I. The Basic Concept Of An Economy

The performance of an investment will be influenced by the economy. The effects of inflation or deflation may interfere with anticipated returns. Thus, the direction of the economy must be considered when formulating an investment strategy.

A. The Business Cycle

The business cycle represents a repetitive succession of changes in economic activity. The business cycle has four phases: expansion (also called recovery), peak, recession (also call contraction), and trough.

In the expansion phase, business activity is growing, production and demand are increasing, and employment is expanding. Businesses and consumers normally borrow money to expand, which causes interest rates to rise.

B. Inflation

As the cycle moves into the peak, demand for goods overtakes supply and prices rise. This creates inflation. During inflationary times, there is too much money chasing more for their items causing prices to rise. This, in turn, reduces the purchasing power of the consumer.

As prices rise, demand slackens which causes economic activity to decrease. The cycle then enters the recessionary phase.

C. Deflation

As business activity contracts, employers lay off workers (unemployment increases) and demand slackens. Usually, this cause prices to fall creating deflation. The cycle enters the trough. Deflation is the persistent and appreciable fall in the general level of prices. Eventually, lower prices will stimulate demand and the economy moves into the next cycles, expansion.

II. Gross National Product

One of the most significant measures of economic activity is the Gross National Product (GNP). GNP is the total value of goods and services produced by the entire US economy. Components of the GNP include consumer spending, investments, government spending, and net exports.

The government reports GNP quarterly. There are two types of GNP. “Normal GNP” reflects the total dollars spent on goods and services for the quarter. “Real GNP” adjusts the nominal GNP for the effects of inflation. Real GNP is measured in constant dollars (money adjusted for inflation) and is the best method for comparing GNP over time.

A recession occurs when Real GNP (Gross National Product adjusted for inflation) has declined for two successive quarters.

III. Business Cycle Indicators

Economists use three types of indicators that provide monthly data on the movement of the economy as the business cycle enters different phases. The three types are leading, coincident, and lagging indicators. For FOREX trading we will only look at leading economic indicators that provide the greatest impact on the economy.

A. Leading Economic Indicators

Leading economic indicators precede the upward and downward movements of the business cycle. They may also be used to predict the near term activity of the economy. The US Government compiles an index of eleven leading economic indicators. This index is released monthly and is adjusted for inflation. The components of the index are:

1. The average workweek for production workers in manufacturing.
2. The average weekly initial claims for state unemployment insurance.
3. New orders for consumer goods and materials.
4. Vendor performance (companies receiving slower deliveries from supplies).
5. Contracts and orders for plant and materials.
6. New building permits for private housing units.
7. Changes in inventories on hand and on order.
8. Changes in sensitive materials prices.
9. The prices for the S&P 500 common stocks.
10. The money supply (M2).
11. The change in credit outstanding for business and consumer borrowing.

IV. The Effect Of The Business Cycle On FOREX Market

As the economy moves through the different phases of the business cycle, the FOREX market reacts to these changes. Investors view these changes and take corresponding action, attempting to take advantage of changes in the economy.

In the FOREX market, the US Dollar will move inversely to interest rates. As interest rates increase, there will be a drain on earnings, resulting in a decline in the US Dollar Index.

V. Monetary Policy

Monetary policy attempts to control the supply of money and credit in the economy. This will affect interest rates causing an increase or decrease in economic activity. The primary focus of monetary policy is the control of inflation.

VI. The Federal Reserve System

The Federal Reserve System implements monetary policy in the US. An Act of Congress established the Federal Reserve System, the nation’s central bank, in 1913. The Act divided the country into 12 Federal Reserve districts. Responsibility for coordination the activities of the district banks lies with the Federal Reserve Board of Governors in Washington D.C. The board has seven members appointed by the President and confirmed by the Senate.

A. Major Tools Of The Federal Reserve Board

Since money is primarily created by the commercial banking system, the FRB must control the banking system to implement monetary policy decisions. The Fed has various tools at its disposal through which it may implement its monetary policy. These tools are:

• Setting reserve requirements
• Setting margin requirements
• Setting the discount rate
• Implementing open market operations
• Utilizing moral suasion

B. Effects Of The Federal Reserve Board’s Activities

As with any product, when the supply increases, the price of that product will decrease. If supply contracts, the price will increase. The “price of money” is the interest rate that lenders charge borrowers. Thus, as FRB changes the supply of money, the “price of money” (interest rates) must also change. As interest rates changes, the FRB will adjust its monetary policy in order to influence the various sectors of the economy.

In summary, Federal Reserve Board activities tend to cause the following: