Investors are likely to hear the terms inflation and gross domestic product (GDP) just

about every day. They are often made to feel that these metrics must be studied as a
surgeon would study a patient's chart prior to operating. Chances are that we have some
concept of what they mean and how they interact, but what do we do when the best
economic minds in the world can't agree on basic distinctions between how much the
U.S. economy should grow, or how much inflation is too much for the financial markets
to handle? Individual investors need to find a level of understanding that assists their
decision-making without inundating them in piles of data. Find out what inflation
and GDP mean for the market, the economy and your portfolio.

Inflation

Inflation can mean either an increase in the money supply or an increase in price levels.
Generally, when we hear about inflation, we are hearing about a rise in prices compared
to some benchmark. If the money supply has been increased, this will usually manifest
itself in higher price levels - it is simply a matter of time. For the sake of this discussion,
we will consider inflation as measured by the core Consumer Price Index (CPI), which is
the standard measurement of inflation used in the U.S. financial markets. Core CPI
excludes food and energy from its formulas because these goods show more price
volatility than the remainder of the CPI. (To read more on inflation, see All About
Inflation, Curbing The Effects Of Inflation and The Forgotten Problem Of Inflation.)

GDP
Gross domestic product in the United States represents the total aggregate output of the
U.S. economy. It is important to keep in mind that the GDP figures as reported to
investors are already adjusted for inflation. In other words, if the gross GDP was
calculated to be 6% higher than the previous year, but inflation measured 2% over the
same period, GDP growth would be reported as 4%, or the net growth over the period.
(To learn more about GDP, read Macroeconomic Analysis, Economic Indicators To
Know and What is GDP and why is it so important?)

What Does Gross Domestic Product - GDP Mean?

The monetary value of all the finished goods and services produced within a country's
borders in a specific time period, though GDP is usually calculated on an annual basis. It
includes all of private and public consumption, government outlays, investments and
exports less imports that occur within a defined territory.

GDP = C + G + I + NX

where:

"C" is equal to all private consumption, or consumer spending, in a nation's economy

"G" is the sum of government spending
"I" is the sum of all the country's businesses spending on capital
"NX" is the nation's total net exports, calculated as total exports minus total imports. (NX
= Exports - Imports)
Investopedia explains Gross Domestic Product - GDP
GDP is commonly used as an indicator of the economic health of a country, as well as to
gauge a country's standard of living. Critics of using GDP as an economic measure say
the statistic does not take into account the underground economy - transactions that, for
whatever reason, are not reported to the government. Others say that GDP is not intended
to gauge material well-being, but serves as a measure of a nation's productivity, which is
unrelated.

Over time, the growth in GDP causes inflation, and inflation begets hyperinflation. Once
this process is in place, it can quickly become a self-reinforcing feedback loop. This is
because in a world where inflation is increasing, people will spend more money because
they know that it will be less valuable in the future. This causes further increases in GDP
in the short term, bringing about further price increases. Also, the effects of inflation are
not linear; 10% inflation is much more than twice as harmful as 5% inflation. These are
lessons that most advanced economies have learned through experience; in the U.S., you
only need to go back about 30 years to find a prolonged period of high inflation, which
was only remedied by going through a painful period of high unemployment and lost
production as potential capacity sat idle.

Implications for Investors

Keeping a close eye on inflation is most important for fixed-income investors, as future
income streams must be discounted by inflation to determine how much value today'
money will have in the future. For stock investors, inflation, whether real or anticipated,
is what motivates us to take on the increased risk of investing in the stock market, in the
hope of generating the highest real rates of return. Real returns (all of our stock market
discussions should be pared down to this ultimate metric) are the returns on investment
that are left standing after commissions, taxes, inflation and all other frictional costs are
taken into account. As long as inflation is moderate, the stock market provides the best
chances for this compared to fixed income and cash.

