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Many factors influence daily financial decisions, ranging from age and household size to interest rates and inflation. Three main elements affect financial planning activities: life situation, personal values, and economic factors.
LIFE SITUATION AND PERSONAL VALUESPeople in their 20s spend money differently than those in their 50s. Personal factors such as age, income, household size, and personal beliefs influence your spending and saving patterns. Your life situation or lifestyle is created by a combination of factors. As our society changes, different types of financial needs evolve. Today people tend to get married at a later age, and more households have two incomes. Many households are headed by single parents. More than 2 million women provide care for both dependent children and parents. We are also living longer; over 80 percent of all Americans now living are expected to live past age 65.
As Exhibit 1-5 shows, the adult life cycleThe stages in the family situation and financial needs of an adult.—the stages in the family and financial needs of an adult—is an important influence on your financial activities and decisions. Your life situation is also affected by marital status, household size, and employment, as well as events such as
In addition to being defined by your family situation, you are defined by your valuesIdeas and principles that a person considers correct, desirable, and important—the ideas and principles that you consider correct, desirable, and important. Values have a direct influence on such decisions as spending now versus saving for the future or continuing school versus getting a job. ECONOMIC FACTORSDaily economic activities are another important influence on financial planning. In our society, the forces of supply and demand play an important role in setting prices. EconomicsThe study of how wealth is created and distributed is the study of how wealth is created and distributed. The economic environment includes various institutions, principally business, labor, and government, that must work together to satisfy our needs and wants. While various government agencies regulate financial activities, the Federal Reserve System, our nation’s central bank, has significant responsibility in our economy. The Fed, as it is called, is concerned with maintaining an adequate money supply. It achieves this by influencing borrowing, interest rates, and the buying or selling of government securities. The Fed attempts to make adequate funds available for consumer spending and business expansion while keeping interest rates and consumer prices at an appropriate level. GLOBAL INFLUENCES The global marketplace influences financial activities. Our economy is affected by both the financial activities of foreign investors and competition from foreign companies. American businesses compete against foreign companies for the spending dollars of American consumers. When the level of exports of U.S.-made goods is lower than the level of imported goods, more U.S. dollars leave the country than the dollar value of foreign currency coming into the United States. This reduces the funds available for domestic spending and investment. Also, if foreign companies decide not to invest their dollars in the United States, the domestic money supply is reduced. This reduced money supply may cause higher interest rates. ECONOMIC CONDITIONS Newspapers and business periodicals regularly publish current economic statistics. Exhibit 1-6 provides an overview of some economic indicators that influence financial decisions. Your personal financial decisions are most heavily influenced by consumer prices, consumer spending, and interest rates.
1. Consumer Prices InflationA rise in the general level of prices is a rise in the general level of prices. In times of inflation, the buying power of the dollar decreases. For example, if prices increased 5 percent during the last year, items that cost $100 one year ago would now cost $105. This means it now takes more money to buy the same amount of goods and services. The main cause of inflation is an increase in demand without a comparable increase in supply. For example, if people have more money to spend because of pay increases or borrowing but the same amounts of goods and services are available, the increased demand can bid up prices for those goods and services. Inflation is most harmful to people living on fixed incomes. Due to inflation, retired people and others whose incomes do not change are able to afford smaller amounts of goods and services. Inflation can also adversely affect lenders of money. Unless an adequate interest rate is charged, amounts repaid by borrowers in times of inflation have less buying power than the money they borrowed. If you pay 10 percent interest on a loan and the inflation rate is 12 percent, the dollars you pay the lender have lost buying power. For this reason, interest rates rise in periods of high inflation.
The rate of inflation varies. During the late 1950s and early 1960s, the annual inflation rate was in the 1 to 3 percent range. During the late 1970s and early 1980s, the cost of living increased 10 to 12 percent annually. At a 12 percent annual inflation rate, prices double (and the value of the dollar is cut in half) in about six years. To find out how fast prices (or your savings) will double, use the rule of 72: Just divide 72 by the annual inflation (or interest) rate. An annual inflation rate of 8 percent, for example, means prices will double in nine years (72 ÷ 8 = 9). More recently, the annual price increase for most goods and services as measured by the consumer price index has been in the 2 to 4 percent range. The consumer price index (CPI), published by the Bureau of Labor Statistics, is a measure of the average change in the prices urban consumers pay for a fixed “basket” of goods and services. For current CPI information, go to www.bls.gov.
Inflation rates can be deceptive, since the index is based on specific items calculated in a predetermined manner. Many people face hidden inflation since the cost of necessities (food, gas, health care), on which they spend most of their money, may rise at a higher rate than the cost of nonessential items, which could be dropping in price. This results in a reported inflation rate much lower than the actual cost-of-living increase being experienced by consumers. 2. Consumer Spending Total demand for goods and services in the economy influences employment opportunities and the potential for income. As consumer purchasing increases, the financial resources of current and prospective employees expand. This situation improves the financial condition of many households. In contrast, reduced spending causes unemployment, since staff reduction commonly results from a company’s reduced financial resources. The financial hardships of unemployment are a major concern of business, labor, and government. Retraining programs, income assistance, and job services can help people adjust. 3. Interest Rates In simple terms, interest rates represent the cost of money. Like everything else, money has a price. The forces of supply and demand influence interest rates. When consumer saving and investing increase the supply of money, interest rates tend to decrease. However, as consumer, business, government, and foreign borrowing increase the demand for money, interest rates tend to rise. Interest rates affect your financial planning. The earnings you receive as a saver or an investor reflect current interest rates as well as a risk premium based on such factors as the length of time your funds will be used by others, expected inflation, and the extent of uncertainty about getting your money back. Risk is also a factor in the interest rate you pay as a borrower. People with poor credit ratings pay a higher interest rate than people with good credit ratings. Interest rates influence many financial decisions. Current interest rate data may be obtained at www.federalreserve.gov.
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