Economic vocabulary start from 'F'

Factor cost

A measure of output reflecting the costs of the factors of production used, rather than market prices, which may differ because of indirect tax and subsidy .

Factors of production

The ingredients of economic activity: land, labour, capital and enterprise.

Factory prices

The prices charged by producers to wholesalers and retailers. Because these prices are eventually passed on to the end customer, changes in factory prices, also known as producer prices, can be a leading indicator of consumer price inflation.

Fair trade

Many politicians and ngos argue that free trade is not enough; it should also be fair. On the face of it, fairness is self-evidently a good thing. However, fairness, in trade as in beauty, lies in the eye of the beholder. Frederic bastiat, a 19th-century french satirist, once observed that the sun offered unfair competition to candle makers. If windows could be boarded up during the day, he argued, more jobs could be created making candles. American trade unions complain that mexicans' lower wages, say, give them an unfair advantage. Mexicans say they cannot compete fairly against more productive american counterparts. Both sides are wrong. Mexicans are paid less than americans largely because they are, in general, less productive. There is nothing unfair about that; indeed, it helps to make trade mutually beneficial. The mutual benefits of trade also disprove the fair traders' other complaint, that free trade harms poor countries.

Federal reserve system

America's central bank. Set up in 1913, and popularly known as the fed, the system divides the united states into 12 federal reserve districts, each with its own regional federal reserve bank. These are overseen by the federal reserve board, consisting of seven governors based in washington, dc. Monetary policy is decided by its federal open market committee.

Financial centre

A place in which an above-average amount of financial business takes place. The big ones are new york, london, tokyo and frankfurt. Small ones such as dublin, bermuda, luxembourg and the cayman islands also play an important part in the global financial system. Globalisation and the increase in electronic trading has raised concerns about whether there will be as much need for financial centres in the 21st century as there was in the 19th and 20th centuries. So far, the evidence suggests that the biggest, at least, will remain important.

Financial instrument

Certificate of ownership of a financial asset, such as a bond or a share.

Financial intermediary

A middleman. An individual or institution that brings together investors (the source of funds) and users of funds (such as borrowers). May be increasingly at risk of disintermediation.

Financial system

The firms and institutions that together make it possible for money to make the world go round. This includes financial markets, securities exchanges, banks, pension funds, mutual funds, insurers, national regulators, such as the securities and exchange commission (sec) in the united states, central banks, governments and multinational institutions, such as the imf and world bank.

Fine tuning

A favourite government policy in the keynesian-dominated 1950s and 1960s, involving frequent adjustments to fiscal policy and/or monetary policy to alter the level of demand to keep the economy growing at a steady rate. The trouble was and is, partly because of the inadequacies of economic forecasting, that these frequent adjustments were and are often mistaken, making the economy's growth path more, rather than less, erratic. In the 1990s, fine tuning was increasingly shunned by central banks and governments, which stopped trying to manage short-term demand and instead aimed to pursue long-term macroeconomic goals, which required fewer adjustments to policy. Or so they claimed. In practice, there continued to be some attempted fine tuning.

Firms

For many years, economists had little interest in what happened inside firms, preferring instead to examine the workings of the different sorts of industries in which firms operate, ranging from perfect competition to monopoly. Since the 1960s, however, sophisticated economic theories of how firms work have been developed. These have examined why firms grow at different rates and tried to model the normal life cycle of a company, from fast-growing start-up to lumbering mature business. The aim is to explain when it pays to conduct an activity within a firm and when it pays to externalise it through short- or long-term arrangements with outsiders, be they individuals, exchanges or other companies. The theories also look at the economic consequences of the different incentives influencing individuals working within companies, tackling issues such as pay, agency costs and corporate governance structures.

First-mover advantage

The early bird gets the worm. Game theory shows that being the first to enter a market or to introduce an innovation can be a huge advantage, not just because the first firm in can erect barriers to entry, but also because potential rivals may be discouraged from committing the resources necessary to compete successfully. However, this advantage may sometimes be cancelled out by the benefits enjoyed by followers, such as the chance to avoid--and learn from--the mistakes made by the first mover.

Fiscal drag

A nice little earner for the state. Fiscal drag is the tendency of revenue from taxation to rise as a share of gdp in a growing economy. Tax allowances, progressive tax rates and the threshold above which a particular rate of tax applies usually remain constant or are changed only gradually. By contrast, when the economy grows, income, spending and corporate profit rise. So the tax-take increases too, without any need for government action. This helps slow the rate of increase in demand, reducing the pace of growth, making it less likely to result in higher inflation. Thus fiscal drag is an automatic stabiliser, as it acts naturally to keep demand stable.

Fiscal neutrality

When the net effect of taxation and public spending is neutral, neither stimulating nor dampening demand. The term can be used to describe the overall stance of fiscal policy: a balanced budget is neutral, as total tax revenue equals total public spending. It can also refer more narrowly to the combined impact of new measures introduced in an annual budget: the budget can be fiscally neutral if any new taxes equal any new spending, even if the overall stance of the budget either boosts or slows demand.

Fiscal policy

One of the two instruments of macroeconomic policy; monetary policy's side-kick. It comprises public spending and taxation, and any other government income or assistance to the private sector (such as tax breaks). It can be used to influence the level of demand in the economy, usually with the twin goals of getting unemployment as low as possible without triggering excessive inflation. At times it has been deployed to manage short-term demand through fine tuning, although since the end of the keynesian era it has more often been targeted on long-term goals, with monetary policy more often used for shorter-term adjustments.

For a government, there are two main issues in setting fiscal policy: what should be the overall stance of policy, and what form should its individual parts take?

Some economists and policymakers argue for a balanced budget. Others say that a persistent deficit (public spending exceeding revenue) is acceptable provided, in accordance with the golden rule, the deficit is used for investment (in infrastructure, say) rather than consumption. However, there may be a danger that public-sector investment will result in the crowding out of more productive private investment. Whatever the overall stance on average over an economic cycle, most economists agree that fiscal policy should be counter-cyclical, aiming to automatically stabilise demand by increasing public spending relative to revenue when the economy is struggling and increasing taxes relative to spending towards the top of the cycle. For instance, social (welfare) handouts from the state usually increase during tough times, and fiscal drag boosts government revenue when the economy is growing.