There are times when it is most helpful to simply take the inflation and GDP numbers at
face value and move on; after all, there are many things that demand our attention as
investors. However, it is valuable to re-expose ourselves to the underlying theories
behind the numbers from time to time so that we can put our potential for investment
returns into the proper perspective.
When investors think about the capital markets, they typically ponder the merits of
bonds, stocks or derivatives. Because it isn't as sexy and doesn't have the volatility of
other securities, the money market is often far from the top of the list. Nevertheless,
virtually all investors can use the money market to enhance their portfolios in one way or
another. In this article, we'll explain how investors can use the dependability of the
money market to their advantage.
What Is It?
The money market is a market that provides liquidity for individuals and institutions by
dealing in short-term borrowing such as certificates of deposit, T-bills or other similar
instruments with a maturity date of about one year or less. With that in mind, because the
vehicles used in the money market are relatively safe when compared to their equity and
debt counterparts, and are often backed by the full faith and credit of the U.S. government
(such as with T-bills), the rate of return on a money market account is in the low single
digits.
Asset Preservation
In spite of the relatively low returns, the money market can be a great way for investors
to preserve, and even make, a little bit of money. Just think about this scenario: suppose
that you have recently bailed out of a stock, but you haven't yet decided where to invest
the proceeds. In this case, the money market can provide a relative safe haven for that
capital by offering an annualized return of around 3- 4% without having to absorb any
real risk.

Hedging
The money market is also a useful hedge against market declines. Suppose an investor is
bearish on the outlook for the stock or the bond market. This investor could liquidate his
account and opt to receive a check for the proceeds. Or, he may weather the storm while
earning single-digit returns in the money market. In fact, the money market is where the
big investment banks keep their funds in between deals, and where municipalities often
invest proceeds from debt offerings while waiting to put the money to use in a project.
(For more insight, see A Beginner's Guide To Hedging.)

Liquidity
Perhaps the biggest advantage and the most attractive feature of the money market is
liquidity. That is because there are countless entities looking to invest their capital in
between investments, or as a hedge. This means that if an investor wants to liquidate a
money market position, he or she will have very little trouble turning the funds into cash.
This comes in handy if you need to write a check against the account. In fact, most
brokerage firms and mutual funds will give their clients a book of checks when they open
their accounts. Talk about convenient!

Risks
There are risks in every investment, but the money market is probably one of the safest
places for your capital. After all, the funds are invested in relatively secure government or
other short-term, high-quality debt. Usually, the real risk represents an opportunity cost.
In other words, the risk that the funds invested in a money market account could have
fared better in a different investment vehicle such as a stock or a bond. Also keep in mind
that money market funds can sometimes fail to keep pace with inflation. This means that
an investor's purchasing power may decline each year even if that investor is fully
invested. For this reason, it rarely makes sense to put all of your funds into the money
market for an extended period of time. (For related reading, see All About Inflation.)

Buying In
How can you get involved? Most brokerage houses will give investors the option of
"sweeping" proceeds from a stock or bond sale into a money market account so that they
may earn interest while their money is in limbo. The only real disadvantage is that money
market income will likely be taxed as a short-term capital gain, which means that you
may owe the Internal Revenue Service a larger amount than if you were able to hold the
securities for more than a year. (To learn more, see A Long-Term Mindset Meets Dreaded
Capital Gains Tax.)

A taxable event can be avoided by buying into tax exempt money market funds. In this
case, you would invest your capital in municipal notes. The income from these notes, if
you live in the state in which they are originated, is often exempt from federal, state and
local taxes. This means that the actual return, because of the tax advantages, may be
much better then the taxable investment you might have considered as an alternative. (For
more insight, read Avoid Tricky Tax Issues On Municipal Bonds.)

Conclusion
While the money market probably won't make you rich - it may not even outpace
inflation by a large margin - it is a great place to park money while waiting for other
investment opportunities to come to fruition, and for hedging a percentage of your
portfolio against a market decline.