Recession, What!?

Welcome back to just another article!

If you want to sound cool in any group discussion – randomly insert these words into your conversation: “Recession – Inflation – Interest Rates – Fed – Inventory – Markets – Consumer – Corporates”. That’s it – you will grab the group’s attention more quickly than you expect.

But what if somebody knows – what they are? Don’t worry if you are already reading this – continue reading till the end, and you will be still that cool guy at the end of the discussion.

Jokes apart, let’s talk about what these things actually are and how does it affect us. To understand more clearly, I will try creating a setup (maybe with an interesting setup).

Setup:

“There is a village with 100 people: 30 children, 70 Adults. Obviously, 30 children are still students,, and assume all 70 adults are working.

GDP:

The amount of spending by 70 adults of the village on goods and services produced in that village is the Gross Domestic Product (GDP) of that village.”

But it is very common to see percentage figures (like 6.5% or 3.4%) while talking about GDP – those are nothing but the year-over-year/quarter-over-quarter growth rate of GDP compared to the previous quarter/year.

Let’s see how the growth rate is calculated – In the village, 70 working adults had a GDP of Rs.20,000 in the year 2021 and Rs.20,400 in the year 2022. Growth in GDP is (growth in GDP/the previous GDP) i.e 400/20,000 = 2% growth

What if we wanna compare GDP with other places/cities/villages to understand how we are doing. In this case, GDP maybe not right metric to look at. Why?

If there is a city 100 km away from this village, how do we compare if the village economy is relatively doing? By comparing GDP? What if the city got 1000 people – there will be an obvious increase in spending compared to a village with 100 people. That’s where GDP per capita is helpful – it is nothing but GDP divided by population – literally means GDP per person.

Given GDP, what is the Recession?

A negative growth/contraction in the GDP for two consecutive quarters will result in a recession.

Wait a minute, why would GDP contract?

I will try to explain with the same village example but it will not accurately reflect the real world, still, you will get the idea. In the real world, there will be exports/imports, foreign investments, migrations, and many more involved. To keep it simple, let’s say there is “p product” in the village which hasn’t grown well in that respective year. But as the 70 adults of the village are working and want to buy the “p product” which has limited supply. This would increase demand for the “p product” and leads to a price increase. With the ripple effect, the usage of “p product” in cooking led restaurants to increase their prices on menus, and beauty products using “p product” increased their sale price.

What’s happening here? There is an increase in prices which leads to a decrease in purchasing power of the 70 people in the village. Not everyone can afford “p product” – especially low-wage workers in the village. This is called “Inflation” – an increase in prices affecting the purchasing power of people.

Due to the demand – let’s say some villagers (other than traditional sellers) figured out a way to import some “p product” and start selling for high prices for more profit. As this goes on, more and more villagers start buying this p product on EMI (Monthly installments).

Now – what happens next?

Though this indicates, GDP growth is very short-term, because people are spending more and more – meaning GDP overheat. As the prices keep increasing, someone should control this before becoming worse – that’s where Fed or Central Govt steps in.

What can they do about this? – They will increase the interest rates on loans/EMI with the help of the central bank that will issue circulars to all banks/finance services in the country/village.

Why? An increase in interest rate would affect “p product” sales fearing high-interest rates. When people withdraw from buying – this would ultimately impact demand to drop. If they don’t, Fed/Central Govt keeps increasing interest rates until the inflation declines. When demand declines, prices would ultimately come down decreasing inflation.

What about people who started importing and selling “p product”? With the decline in demand, the company starts experiencing losses – they will start firing the employees (as they no more need supply). This is the reason – unemployment increases.

Okay – but how does Fed/Central Govt know when to stop increasing so that it won’t result in a recession? By looking at the Inflation rate, Unemployment records, and GDP growth – Fed/Central Govt decides when to start lowering the interest rates.

InThe interestrestate is the brake that Fed/Central Govt holds to control the economy – If it is going too fast, it will apply that little break. If it is becoming too slow – it will loosen the break to maintain the speed.

Note: Here the “p product” is intentionally kept naive to keep the scenario simple, single product demand/price increase doesn’t determine the inflation rather multiple crucial product demand (or supply chain issues) increases overall inflation. Generally, some of the crucial product prices that are taken into account while calculating inflation are food, gas, rent, and other essential commodities.

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How does this info helpful in personal finance?

In sensitive times like these, markets are generally too volatile. It is advised to use this interest rate increase in our favor with a high-yield savings account (or) buying Fed/Central Govt bonds like I-bonds. And other common advice is to hold off on buying something unless found very cheap.

That’s it for this article – mainly intended for the big picture of how these terms are interconnected and affect us. Keep reading and let me know what you think!

Peace!