As for the bits and pieces making up fiscal policy, one debate is about how high public spending should be relative to gdp. In the united states and many asian countries, public spending is less than 30% of gdp; in european countries, such as germany and sweden, it has been as high as 40-50%. Some economic studies suggest that lower public spending relative to gdp results in higher rates of growth, though this conclusion is controversial. Certainly, over the years, much public spending has been highly inefficient.

Another issue is the form that taxation should take, especially the split between direct taxation and indirect taxation and between capital, income and expenditure tax.

Fixed costs

Production costs that do not change when the quantity of output produced changes, for instance, the cost of renting an office or factory space. Contrast with variable costs.

Flotation

Going public. When shares in a company are sold to the public for the first time through an initial public offering. The number of shares sold by the original private investors is called the "float". Also, when a bond issue is sold in the financial markets.

Forecasting

Best guesses about the future. Despite complex economic theories and cutting-edge econometrics, the forecasts economists make are often badly wrong. Indeed, following economic forecasts has been likened to driving a car blindfolded, following directions given by a person who is looking out of the back window. Some of the inaccuracies in forecasts reflect badly designed models; often, the problem is that the future actually is unpredictable. Maybe it would be better to take the advice of sam goldwyn, a movie mogul, "never prophesy, especially about the future."

Foreign direct investment

Investing directly in production in another country, either by buying a company there or establishing new operations of an existing business. This is done mostly by companies as opposed to financial institutions, which prefer indirect investment abroad such as buying small parcels of a country's supply of shares or bonds. Foreign direct investment (fdi) grew rapidly during the 1990s before slowing a bit, along with the global economy, in the early years of the 21st century. Most of this investment went from one oecd country to another, but the share going to developing countries, especially in asia, increased steadily.

There was a time when economists considered fdi as a substitute for trade. Building factories in foreign countries was one way of jumping tariff barriers. Now economists typically regard fdi and trade as complementary. For example, a firm can use a factory in one country to supply neighbouring markets. Some investments, especially in services industries, are essential prerequisites for selling to foreigners. Who would buy a big mac in london if it had to be sent from new york?

Governments used to be highly suspicious of fdi, often regarding it as corporate imperialism. Nowadays they are more likely to court it. They hope that investors will create jobs, and bring expertise and technology that will be passed on to local firms and workers, helping to sharpen up their whole economy. Furthermore, unlike financial investors, multinationals generally invest directly in plant and equipment. Since it is hard to uproot a chemicals factory, these investments, once made, are far more enduring than the flows of hot money that whisk in and out of emerging markets (see developing countries).

Mergers and acquisitions are a significant form of fdi. For instance, in 1997, more than 90% of fdi into the united states took the form of mergers rather than of setting up new subsidiaries and opening factories.

Free riding

Getting the benefit of a good or service without paying for it, not necessarily illegally. This may be possible because certain types of goods and services are actually hard to charge for--a firework display, for instance. Another way to look at this may be that the good or service has a positive externality. However, there can sometimes be a free-rider problem, if the number of people willing to pay for the good or service is not enough to cover the cost of providing it. In this case, the good or service might not be produced, even though it would be beneficial for the economy as a whole to have it. Public goods are often at risk of free riding; in their case, the problem can be overcome by financing the good by imposing a tax on the entire population.

Free trade

The ability of people to undertake economic transactions with people in other countries free from any restraints imposed by governments or other regulators. Measured by the volume of imports and exports, world trade has become increasingly free in the years since the second world war. A fall in barriers to trade, as a result of the general agreement on tariffs and trade and its successor, the world trade organisation, has helped stimulate this growth. The volume of world merchandise trade at the start of the 21st century was about 17 times what it was in 1950, and the world's total output was not even six times as big. The ratio of world exports to gdp had more than doubled since 1950. Of this, trade in manufactured goods was worth three times the value of trade in services, although the share of services trade was growing fast.

For economists, the benefits of free trade are explained by the theory of comparative advantage, with each country doing those things in which it is comparatively more efficient. As long as each country specialises in products in which it has a comparative advantage, trade will be mutually beneficial. Some critics of free trade argue that trade with developing countries, where wages are usually lower and working hours longer than in developed countries, is unfair and will wipe out jobs in high-wage countries. They want autarky or fair trade.

Real-world trade patterns sometimes seem to challenge the theory of comparative advantage (see new trade theory). Most trade occurs between countries that do not have huge cost differences. The biggest trading partner of the united states, for instance, is canada. Well over half the exports from france, germany and italy go to other european union countries. Moreover, these countries sell similar things to each other: cars made in france are exported to germany, and german cars go to france. The main reason seems to be cross-border differences in consumer tastes. But the agricultural exports of australia, say, or saudi arabia's reliance on oil, do clearly stem from their particular stock of natural resources. Also poorer countries often have more unskilled labour, so they export simple manufactures such as clothing.

Frictional unemployment

That part of the jobless total caused by people simply changing jobs and taking their time about it, because they are spending time on job search or are taking a break before starting with a new employer. There is likely to be some frictional unemployment even when there is technically full employment, because most people change jobs from time to time.

Friedman, milton

Loved and loathed; perhaps the most influential economist of his generation. He won the nobel prize for economics in 1976, one of many chicago school economists to receive that honour. He has been recognised for his achievements in the study of consumption, monetary history and theory, and for demonstrating how complex policies aimed at economic stabilisation can be.

A fierce advocate of free markets, mr friedman argued for monetarism at a time when keynesian policies were dominant. Unusually, his work is readily accessible to the layman. He argues that the problems of inflation and short-run unemployment would be solved if the federal reserve had to increase the money supply at a constant rate.

Like adam smith and friedrich hayek, who inspired him, mr friedman praises the free market not just for its economic efficiency but also for its moral strength. For him, freedom--economic, political and civil--is an end in itself, not a means to an end. It is what makes life worthwhile. He has said he would prefer to live in a free country, even if it did not provide a higher standard of living, than a country run by an alternative regime. However, the likelihood of a free country being poorer than an unfree one strikes him as implausible; the economic as well as the moral superiority of free markets is, he has declared, "now proven".

