11 key economic terms you should know 

With stories about the economy in the news 24/7, you might be hearing a lot of terms you're not familiar with. To help you better follow the latest trends, now is a great time to work on growing your financial vocabulary.

The Scotiabank Perspectives podcast had on Laura Gu, Scotiabank economist, to help explain 11 commonly used economic terms. 

Click here for the transcript.

Read on for a crash course on the terms she believes everyone should know — and understand.

In the simplest terms, gross domestic product (GDP) is how you measure economic output. "Essentially, GDP is just a total value of everything produced within the border of our economy," Gu said.

So, if you were to add up the monetary value of all the goods and services produced in Canada during a certain period of time, you would get the GDP.

Gu also pointed out the difference between GDP and “real GDP." The real GDP removes the effects of inflation. It captures trends in economic activity using constant prices. This allows economists to measure the actual change in GDP output rather than changes that are due to inflation.

Although monetary and fiscal policies are both tools used to influence a country's economic activity, they are different in terms of who controls them and their purpose.

Central banks manage monetary policies and use them to help control the amount of money in circulation. The main goal of a monetary policy is to keep inflation under control. For example, the Bank of Canada can increase interest rates to try and manage inflation.

Government departments are responsible for managing fiscal policies. Their main goal is to improve economic activity through taxing and spending actions.

“To stimulate the economy, a government can cut tax rates while increasing spending," Wu said. "And when they need to cool down an overheating economy, they can raise tax rates and cut back on spending."

An output gap is an economic measure of the difference between the actual output of an economy and its potential output, which is the maximum amount of goods and services the economy can produce when it's running at full employment.

“Us economists love talking about output gaps," Gu said. “The reason we like talking about it is because it gives us a sense of where the economy is."

A positive output gap means the economy is operating above its full capacity and is usually a result of higher inflation and lower unemployment. In this case, Gu explained, “The central banks might raise interest rates to cool down demand and lower inflation."

When the economy is experiencing a negative output gap and operating below its potential, the central banks might cut interest rates to stimulate growth.

Most ideal is having as small of a gap as possible. Although, “the economy is never at this point," Gu said.

Quantitative tightening (QT) might sound like something you do to fix your car, but it's actually a policy tool that central banks use. The purpose of QT is to reduce the supply of money in the economy to help control inflation.

The central bank can try to use a few different methods to reduce inflation. One is to increase interest rates. Rising rates make it more expensive to borrow for a mortgage or car loan. But raising the cost of borrowing can help reduce demand and stabilize prices.

Quantitative tightening is another method. The central bank can attempt to reduce the size of its balance sheet by either selling government bonds or allowing the bonds to mature. The purpose is to remove money from the financial markets.

While both of these methods aim to reduce inflation, Gu explained that an increase in interest rates typically influences shorter-term interest rates and quantitative tightening affects longer-term interest rates.

Stagflation is an extended period of high inflation. An economy is in a state of stagflation when it meets three criteria:

• Slow economic growth
• High unemployment
• Rising prices

According to Gu, stagflation is “one of the worst outcomes that can come out of having an extended period of high inflation."

As unemployment rates go up, economc growth can slow down, and this can create a large challenge for central banks to deal with, she said.

One common cause of stagflation is a supply shock — when the supply of a product or commodity changes unexpectedly and there's a sudden increase or decrease in price as a result. For instance, in 1973, there was an oil shock that caused oil prices to rise significantly due to unexpected fuel shortages.¹

Core inflation is a measure of inflation that excludes the most volatile categories of food and energy. Why exclude food and energy? Because the price of these goods and services tends to fluctuate more than others.

Removing food and energy from the mix helps give a more accurate picture of the overall price of goods and services, and can assist the Bank of Canada in making better decisions about interest rates. For instance, if core inflation is rising too quickly, this might motivate the government to take steps to bring it back down.

Hyperinflation is a term that describes very high and typically accelerating inflation. In episodes of hyperinflation, the real value of a local currency starts to quickly depreciate. The cause of hyperinflation is often due to the rapid expansion of the country's money supply, and it tends to occur during periods of economic turmoil.

There are several examples of hyperinflation throughout history, with two of the more recent cases happening in Turkey and Argentina.

Turkey has held an annual inflation rate of approximately 40% over the last 50 years.² In October 2022, inflation hit a 24-year high of 85.5%. Recent inflation in Argentina was just shy of 100%.³,⁴ In both countries, people have had to change how they shop and completely rethink what they spend their money on.

Disinflation is the temporary slowing down of inflation. “If inflation slows from 8% to 6%, this is an example of disinflation," Gu said.

