is something that your country imports from other nations.

When it comes to interest rates? You may have noticed these changes reflected in:

  • Mortgage costs and loan rates
  • Long-term deposit rates and bond yields
  • Investment returns in your portfolio.

Who runs the central banks?

At this point, you’re probably wondering who makes these big decisions in central banks. Is it the government? A top official? A private organisation? Something more sinister?

If you’ve been keeping track of central bank interest rate statements? ou probably know that these institutions are governed by a top official. Often referred to as the Chairperson or Governor.

In the US, we’ve got Federal Reserve Chairperson Janet Yellen. In the Eurozone, the European Central Bank is currently headed by Governor Mario Draghi. The Bank of England in the United Kingdom is led by Governor Mark Carney, while the Swiss National Bank is headed by Chairperson Thomas Jordan. The Reserve Bank of Australia currently has Governor Philip Lowe at the helm. While the Reserve Bank of New Zealand is led by Governor Graeme Wheeler. In Japan, we’ve got Governor Haruhiko Kuroda leading the Bank of Japan.

Central Bank Figureheads:

  • Federal Reserve (FED): Janet Yellen
  • European Central Bank (ECB): Mario Draghi
  • Bank of England (BOE): Mark Carney
  • Swiss National Bank (SNB): Thomas Jordan
  • Reserve Bank of Australia (RBA): Philip Lowe
  • Reserve Bank of New Zealand (RBNZ): Graeme Wheeler
  • Bank of Japan (BOJ): Haruhiko Kuroda

These leaders organise monetary policy meetings. And they respond to questions from the press during post-statement conferences. The actual decisions are usually made through a vote of policymakers or select committee members.

They then publish these discussions to help market watchers understand:

  • The dynamics behind the official announcement
  • How monetary policy could evolve in the future

Financial traders follow these discussions closely. Especially central bank policy that could have a big impact on financial market prices. This way they try to be one step ahead of the competition.

(Click on infographic to enlarge)

Infographic about the value of your money

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Basis for policy decisions

Every economy is unique. That’s why central banks mostly use different parameters to assess performance and projecting outlook. But also for making monetary policy decisions. There are also different macroeconomic schools of thought that influence their decision-making.

These schools of thought can be categorised into four main ones:

  1. 1. Classical economics

    Classical economists maintain that prices, wages, and rates are flexible. And that markets are always clear and have a tendency to move towards equilibrium. As such, growth is seen to be dependent on the supply of production factors.

  2. 2. Keynesian economics

    Keynesian economics is based on the works of John Maynard Keynes. Keynes espoused that aggregate demand is the principal factor in employment and the business cycle. Keynesian economists then believe that this business cycle can be managed by government action. Through fiscal policy and central bank decisions through monetary policy. They also acknowledge that there are rigid factors in the system. Such as wages and prices that interfere with the traditional influence of supply and demand.

  3. 3. Monetarist economics

    Monetarist economics is largely credited to Milton Friedman. Friedman believed that the role of the government is to control inflation by managing the money supply. Like classical economists, they also believe that the markets are clear. And that participants have rational expectations. Unlike Keynesian economists, they think that government intervention to manage demand can:

    • Destabilise the system
    • Complicate inflationary pressures
  4. 4. Neoclassical economists

    Neoclassical economists also assume that participants in an economy have rational expectations. But that they strive to maximise their utility. This implies that businesses and consumers can act independently based on the information that they have. They also believe that markets are always in equilibrium. And that policy should be aimed at supply factors and the role of money supply in growth and inflation.

Austrian school of economics

Lastly, we have the Austrian school of economics. Unlike neoclassical and Keynesian economics, which rely heavily on the use of data and mathematical models, the Austrian school prefers the use of deep, original thought. The logic that a person can think on his/her own without relying on data or the outside world to come up with economic laws forms the basis of the theory. As a result, the Austrian school has many original ideas on price, interest rates, inflation and business cycles. For example, the idea that market prices are determined by subjective factors. Like individual preferences rather than by the equilibrium of supply and demand.

Differences in monetary policy

Changes or biases in monetary policy can influence the return rate for holding currency. And therefore, its demand and value. These dynamics are interesting to watch in the foreign exchange market. Because they create trends and trade opportunities based on central bank expectations.