An adviser to richard nixon, he was disappointed when the president went against the spirit of monetarism in 1971 by asking him to urge the chairman of the fed to increase the money supply more rapidly. The 1980s economic policies of margaret thatcher and general pinochet were inspired--and defended--by mr friedman. However, in 2003, he admitted that one of those policies, the targeting of the money supply, had "not been a success" and that he doubted he would "as of today push it as hard as i once did".

Full employment

Jobs for all that want them. This does not mean zero unemployment because at any point in time some people do not want to work. Also, because some people are always between jobs, there will usually be some frictional unemployment. Full employment means that everyone who wants work and is willing to work at the market wage is in work. Most governments aim to achieve full employment, although nowadays they rarely try to lower unemployment below the nairu: the lowest jobless rate consistent with stable, low inflation.

Fungible

You can't tell them apart. Something is fungible when any one single specimen is indistinguishable from any other. Somebody who is owed $1 does not care which particular dollar he gets. Anything that people want to use as money must be fungible, whether it be gold bars, beads or shells.

Economics vocabulary start from 'E'

Econometrics

Mathematics and sophisticated computing applied to economics. Econometricians crunch data in search of economic relationships that have statistical significance. Sometimes this is done to test a theory; at other times the computers churn the numbers until they come up with an interesting result. Some economists are fierce critics of theory-free econometrics.

Economic and monetary union

In january 1999, 11 of the 15 countries in the european union merged their national currencies into a single european currency, the euro. This decision was motivated partly by politics and partly by hoped-for economic benefits from the creation of a single, integrated european economy. These benefits included currency stability and low inflation, underwritten by an independent european central bank (a particular boon for countries with poor inflation records, such as italy and spain, but less so for traditionally low-inflation germany). Furthermore, european businesses and individuals stood to save from handling one currency rather than many. Comparing prices and wages across the euro zone became easier, increasing competition by making it easier for companies to sell throughout the euro-zone and for consumers to shop around.

Forming the single currency also involved big risks, however. Euro members gave up both the right to set their own interest rates and the option of moving exchange rates against each other. They also agreed to limit their budget deficits under a stability and growth pact. Some economists argued that this loss of flexibility could prove costly if their economies did not behave as one and could not easily adjust in other ways. How well the euro-zone functions will depend on how closely it resembles what economists call an optimal currency area. When the euro economies are not growing in unison, a common monetary policy risks being too loose for some and too tight for others. If so, there may need to be large transfers of funds from regions doing well to those doing badly. But if the effects of shocks persist, fiscal transfers would merely delay the day of reckoning; ultimately, wages or people (or both) would have to shift.

In its first few years,the euro fell sharply against the dollar, though it recovered during late 2002. Sluggish growth in some european economies led to intense pressure for interest rate cuts, and to the stability and growth pact being breached, though not scrapped. Even so, by 2003 12 countires had adopted the euro, with the expectation of more to follow after the enlargement of the eu to 25 members in 2004.

Economic indicator

A statistic used for judging the health of an economy, such as gdp per head, the rate of unemployment or the rate of inflation. Such statistics are often subject to huge revisions in the months and years after they are first published, thus causing difficulties and embarrassment for the economic policymakers who rely on them.

Economic man

At the heart of economic theory is homo economicus, the economist's model of human behaviour. In traditional classical economics and in neo-classical economics it was assumed that people acted in their own self-interest. Adam smith argued that society was made better off by everybody pursuing their selfish interests through the workings of the invisible hand. However, in recent years, mainstream economists have tried to include a broader range of human motivations in their models. There have been attempts to model altruism and charity. Behavioural economics has drawn on psychological insights into human behaviour to explain economic phenomena.

Economic sanctions

A way of punishing errant countries, which is currently more acceptable than bombing or invading them. One or more restrictions are imposed on international trade with the targeted country in order to persuade the target's government to change a policy. Possible sanctions include limiting export or import trade with the target; constraining investment in the target; and preventing transfers of money involving citizens or the government of the target. Sanctions can be multi­lateral, with many countries acting together, perhaps under the auspices of the united nations, or unilateral, when one country takes action on its own.

How effective sanctions are is debatable. According to one study, between 1914 and 1990 there were 116 occasions on which various countries imposed economic sanctions. Two-thirds of these failed to achieve their stated goals. The cost to the country imposing sanctions can be large, particularly when it is acting unilaterally. It is estimated that in 1995 imposing sanctions on other countries cost the american economy over $15 billion in lost exports and 200,000 in lost jobs in export industries.

Widely considered a notable success was the use of economic sanctions against the apartheid regime in south africa, although some economists question how big a part the sanctions actually played. Clearly important was the fact that the sanctions were imposed multilaterally by the international community, so there were comparatively few breaches of the restrictions. But, arguably, the most crucial factor in persuading the government in pretoria to cave in was that foreign companies fearing that their share price would fall because their investments in south africa would attract bad publicity voluntarily chose for commercial reasons to disinvest.

Economics

The “dismal science”, according to thomas carlyle, a 19th-century scottish writer. It has been described in many ways, few of them flattering. The most concise, non-abusive, definition is the study of how society uses its scarce resources.

Economies of scale

Bigger is better. In many industries, as output increases, the average cost of each unit produced falls. One reason is that overheads and other fixed costs can be spread over more units of output. However, getting bigger can also increase average costs (diseconomies of scale) because it is more difficult to manage a big operation, for instance.

Efficiency

Getting the most out of the resources used. For a particular sort of efficiency often favoured by economists, see pareto efficient.

Efficiency wages

Wages that are set at above the market clearing rate so as to encourage workers to increase their productivity.

Efficient market hypothesis

You can't beat the market. The efficient market hypothesis says that the price of a financial asset reflects all the information available and responds only to unexpected news. Thus prices can be regarded as optimal estimates of true investment value at all times. It is impossible for investors to predict whether the price will move up or down (future price movements are likely to follow a random walk), so on average an investor is unlikely to beat the market. This belief underpins ­arbitrage pricing theory, the capital asset pricing model and concepts such as beta.

The hypothesis had few critics among financial economists during the 1960s and 1970s, but it has come under increasing attack since then. The fact that financial prices were far more volatile than appeared to be justified by new information, and that financial bubbles sometimes formed, led economists to question the theory. Behavioural economics has challenged one of the main sources of market efficiency, the idea that all investors are fully rational homo economicus. Some economists have noted the fact that information gathering is a costly process, so it is unlikely that all available information will be reflected in prices. Others have pointed to the fact that arbitrage can become more costly, and thus less likely, the further away from fundamentals prices move. The efficient market hypothesis is now one of the most controversial and well-studied propositions in economics, although no consensus has been reached on which markets, if any, are efficient. However, even if the ideal does not exist, the efficient market hypothesis is useful in judging the relative efficiency of one market compared with another.

Elasticity

A measure of the responsiveness of one variable to changes in another. Economists have identified four main types.

Price elasticity measures how much the quantity of supply of a good, or demand for it, changes if its price changes. If the percentage change in quantity is more than the percentage change in price, the good is price elastic; if it is less, the good is inelastic.

Income elasticity of demand measures how the quantity demanded changes when income increases.

Cross-elasticity shows how the demand for one good (say, coffee) changes when the price of another good (say, tea) changes. If they are substitute goods (tea and coffee) the cross-elasticity will be positive: an increase in the price of tea will increase demand for coffee. If they are complementary goods (tea and teapots) the cross-elasticity will be negative. If they are unrelated (tea and oil) the cross-elasticity will be zero.

Elasticity of substitution describes how easily one input in the production process, such as labour, can be substituted for another, such as machinery.

Endogenous

Inside the economic model; the opposite of exogenous).

Engel's law

People generally spend a smaller share of their budget on food as their income rises. Ernst engel, a russian statistician, first made this observation in 1857. The reason is that food is a necessity, which poor people have to buy. As people get richer they can afford better-quality food, so their food spending may increase, but they can also afford luxuries beyond the budgets of poor people. Hence the share of food in total spending falls as incomes grow.

Enron

In a word, all that was wrong with american capitalism at the start of the 21st century. Until late 2001, enron, an energy company turned financial powerhouse based in houston, texas, had been one of the most admired firms in the united states and the world. It was praised for everything from pioneering energy trading via the internet to its innovative corporatate culture and its system of employment evaluation by peer review, which resulted in those that were not rated by their peers being fired. However, revelations of accounting fraud by the firm led to its bankruptcy, prompting what was widely described as a crisis of confidence in american capitalism. This, as well as further scandals involving accounting fraud (worldcom) and other dubious practices (many by wall street firms), resulted in efforts to reform coporate governance, the legal liability of company bosses, accounting, wall street research and regulation.

Enterprise

One of the factors of production, along with land, labour and capital. The creative juices of capitalism; the animal spirits of the entrepreneur.

Entrepreneur

The life and soul of the capitalist party. Somebody who has the idea and enterprise to mix together the other factors of production to produce something valuable. An entrepreneur must be willing to take a risk in pursuit of a profit.

Environmental economics

Some people think capitalism is wholly bad for the environment as it is based on consuming scarce resources. They want less consumption and greater reliance on renewable resources. They oppose free trade because they favour self-sufficiency (autarky), or at least so-called fair trade, and because they believe it encourages poorer countries to destroy their natural resources in order to get rich quick. Although few professional economists would share these views, in recent years many attempts have been made to incorporate environmental concerns within mainstream economics.

The traditional measure of gdp incorporates only those things that are paid for; this may include things that reduce the overall quality of life, including harming the environment. For instance, cleaning up an oil spill will increase gdp if people are paid for the clean-up. Attempts have been made to devise an alternative environmentally friendly measure of national income, but so far progress has been limited. At the very least, traditional economists increasingly agree that maximising gdp growth does not necessarily equal maximising social welfare.

Much of the damage done to the environment may be a result of externalities. An externality can arise when people engaged in economic activity do not have to take into account the full costs of what they are doing. For instance, car drivers do not have to bear the full cost of making their contribution to global warming, even though their actions may one day impose a huge financial burden on society. One way to reduce externalities is to tax them, say, through a fuel tax. Another is prohibition, say, limiting car drivers to one gallon of fuel per week. This could result in black markets, however. Allowing trade in pollution rights may encourage 'efficient pollution', with the pollution permits ending up in the hands of those for which pollution has the greatest economic upside. As this would still allow some environmental destruction, it might be unpopular with extreme greens.

There may be a case for international eco markets. For instance, people in rich countries might pay people in poor countries to stop doing activities that do environmental damage outside the poor countries, or that rich people disapprove of, such as chopping down the rain forests. Choices on environmental policy, notably on measures to reduce the threat of global warming, involve costs today with benefits delayed until the distant future. How are these choices to be made? Traditional cost-benefit analysis does not help much. In measuring costs and benefits in the far distant future, two main things seem to intervene and spoil the conventional calculations. One is uncertainty. We know nothing about what the state of the world will be in 2200. The other is how much people today are willing to pay in order to raise the welfare of others who are so remote that they can barely be imagined, yet who seem likely to be much better off materially than people today. Some economists take the view that the welfare of each future generation should be given the same weight in the analysis as the welfare of today's. This implies that a much lower discount rate should be used than the one appropriate for short-term projects. Another option is to use a high discount rate for costs and benefits arising during the first 30 or so years, then a lower rate or rates for more distant periods. Many studies by economists and psychologists have found that people do in fact discount the distant future at lower rates than they apply to the near future.

Equilibrium

When supply and demand are in balance. At the equilibrium price, the quantity that buyers are willing to buy exactly matches the quantity that sellers are willing to sell. So everybody is satisfied, unlike when there is disequilibrium. In classical economics, it is assumed that markets always tend towards equilibrium and return to it in the event that something causes a temporary disequilibrium. General equilibrium is when supply and demand are balanced simultaneously in all the markets in an economy. Keynes questioned whether the economy always moved to equilibrium, for instance, to ensure full employment.