During disinflation, prices are still moving up, just at a slower rate. But that's not a bad thing. Disinflation is pretty normal and necessary to prevent an economy from overheating. A recession can trigger disinflation, as can tighter monetary policies.

The terminal rate is the target interest rate a central bank aims to hit during a rate-hiking or rate-cutting cycle.

To determine the terminal policy rate, central banks have to weigh conditions, including inflation and unemployment rates. The central bank will use monetary policies to influence current interest rates to reach the terminal rate. 

The non-accelerating inflation rate of unemployment (NAIRU) is far more difficult to say than explain and understand. The NAIRU represents the lowest unemployment rate that can be sustained before wages and inflation begin to rise. It's the rate of unemployment consistent with no acceleration in the inflation rate.

When unemployment drops below the NAIRU level and stays there for an extended period of time, the economy tends to overheat, causing inflation to pick up.  

A basis point (bps) is a unit of measurement in finance that is often used to describe small changes in interest rates. One basis point is equal to one-hundredth of a percentage point (0.01%). A hundred basis points are equal to 1.0%. So, instead of just saying, “there was a 1% increase in interest rate," an economist would say, “the interest rate increased by 100 basis points."

The financial world is laden with jargon. But with this list of terms and a little bit of practice, you can improve your vocabulary and follow along easily with the latest economic news and trends.

Transcript:

Stephen Meurice: Have you ever been watching the news or say, been at a dinner party, and someone starts talking about the economy?

Suddenly there’s acronyms flying every which way. Big words. Complex lingo that you’re pretty sure they don’t even understand. Even for those of us who are somewhat up on these things, it can be a word soup. And all you can do is nod along pretending you know what they’re saying. Well – that ends today. Because this episode we’ve rounded up a bunch of economic terms you may have heard lately but might not fully understand. And with the help of Scotiabank economist Laura Gu, we’re going to define them. Things like quantitative tightening, monetary policy and GDP. And even some terms you don’t hear that often, but sound really cool. Like NAIRU, that is non-accelerating inflation rate of unemployment. By the end of the episode, we guarantee you’ll come away with a quiver of quantitative quips, a preponderant pantheon of parlance, a more better big pile of words. I closed my esaurus too early, but you get what I mean. I’m Stephen Meurice and this is Perspectives. You might have heard of a at least a couple of these biases and even if you haven’t you’ve almost certainly experienced some of them firsthand. Confirmation bias is a classic example. That’s when you subconsciously cherry pick facts that confirm what you already believe. Or the spotlight effect. That’s when we assume people are paying way more attention to us then they actually are. And of course, there’s cognitive biases when it comes to investing, too. Little tricks your brain can play that might cloud your judgement and ultimately prevent you from say investing wisely. And they can be hard to avoid.

Laura, thanks so much for joining us again.

LG: Thank you, Stephen. Great to be here.

SM: So, let's jump right into it. We have our list of economic words here. And for each of them, you're not only going to help us define them, but I will also try to prove that I've learned what they mean. And you can tell me if I got it right.

LG: Got it.

SM: Oh, and we also have a speedy lightning round planned. And you specifically asked for us to get you a prize for that. So, there's a lot at stake here. My ego. Your prize. Let's get going.

LG: Let's go.

SM: All right. So, we'll start with something seemingly sort of simple. GDP, which is a term that's pretty common, stands for gross domestic product. But what does that mean and why is it relevant now?

LG: Essentially, GDP is just a total value of everything produced within the border of our economy. The contrast to an alternative concept, which is the gross national product or GNP, which is the output produced by residents of the country. So, if a German-owned company has a factory in the U.S. and the output of that factory would be included in the U.S. GDP, but in German GNP. And when we talk about economic growth, which is, you know, we see a lot in the news, we normally use the real GDP and it’s essentially the measure of economic output adjusted for inflation.

SM: So, GDP is basically, that's how you measure the size of the economy.

LG: Essentially, yes. In the size of economic output.

SM: Okay. So, when people say, ‘The economy grew by 1%, seasonally adjusted, whatever or whatever.’ They're talking about in relation to the GDP, it's the GDP that grew by that amount?

LG: The real GDP, yes.

SM: Okay. And so, when we hear about GDP in the news, mostly they are talking about real GDP generally?

LG: The real growth. Yes. Because it’s adjusted for inflation, so that more captures the trends in economic activity net of the changes in prices.

SM: All right. Next one, when you read about the economy these days, you often hear the terms monetary policy and fiscal policy. Now, what are those and what's the difference between them?

LG: So essentially, they're both tools to influence a country's economic activity. Monetary policies are managed by the central banks by controlling the money supply and aim to keep inflation levels under control. Fiscal policies are managed by the governmental departments and aim to improve the economic activity of the country. It broadly refers to taxing and spending actions that the government conducts. An example, to stimulate the economy a government can cut tax rates while increasing its spending. And while when they need to cool down the overheating economy, they can raise tax rates and cut back on spending.

SM: Okay. So fiscal policy is the stuff the government does, the decisions that it makes to try and influence the economy in one way or the other. And monetary policy is the stuff that the Bank of Canada does to try and affect inflation… what are they trying to affect?

LG: So, yeah, the primary goal of a central bank is to keep inflation under control, which could affect economic activity, employment and currency as well.

SM: Okay. So, when the government raises my taxes, that's fiscal policy. When the Bank of Canada increases the cost of my mortgage. That's monetary policy.

LG: Exactly. You got it.

SM: All right. Next up is output gap. Now we often have the Chief Economist at Scotiabank, JF Perreault, on the show. And he has used this expression several times. And normally I just nod politely. So maybe you can help me through that and say what output gap actually is.

LG: Absolutely. Us economists love talking about output gaps. Economists and policymakers, we’re interested in not only whether GDP is going up or down, but also if it's above or below its potential. Essentially, the output gap is an economic measure of the difference between the actual output and an economy's potential output. Potential output is basically the maximum amount of goods and services the economy can produce when it is at its full capacity. Its full employment. The reason we like talking about it is because it gives us a sense of where the economy is. A positive output gap indicates the economy is operating above its full capacity and usually results in higher inflation and lower unemployment. And vice versa, when there is a positive output gap, the central banks might raise interest rates to cool down demand and lower inflation, and they might cut rates when the output gap is negative.

SM: So, the output gap is the difference between what the economy is actually producing versus what it could potentially be producing if it was running full steam ahead at full capacity?

LG: Bingo.

SM: Okay. Does that mean that you want to have as small as possible of an output gap? Is the goal for there not to be a gap?

LG: That's the ideal state, the equilibrium. But, you know, the economy is never at that point. And so that's why, you know, we need both monetary policy and fiscal policy to work to help the economy rebalance and operate at the full capacity.

SM: I think I got it. We will move on to number four. One of the things I know the Bank of Canada does in order to try and influence, I guess, interest rates is what I hear referred to as quantitative tightening. It sounds kind of painful. Can you explain what that is and why we should care about it?

LG: Sure. So quantitative tightening or QT as we call it, it is essentially a monetary policy tool that central banks use to bring inflation down to meet its target. It is the opposite of quantitative easing, which they used to bring inflation up. So, quantitative tightening, it's a practice of central banks used to shrink the size of their balance sheets and to control money supply. It is a complement to their primary policy tool, which is policy rates. So, they shrink the size of balance sheets by either selling the government bonds they hold or simply let them mature and just remove them from the balance sheets. And through, you know, quantitative tightening, the central banks remove some demand for bonds on the market, which increases the bond yields and increases the borrowing costs for households and businesses. And in that way, they can help control inflation.

SM: Okay. [laughs] That's a lot to grasp. You'll have to help me a little bit more with this one. So quantitative tightening is when they're trying to reduce the money supply?

LG: Essentially.

SM: Right. And they do that by selling the bonds that they own.

LG: They can either sell it or just let in mature, which is what the Bank of Canada is doing at this moment.

SM: And what does it mean for them to let the bonds mature?

LG: So, a bond is essentially just an IOU, and, ‘let it mature’ means that the contract expires and the money borrowed goes back to where it was before.

SM: Right. Is that related to when people talk about printing money? That, you know, the government or the Bank of Canada is printing money, increasing the money supply, and sometimes politicians will accuse them of that. Is that the same thing?

LG: It's not the same thing. It is not printing money, per se. It is instead controlling the amount of money circulating within the economy.

SM: Okay. So quantitative tightening is a tool that they use to control the money supply and along with interest rates, is one of the tools the Bank of Canada uses to control inflation.

LG: Exactly. You know, the interest rate hikes they more influence shorter term interest rates. But quantitative tightening affects longer term interest rates that is more tied to fixed rate mortgages.

SM: Okay. The next one before we move on to our lightning round is stagflation, something I've wondered about for a while. Inflation is obviously top of mind for everybody. But what is stagflation?

