Interest rates, economic slow-down, unemploy­ment, and inflation, these are terms we starting to hear every day. While most of us have a rough working knowledge of their meanings, we’d be hard-pressed to explain the impact they have on our daily lives. But they do have an impact—especially if we are invested in the stock market. So before we get into the heart of this chapter on stocks, let’s take a moment to walk through some basic prin­ciples of economics.

Before we get into that here's a funny guy with 2008 predictions who seems to be hitting it out of the park.

We’ll begin with interest rates. Interest rates are an indication of how much it costs to borrow money. When interest rates are high, people are slower to borrow to buy big-ticket items, such as houses or cars. When interest rates are low, con­sumers are quicker to take on debt, because paying it off will be less expensive. And when people are not spending money, the economy slows-down.

As the economy slows, jobs are lost, which means unemployment goes up. When there are more people out of work, employers generally have an easier time to look for workers and pay them a lower salary. Sounds like a bad thing, doesn’t it? Not necessarily, because high unemployment and lowering wages are factors that contribute to de-flation. The opposite of deflation is inflation , in a period of inflation, goods and services cost more, and money doesn’t buy as much. Inflation occurs at times of high employment because as more people make more money, prices go up. (This is partially because companies’ costs go up when they have to pay higher wages, and par­tially because when people have more money, they want to buy more than the economy is able to produce, which triggers that most basic eco­nomic principle: the law of supply and demand. Even though we seem to be going thru inflation every aspect that is happening in our economy is in focus to try and fight inflation.

A side effect of inflation is an increase in in­terest rates. The government tends to raise inter­est rates when the economy shows signs of inflation, in order to slow people’s buying and curb economic growth. But higher interest rates also make it more expensive for companies to raise capital by borrowing, and that cuts into their profitability which is one of the top things investors consider in valuing stocks. Also, when interest rates are high, yields go up on bonds, and bonds begin to look like better in­vestments than stocks. So investors take money out of stocks and put them into bonds, and stock prices fall. So inflation, as you can see, is an enemy of the stock market.

It’s fascinating, isn’t it? What seems to be good for you as a worker lots of jobs and higher wages may be bad for you as an investor. And the inverse is also true. The markets tend to go up in reaction to “bad” economic news, like a mod­erate increase in unemployment or a slowdown in wage growth. (Note, however, that I said “mod­erate.” If unemployment is high, growth stag­nant, and consumer spending low, that’s just as bad for stocks as high interest rates are.)