Equity

There are two definitions in economics.

1 the capital of a firm, after deducting any liabilities to outsiders other than shareholders, who are typically the legal owners of the firm's equity. This ownership right is the reason shares are also known as equities.

2 fairness. Dividing up the economic pie. Economists have been particularly interested in this with regard to how systems of taxation work. They have examined whether taxes treat fairly people with the same ability to pay (horizontal equity) and people with different abilities to pay (vertical equity).

The fairness of other aspects of how the gains from economic activity are distributed through society have also been debated by economists, especially those interested in welfare economics. Some economists start with the presumption that the free-market outcome is inherently inequitable, and that equity (sharing out the pie) must be traded off against efficiency (maximising the size of the pie). Others argue that it is inequitable to take money away from someone who has created economic value to give to people who have been less skilled or industrious.

Equity risk premium

The extra reward investors get for buying a share over what they get for holding a less risky asset, such as a government bond. Modern financial theory assumes that the premium will be just big enough on average to compensate the investor for the extra risk. However, studies have found that the average equity premium over many years has been much larger than appears to be justified by the average riskiness of shares. To solve this so-called equity premium puzzle, some economists have suggested that investors may have greater risk aversion towards shares than traditional theory assumes. Some claim that the past equity premium was mismeasured, or reflected an unrepresentative sample of share prices. Others suggest that the high premium is evidence that the efficient market hypothesis does not apply to the stockmarket. Some economists think that the premium fell to more easily explained levels during the 1990s. Nobody really knows which, if any, of these interpretations is right.

Euro

The main currency of the european union, launched in january 1999 and in general circulation since 2002 .

Euro zone

The economy comprising all the countries that have adopted the euro. There is much debate among economists about whether the euro zone is in fact an optimal currency area.

Eurodollar

A deposit in dollars held in a bank outside the united states. Such deposits are often set up to avoid taxes and currency exchange costs. They are frequently lent out and have become an important method of credit creation.

European central bank

The central bank of the european union, responsible since january 1999 for setting the official short-term interest rate in countries using the euro as their domestic currency. In this role, the european central bank (ecb) replaced national central banks such as germany's bundesbank, which became local branches of the ecb.

European union

A club of european countries. Initially a six-country trade area established by the 1957 treaty of rome and known as the european economic community, it has become an increasingly political union. In 1999 a single currency, the euro, was launched in 11 of the then 15 member countries. Viewed as a single entity, the eu has a bigger economy than the united states. In 2002, a further 10 countries were invited to join the eu in 2004, increasing its membership to 25 countries, with more countries likely to follow later.

Evolutionary economics

A darwinian approach to economics, sometimes called institutional economics. Following the tradition of schumpeter, it views the economy as an evolving system and places a strong emphasis on dynamics, changing structures (including technologies, institutions, beliefs and behaviour) and disequilibrium processes (such as innovation, selection and imitation).

Excess returns

Getting more money from an economic investment than you needed to justify investing. In perfect competition, the factors of production earn only normal returns, that is, the minimum amount of wages, profit, interest or rent needed to secure their use in the economic activity in question, rather than in an alternative. Excess returns can only be earned for more than a short period when there is market failure, especially monopoly, because otherwise the existence of excess returns would quickly attract competition, which would drive down returns until they were normal.

Exchange controls

Limits on the amount of foreign currency that can be taken into a country, or of domestic currency that can be taken abroad.

Exchange rate

The price at which one currency can be converted into another. Over the years, economists and politicians have often changed their minds about whether it is a good idea to try to hold a country's exchange rate steady, rather than let it be decided by market forces. For two decades after the second world war, many of the major currencies were fixed under the bretton woods agreement. During the following two decades, the number of currencies allowed to float increased, although in the late 1990s a number of european currencies were permanently fixed under economic and monetary union and some other countries established a currency board.

When capital can flow easily around the world, countries cannot fix their exchange rate and at the same time maintain an independent monetary policy. They must choose between the confidence and stability provided by a fixed exchange rate and the control over interest rate policy offered by a floating exchange rate. On the face of it, in a world of capital mobility a more flexible exchange rate seems the best bet. A floating currency will force firms and investors to hedge against fluctuations, not lull them into a false sense of stability. It should make foreign banks more circumspect about lending. At the same time it gives policymakers the option of devising their own monetary policy. But floating exchange rates have a big drawback: when moving from one equilibrium to another, currencies can overshoot and become highly unstable, especially if large amounts of capital flow in or out of a country. This instability has real economic costs.

To get the best of both worlds, many emerging economies have tried a hybrid approach, loosely tying their exchange rate either to a single foreign currency, such as the dollar, or to a basket of currencies. But the currency crises of the late 1990s, and the failure of argentina's currency board, led many economists to conclude that, if not a currency union such as the euro, the best policy may be to have a freely floating exchange rate.

Exogenous

Outside the model. For instance, in traditional neo-classical economics, models of growth rely on an exogenous factor. To keep growing, an eco­nomy needs continual infusions of technological progress. Yet this is a force that the neo-classical model makes no attempt to explain. The rate of technological progress comes from outside the model; it is simply assumed by the economic modellers. In other words, it is exogenous. New growth theory tries to calculate the rate of technological progress inside the economic model by mapping its relationship to factors such as human capital, free markets, competition and government expenditure. Thus, in these models, growth is ­endogenous.

Expectations

What people assume about the future, especially when they make decisions. Economists debate whether poeple have irrational or rational expectations, or adaptive expectations that change to reflect learning from past mistakes.

Expected returns

The capital gain plus income that investors think they will earn by making an investment, at the time they invest.

Expenditure tax

A tax on what people spend, rather than what they earn or their wealth. Economists often regard it as more efficient than other taxes because it may discourage productive economic activity less; it is not the creating of income and wealth that is taxed, but the spending of it. It can be a form of indirect taxation, added to the price of a good or service when it is sold, or direct taxation, levied on people's income minus their savings over a year.