In particular, if currency (XXX) with a hawkish central bank is paired with a currency (YYY) with a dovish central bank? Then this typically leads to an increase in the exchange rate of XXX/YYY as the central banks move closer to making actual interest rate changes. Conversely, currency (ZZZ) with a dovish central bank paired with a currency (XXX) with a hawkish central bank typically leads to a decrease in the exchange rate of ZZZ/XXX.

Forex traders often price in their central bank expectations way ahead of the official statements. By analysing economic reports that give clues on how overall growth and inflation might turn out.

These consist of reports such as:

  • Employment change (such as non-farm payrolls)
  • Retail sales
  • Producer price index and inflation figures
  • Private mortgage insurance (PMI) readings
  • Manufacturing and industrial production figures
  • Housing starts

Sharp divergences in monetary policy often result in lasting trends in the currency market. But you can also find trade opportunities with currencies whose central banks hint at a shift in monetary policy bias. Again, leading economic indicators can provide analysts with early signals of when this might take place. And this allows them to time their trade entries better.

Global trends in macroeconomics and policy

Global macroeconomic data has been mostly moving in a unified direction since the financial crisis hit. Because central banks rushed to ease monetary policy by cutting interest rates of record low levels in 2007 until 2010. This was accompanied by the European debt crisis that also prompted additional monetary stimulus from the ECB. On top of bailout programs from global institutions. At that time, forex traders shorted the weakest performing currencies or those expecting more interest rate cuts. While putting their money into safe-haven currencies such as the US dollar and Swiss franc.

As the impact of these stimulus efforts kicked in, central banks moved on to trimming their stimulus programs. To see how their respective economic might fare all on their own. Forex traders tried to measure which among the central banks would hike interest rates first. Or taper their easing programs to see which currency they should go long. This proved to be a make-or-break decision for several economies. As some who rushed to hike rates too soon experienced sharp blows to growth and inflation.

Increasing interest rates

It wasn’t a surprise that inflation became front-and-center of most major economies’ woes in the years that followed. A slowdown in China and weakening crude oil prices only made this worse. These macroeconomic factors reduced global growth prospects. And they brought risk aversion back to the table, drawing traders back to safe-haven holdings once more. Around this time, the US central bank was almost finished tapering its QE program and was considering increasing interest rates.

When the Fed finally hiked rates, the rest of the global economy was still on shaky footing, making the rebound a tad more challenging. Falling energy prices started seeping into domestic inflation trends.

This caused some central banks to:

  • Loosen their purse strings once more
  • Inject fresh liquidity into the markets to keep growth steady.

These days, the focus has shifted to global uncertainties owing to the EU referendum’s Brexit result. And upcoming general elections in top Eurozone economies. The presidential election in the US isn’t without its headwinds either. As the Trump administration is adding more uncertainties to the mix. This seems to make central banks more cautious with making major monetary policy changes. Because first they probably want to have a good sense of how global macroeconomic trends could fare.

One of the main issues that the Federal Reserve currently faces? Balancing expansionary spending plans by the new administration. This while keeping inflation and potential bubbles asset prices in check.

Megatrends that might change the world

Many believe that geopolitical risks have increased following the growing anti-establishment sentiment in America and Europe. This volatility not only threatens to spill over into financial markets. But could even bring down long-standing financial institutions such as the central banks themselves.

This is seen to be the case for the US. With President Trump known to be critical of the Federal Reserve. And several nations in the Eurozone also want to exit the monetary bloc. To top it off, other megatrends are expected to come strongly into play over the next decade and shape global monetary policy:

  • The rise in individual empowerment
  • Urbanisation and ageing of the population
  • A shift towards Asia

The rise in individual empowerment

In a US government report entitled “Global Trends 2030: Alternative Worlds” analysts predicted that the majority of the world’s population would no longer be living in poverty over the next 15-20 years. This grants individuals newfound control and empowerment in their lives as they move to a different economic class and are afforded more privileges and decisions.

This shift has vast consequences for the roles of workers and individuals. But also for governments, private corporations and money itself. We are already witnessing the decentralisation of money in the form of Bitcoin. Bitcoin has grown at a staggering pace since the launch in 2009/2010.

The power of the internet and its ability to garner support from all over the world is resulting in numerous decentralised movements. These could upheave the status quo just as it has in many an industry.

Some nongovernmental movements are notable for their distrust of the current monetary system. And they campaign for a more democratic and transparent system.

We’re campaigning for the power to create money to be used in the public interest, in a democratic, transparent and accountable way, rather than by the same banks that caused the financial crisis.

— PositiveMoney.org

Yet, the report also warns that this kind of empowerment, when left unchecked, can allow people to have greater access to lethal weapons and networks that were previously accessible or even monopolised by states.

Urbanisation and ageing of the population

Making this more complicated is the projected rise in urbanisation. Because a combination of ageing populations, lower birth rates, and migration could draw more people to cities than rural areas as the years go by.

As a result, infrastructure such as roads, trains, and buildings are expected to rise at a much faster pace. But the level of innovation and output could slow down in return. The report suggested that ageing nations might face an uphill battle in maintaining their living standards. This could result in uncomfortable scenarios such as congestion and increased pollution in urban areas. With that, demand for resources such as food, water, and energy could accelerate while climate change could hurt supply. A recipe for higher inflation and higher commodity prices.

Should you prepare for the collapse of the Eurozone?

Brexit negotiations could be the main theme to watch for the year. As this might set the tone for the European monetary union’s future. The United Kingdom has set a precedent by being the first major country to withdraw from the union. And this withdrawal could lead to a domino effect given the Eurosceptic trends we are witnessing. With leadership changes and elections in top nations like Germany and France, the future of the European Union – and ultimately the euro – hangs in the balance.

A total collapse of the European Union is not an unlikely possibility. And such a scenario would make the future of the euro untenable. This outcome and threat are likely to affect macroeconomic policy for years to come in the European area.

A shift towards Asia

Another megatrend is the shift towards Asia and away from the West when it comes to prominent world powers. A bit of this trend is already being manifested these days. Because uncertainties in Europe and the US could benefit Asian superpowers like China. Because they could establish new trade alliances or take advantage of potential weak spots.

China alone will probably have the largest economy, surpassing that of the United States a few years before 2030. As mentioned in the above-linked report this could lead to ‘a tectonic shift, where the health of the global economy increasingly will be linked to how well the developing world does — more so than the traditional West.’

Who’s afraid of China?

Superpowers in the East such as China and Russia could be waiting for a ‘divide and conquer’ opportunity. This way they hope to reshape the macroeconomic framework. To one that favours emerging economies more than the developed ones in Europe and the US. Individual empowerment can encourage people from all socioeconomic classes to be more aggressive about their political leanings. Possibly serving as a catalyst for huge changes from the status quo.

While all this has been happening, China has already established the Yuan as part of the special drawing rights (SDR) of the IMF. The SDR is the basket of reserve currencies of the International Monetary Fund. This way China has a chance to outshine the US dollar if push comes to shove. Officials are already discussing potential trade ties with individual economies should they choose to renounce some of their existing agreements. China’s central bank has a different way of adjusting monetary policy. As it puts more weight on exchange rate dynamics rather than interest rates. So much so that it has been dubbed as a currency manipulator by no less than the current US President.

What if the balance of power does shift to China?

The global economy could also witness a transformation in monetary policy decision-making. Because other nations might turn the spotlight on currency levels as well. Some central banks such as the SNB and RBNZ have actively stepped in the currency market. To interfere with trading levels and engineer depreciation for their currency as a way of boosting export demand and domestic inflation. A few years back, there was a lot of debate on exchange rate targeting and economic rebalancing. With G7 nations eventually pledging to refrain from these activities.

However, G7 countries may not coordinate forever. At some point, particularly if dog-eat-dog scenarios and trade wars come into play, there is potential for major changes in domestic and foreign monetary policies. These changes will also play out in financial markets with expected volatility and unpredictable price movements.

What should you do as a self-directed investor?

As a self-directed investor the safest option, as always, is to stay well diversified across a broad range of assets. That means emerging markets as well as developed, bonds, commodities, inflation-protected securities and real estate. If global trends continue as they are, it may even include exposure to decentralised assets such as cryptocurrencies.

Conclusion

Taking global trends into consideration could lead you to:

  • Predict stronger growth prospects
  • Tighter monetary policy
  • Higher interest rates (and therefore appreciating currencies for the Asia-Pacific region as this area stands to benefit the most from potential shifts)

For the West, there might be different prospects on the card:

  • Weaker growth prospects
  • Looser monetary policy
  • Lower interest rates
  • Depreciating currencies

This is particularly the case in Europe as it goes through a political and economic transition.

This article is for educational purposes only and should not be seen as financial advice.
Economy

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