LG: Stagflation is the state of economy when it meets three criteria; slow growth, high unemployment and rising prices. It is widely believed that the common cause for stagflation is supply shocks, you know, such as oil shock or the supply chain disruption that's removed supply and slows down economic growth, causing companies to cut labour demands and causing prices to go up. At least that was a cause of the stagflation episode back in the 1970s. But the causes of stagflation, it’s still widely debated in the economics world, but most of us can agree that it is bad and is a problem.

SM: It sounds bad.

LG: It is bad.

SM: I think there was some concern when inflation started ratcheting up, people wondered whether that was a problem that we might have, but it doesn't seem to have happened.

LG: Mmm hmm. That is one of the worst outcomes that can come out of having an extended period of high inflation. Unemployment rate goes up. Sometimes it gets really high and slows down growth, and that is a big challenge for the central banks to deal with the situation. As you know, when they focus on tackling unemployment, that's not good for inflation and they usually tackle employment first and they move on to tackling inflation. So, it's kind of a battle on all fronts. That is definitely a nightmare.

SM: Right. So, we haven't had the nightmare scenario because employment has been pretty strong through all of this. And the economy's slowed down but hasn't sort of shrunk in any sort of terrible way.

LG: That is right. As I said, there are three criteria; slow growth, high unemployment and rising prices. And so, we're not there yet.

SM: Right. That's where the stag in stagflation comes from, right? It's stagnation and inflation at the same time?

LG Yeah, yeah. I don't know who coined the term, but that's a good way to interpret it. Yeah.

SM: So, stagflation, if I understand correctly, is a combination of high inflation, increasing unemployment and economic slowdown, all at once for terrible effect.

LG: Yes, all the bad things you can imagine.

SM: Okay. All right, it's time for the lightning round. Now, here we have to get through as many definitions as we can as quickly as we can. And at stake here is a mystery prize that I will give you regardless of how you do since I'm not timing you or keeping score. Are you ready, Laura, for the lightning round?

LG: Yes, I am.

SM: Producer Andrew, can you give us some dramatic game show music?

[dramatic music begins]

SM: All right. And go. Number one. Core inflation.

LG: Core inflation. It’s a measure of inflation that excludes the more volatile categories of food and energy prices.

SM: Okay. Terminal rate.

LG: Terminal rate is the ultimate level of policy rate that central banks expect to hit in a rate hiking cycle, a rate cutting cycle.

SM: Hopefully we've hit that now, right?

LG: We're getting there.

SM: [laughs] We’re getting there. The Mendoza line.

LG: Umm…

SM: That's actually a baseball term that we just want to throw in there to see if you're paying attention.

LG: [laughs] I don’t watch baseball.

SM: [laughs] Basis point.

LG: Basis point is 0.01%. In other words, 100 basis points is equal to one percentage point.

SM: So, for some reason, when economists insist on saying 50 basis points, they mean half a percentage point?

LG: That's right.

SM: Okay. Hyperinflation.

LG: Oh, hyperinflation is a very high and typically accelerating inflation. In hyperinflation episodes, the real value of local currencies depreciating really rapidly.

SM: So, is that what we had last year?

LG: Not here in Canada, by all we can see hyperinflation in countries such as Argentina and Turkey.

SM: Right.

LG: Yeah.

SM: Now we're seeing disinflation?

LG: That's right. Disinflation, it’s still inflation. But it's when prices and wages grow at a slowing pace. For example, if inflation slows from 8% to 6%, that’s disinflation.

SM: Okay. And finally, the non-accelerating inflation rate of unemployment or NAIRU.

LG: Oh, that's a mouthful. The non-accelerating inflation rate of unemployment is the lowest unemployment rate that can be sustained without causing wage growth and inflation to rise.

[dramatic music ends]

SM: Okay, Laura, that concludes the lightning round. You did amazing. As promised, we have an exciting prize for you. Andrew, tell Laura what she's won.

Andrew Norton: Well, Stephen, Laura will be crunching numbers in style on her brand-new calculator! That's right, it features an eight-digit display, a memory function, and was the best thing I could find after nearly 30 minutes of searching at the dollar store. Congratulations, Laura.

LG: Thank you. I'm pretty sure I have one on my phone, but this one is special.

SM: Andrew thought it would be appropriate for an economist, and it's a really high tech one, too, as you can see.

LG: Yeah, it shows.

SM: [laughs] Laura, enjoy it. It was a lot of fun, and our vocabularies are much the richer for it.

LG: Thank you.

SM: I've been speaking with Laura Gu, Economist at Scotiabank. The Perspectives podcast is made by me Stephen Meurice, Armina Ligaya and our producer Andrew Norton. Who, rest assured, every time there is a baseball reference on the show, he’s behind it.