Export credit

Loans to boost exports. In many countries these are subsidised by a government keen to encourage exports. Typically, the credit comes in two forms: loans to foreign buyers of domestic produce; and guarantees on loans made by banks to domestic companies so they can produce the exports that should pay off the loan. This effectively insures producers against non-payment. When governments compete aggressively with export credits to win business for domestic firms the sums involved can become large. The economic benefit of export credits is unclear at the best of times. This may be because they are largely motivated by political goals.

Exports

Sales abroad. Exports grew steadily as a share of world output during the second half of the 20th century. Yet by some measures this share was no higher than at the end of the 19th century, before free trade fell victim to a political backlash.

Externality

An economic side-effect. Externalities are costs or benefits arising from an economic activity that affect somebody other than the people engaged in the economic activity and are not reflected fully in prices. For instance, smoke pumped out by a factory may impose clean-up costs on nearby residents; bees kept to produce honey may pollinate plants belonging to a nearby farmer, thus boosting his crop. Because these costs and benefits do not form part of the calculations of the people deciding whether to go ahead with the economic activity they are a form of market failure, since the amount of the activity carried out if left to the free market will be an inefficient use of resources. If the externality is beneficial, the market will provide too little; if it is a cost, the market will supply too much.

One potential solution is regulation: a ban, say. Another, when the externality is negative, is a tax on the activity or, if the externality is positive, a subsidy. But the most efficient solution to externalities is to require them to be included in the costings of those engaged in the economic activity, so there is self-regulation. For instance, the externality of pollution can be solved by creating property rights over clean air, entitling their owner to a fee if they are infringed by a factory pumping out smoke. According to the coase theorem (named after a nobel prize-winning economist, ronald coase), it does not matter who has ownership, so long as property rights are fully allocated and completely free trade of all property rights is possible.

Economics vocabulary start from 'D'

Deadweight cost/loss

The extent to which the value and impact of a tax, tax relief or subsidy is reduced because of its side-effects. For instance, increasing the amount of tax levied on workers’ pay will lead some workers to stop working or work less, so reducing the amount of extra tax to be collected. However, creating a tax relief or subsidy to encourage people to buy life insurance would have a deadweight cost because people who would have bought insurance anyway would benefit.

Debt

'Neither a borrower nor a lender be,' wrote shakespeare in 'hamlet'. Actually, the availability of debt, and the willingness to take it on, is a crucial ingredient of economic growth, because it allows individuals, firms and governments to make investments they would not otherwise be able to afford. The price of debt is interest. Until recently, lending was an activity dominated by banks (although mortgages for individuals buying their homes have long been available from special housing savings institutions). Since the 1960s, debt has become increasingly available from other sources. Companies have sold trillions of dollars worth of bonds to investors in the financial markets. Individuals have been able to borrow with credit cards, and for those who have nowhere else to turn there are pawn shops and loan sharks, which charge very high rates of interest. Total private-sector debt in 2003 was around 150% of gdp in the united states, compared with less than 100% in 1928. In most countries, by far the biggest single borrower is the state, through the national debt.

Debt forgiveness

Cancelling or rescheduling a borrower's debts to lessen the pain of the debt burden. Debt forgiveness is increasingly viewed as the best way to relieve the financial problems facing poorer countries. Some of these countries have to pay so much in interest each year to foreign lenders that they have little money left to spend on the long-term solutions to their poverty, such as educating their workers and building a modern infrastructure. In 1998 the world bank calculated that around 40 of the world's poorest countries had an 'unsustainably high' debt burden: the present value of their total debts was more than 220% of their exports.

Debt forgiveness has potential drawbacks. For instance, there is a risk of moral hazard. If countries that borrow too much are let off their financial obligations, poor countries may feel they have nothing to lose by borrowing as much as they can. This is why policymakers often argue that debt forgiveness should come with a conditionality clause, for instance, a requirement that countries have a track record of implementing economic reforms designed to prevent a repeat of the errors that first created the need for debt forgiveness. This is the approach taken by the world bank's hipc (highly indebted poor country) initiative, launched in 1996 and expanded in 1999. However, by 2003, only eight of the 38 poor countries eligible under the programme had made enough progress in reform to have some debt forgiven.

Default

Failure to fulfil the terms of a loan agreement. For example, a borrower is in default if he or she does not make scheduled interest payments on a loan or fails to pay off the loan at the agreed time. Judging the likelihood of default is a crucial part of pricing a loan. Interest rates are set so that, on average , a portfolio of loans will be profitable to the creditor , even if some individual loans are loss-making as a result of borrowers defaulting.

Deficit

In the red – when more money goes out than comes in. A budget deficit occurs when public spending exceeds government revenue. A current account deficit occurs when exports and inflows from private and official transfers are worth less than imports and transfer outflows (see balance of payments).

Deflation

Since 1930 it has been the norm in most developed countries for average prices to rise year after year. However, before 1930 deflation (falling prices) was as likely as inflation. On the eve of the first world war, for example, prices in the uk, overall, were almost exactly the same as they had been at the time of the great fire of london in 1666.

Deflation is a persistent fall in the general price level of goods and services. It is not to be confused with a decline in prices in one economic sector or with a fall in the inflation rate (which is known as disinflation).

Sometimes deflation can be harmless, perhaps even a good thing, if lower prices lift real income and hence spending power. In the last 30 years of the 19th century, for example, consumer prices fell by almost half in the united states, as the expansion of railways and advances in industrial technology brought cheaper ways to make everything. Yet annual real gdp growth over the period averaged more than 4%.

Deflation is dangerous, however, more so even than inflation, when it reflects a sharp slump in demand, excess capacity and a shrinking money supply, as in the great depression of the early 1930s. In the four years to 1933, american consumer prices fell by 25% and real gdp by 30%. Runaway deflation of this sort can be much more damaging than runaway inflation, because it creates a vicious spiral that is hard to escape. The expectation that prices will be lower tomorrow may encourage consumers to delay purchases, depressing demand and forcing firms to cut prices by even more. Falling prices also inflate the real burden of debt (that is, increase real interest rates) causing bankruptcy and bank failure. This makes deflation particularly dangerous for economies that have large amounts of corporate debt. Most serious of all, deflation can make monetary policy ineffective: nominal interest rates cannot be negative, so real rates can get stuck too high.

Demand

One of the two words economists use most; the other is supply. These are the twin driving forces of the market economy. Demand is not just about measuring what people want; for economists, it refers to the amount of a good or service that people are both willing and able to buy. The demand curve measures the relationship between the price of a good and the amount of it demanded. Usually, as the price rises, fewer people are willing and able to buy it; in other words, demand falls (but see giffen goods, normal goods and inferior goods). When demand changes, economists explain this in one of two ways. A movement along the demand curve occurs when a price change alters the quantity demanded; but if the price were to go back to where it was before, so would the amount demanded. A shift in the demand curve occurs when the amount demanded would be different from what it was previously at any chosen price, for example, if there is no change in the market price, but demand rises or falls. The slope of the demand curve indicates the elasticity of demand. For approaches to modelling demand see revealed preference.

Policymakers seek to manipulate aggregate demand to keep the economy growing as fast as is possible without pushing up inflation. Keynesians try to manage demand through fiscal policy; monetarists prefer to use the money supply. Neither approach hasbeen especially successful in practice, particularly when attempting to manage short-term demand through fine tuning.

Demand curve

A graph showing the relationship between the price of a good and the amount of demand for it at different prices.

Demographics

People, and the statistical study of them. In the 200 years since thomas malthus forecast that population growth would result in mass starvation, dire predictions based on demographic trends have come to be taken with a pinch of salt. Even so, demography does matter. In developed countries, economists have studied the impact of the post-war 'baby-boomer' population bulge as it has grown older. In the 1980s, as the bulge dominated the workforce, it may have contributed to a sharp, if temporary, rise in unemployment in many countries. Boomers starting to save for retirement may have increased demand for shares, so fuelling the bull stockmarket of the 1990s; as they retire and sell their shares for spending money, they may cause a long bear market. Furthermore, as they become elderly and retire, health-care spending and retirement pensions are likely to eat up a growing share of gdp. To the extent that these are provided by the state, this will mean increasing public spending and higher taxes. But whether they are provided by the state or by the private sector, the ageing of baby-boomers will impose a growing financial burden on the younger workers that have to support them (see replacement rate). Economists have tried to measure the extent of this burden using generational accounting, which looks at the amount of wealth transferred from one generation to another over the lifetimes of the members of each generation.

Economists have also developed many different theories to explain why populations grow and why the fertility rate slowed sharply, to below the replacement rate, in many developed countries during the 1990s. One explanation is based on the notion that people have children so that there is somebody to look after them in old age. Fertility rates fell because the state increasingly looked after retired people, and infant mortality rates were lower so fewer births were required to ensure that there were some children around in the parental dotage. Also, with a lower probability of a child dying, it paid the parents to have fewer children and to channel their energy and resources into maximising the human capital of the few. Alternatively, it may have had something to do with an important innovation: the cheap and easy availability of reliable contraception.

Deposit insurance

Protection for your savings, in case your bank goes bust. Arrangements vary around the world, but in most countries deposit insurance is required by the government and paid for by banks (and, ultimately, their customers), which contribute a small slice of their assets to a central, usually government-run, insurance fund. If a bank defaults, this fund guarantees its customers' deposits, at least up to a certain amount. By reassuring banks' customers that their cash is protected, deposit insurance aims to prevent them from panicking and causing a bank run, and thereby reduces systemic risk. The united states introduced it in 1933, after a massive bank panic led to widespread bankruptcy, deepening its depression.

The downside of deposit insurance is that it creates a moral hazard. By insulating depositors from defaults, deposit insurance reduces their incentive to monitor banks closely. Also banks can take greater risks, safe in the knowledge that there is a state-financed safety net to catch them if they fall.

There are no easy solutions to this moral hazard. One approach is to monitor what banks do very closely. This is easier said than done, not least because of the high cost. Another is to ensure capital adequacy by requiring banks to set aside, just in case, specified amounts of capital when they take on different amounts of risk.

Alternatively, the state safety net could be shrunk, by splitting banks into two types: super-safe, government-insured'narrow banks' that stick to traditional business and invest only in secure assets; and uninsured institutions, 'broad banks', that could range more widely under a much lighter regulatory system. Savers who invested in a broad bank would probably earn much higher returns because it could invest in riskier assets; but they would also lose their shirts if it went bust.

Yet another possible answer is to require every bank to finance a small proportion of its assets by selling subordinated debt to other institutions, with the stipulation that the yield on this debt must not be more than so many (say 50) basis points higher than the rate on a corresponding risk-free instrument. Subordinated debt (uninsured certificates of deposit) is simply junior debt. Its holders are at the back of the queue for their money if the bank gets into trouble and they have no safety net. Investors will buy subordinated debt at a yield quite close to the risk-free interest rate only if they are sure the bank is low risk. To sell its debt, the bank will have to persuade informed investors of this. If it cannot convince them it cannot operate. This exploits the fact that bankers know more about banking than do their supervisors. It asks banks not to be good citizens but to look only to their profits. Unlike the present regime, it exploits all the available information and properly aligns everybody's incentives. This ingenious idea was first tried in argentina, where it became a victim of the country's economic, banking and political crisis of 2001-02 before it really had a chance to prove itself.

Depreciation

A fall in the value of an asset or a currency; the opposite of appreciation.

Depression

A bad, depressingly prolonged recession in economic activity. The textbook definition of a recession is two consecutive quarters of declining output. A slump is where output falls by at least 10%; a depression is an even deeper and more prolonged slump.

The most famous example is the great depression of the 1930s. After growing strongly during the 'roaring 20s', the american economy (among others) went into prolonged recession. Output fell by 30%. Unemployment soared and stayed high: in 1939 the jobless rate was still 17% of the workforce. Roughly half of the 25,000 banks in the united states failed. An attempt to stimulate growth, the new deal, was the most far-reaching example of active fiscal policy then seen and greatly extended the role of the state in the american economy. However, the depression only ended with the onset of preparations to enter the second world war.

Why did the great depression happen? It is not entirely clear, but forget the popular explanation: that it all went wrong with the wall street stockmarket crash of october 1929; that the slump persisted because policymakers just sat there; and that it took the new deal to put things right. As early as 1928 the federal reserve, worried about financial speculation and inflated stock prices, began raising interest rates. In the spring of 1929, industrial production started to slow; the recession started in the summer, well before the stockmarket lost half of its value between october 24th and mid-november. Coming on top of a recession that had already begun, the crash set the scene for a severe contraction but not for the decade-long slump that ensued.

So why did a bad downturn keep getting worse, year after year, not just in the united states but also around the globe? In 1929 most of the world was on the gold standard, which should have helped stabilise the american economy. As demand in the united states slowed its imports fell, its balance of payments moved further into surplus and gold should have flowed into the country, expanding the money supply and boosting the economy. But the fed, which was still worried about easy credit and speculation, dampened the impact of this adjustment mechanism, and instead the money supply got tighter. Governments everywhere, hit by falling demand, tried to reduce imports through tariffs, causing international trade to collapse. Then american banks started to fail, and the fed let them. As the crisis of confidence spread more banks failed, and as people rushed to turn bank deposits into cash the money supply collapsed.

Bad monetary policy was abetted by bad fiscal policy. Taxes were raised in 1932 to help balance the budget and restore confidence. The new deal brought deposit insurance and boosted government spending, but it also piled taxes on business and sought to prevent excessive competition. Price controls were brought in, along with other anti-business regulations. None of this stopped - and indeed may well have contributed to - the economy falling into recession again in 1937-38, after a brief recovery starting in 1935.

Deregulation

Cutting red tape. The process of removing legal or quasi-legal restrictions on the amount of competition, the sorts of business done, or the prices charged within a particular industry. During the last two decades of the 20th century, many governments committed to the free market pursued policies of liberalisation based on substantial amounts of deregulation hand-in-hand with the privatisation of industries owned by the state. The aim was to decrease the role of government in the economy and to increase competition. Even so, red tape is alive and well. In the united states, with some 60 federal agencies issuing more than 1,800 rules a year, in 1998 the code of federal regulations was more than 130,000 pages thick. However, not all regulation is necessarily bad. According to estimates by the american office of management and budget, the annual cost of these rules was $289 billion, but the annual benefits were $298 billion.

Derivatives

Financial assets that 'derive' their value from other assets. For example, an option to buy a share is derived from the share. Some politicians and others responsible for financial regulation blame the growing use of derivatives for increasing volatility in asset prices, and for being a source of danger to their users. Economists mostly regard derivatives as a good thing, allowing more precise pricing of financial risk and better risk management. However, they concede that when derivatives are misused the leverage that is often an integral part of them can have devastating consequences. So they come with an economists' health warning: if you don't understand it, don't use it.

The world of derivatives is riddled with jargon. Here are translations of the most important bits.

A forward contract commits the user to buying or selling an asset at a specific price on a specific date in the future.

A future is a forward contract that is traded on an exchange.

A swap is a contract by which two parties exchange the cashflow linked to a liability or an asset. For example, two companies, one with a loan on a fixed interest rate over ten years and the other with a similar loan on a floating interest rate over the same period, may agree to take over each other's obligations, so that the first pays the floating rate and the second the fixed rate.

An option is a contract that gives the buyer the right, but not the obligation, to sell or buy a particular asset at a particular price, on or before a specified date.

An over-the-counter is a derivative that is not traded on an exchange but is purchased from, say, an investment bank.

Exotics are derivatives that are complex or are available in emerging economies.

Plain-vanilla derivatives, in contrast to exotics, are typically exchange-traded, relate to developed economies and are comparatively uncomplicated.

Devaluation

A sudden fall in the value of a currency against other currencies. Strictly, devaluation refers only to sharp falls in a currency within a fixed exchange rate system. Also it usually refers to a deliberate act of government policy, although in recent years reluctant devaluers have blamed financial speculation. Most studies of devaluation suggest that its beneficial effects on competitiveness are only temporary; over time they are eroded by higher prices (see j-curve).

Developing countries

A euphemism for the world's poor countries, also known, often optimistically, as emerging economies. Some four-fifths of the world's 6 billion people already live in developing countries, many of them in abject poverty. Developing countries account for less than one-fifth of total world gdp.

Economists disagree about how likely--and how fast--developing countries are to become developed. Neo-classical economics predicts that poor countries will grow faster than richer ones. The reason is diminishing returns on capital. Since poor countries start with less capital, they should reap higher returns than a richer country with more capital from each slice of new investment. But this catch-up effect (or convergence) is not supported by the data. For one thing, there is, in fact, no such thing as a typical developing country. The official developing world includes the (sometimes) fast-growing asian tigers and the poorest nations in africa. Studies of the relationship between growth and gdp per head in rich and poor countries found no evidence that poorer countries grew faster. Indeed, if anything, poorer countries have grown more slowly.

Development economics has argued that this is because poor countries have unique problems that require different policy solutions from those offered by conventional developed-world economics. But new endogenous growth theory instead argues that there is conditional convergence. Hold constant such factors as a country's fertility rate, its human capital and its government policies (proxied by the share of current government spending in gdp), and poorer countries generally grow faster than richer ones. Since, in reality, other factors are not constant (not all countries have the same level of human capital or the same government policies), absolute convergence does not happen.

Government policies seem to be crucial. Countries with broadly free-market policies - in particular, free trade and the maintenance of secure property rights--have raised their growth rates. (although some economists argue that the asian tigers are an exception to this free-market rule.) Open economies have grown much faster on average than closed economies. Higher public spending relative to gdp is usually associated with slower growth. Furthermore, high inflation is bad for growth and so is political instability. The poorest countries can indeed catch up. Their chances of doing so are maximised by policies that give a greater role to competition and incentives, at home and abroad.

Despite starting with a big disadvantage, there is evidence that some developing countries do not help themselves because they squander the resources they have. Institutions that produce effective governance of an economy are crucial. Those countries that use their resources well can grow quickly. Indeed, the world's fastest-growing economies are a small subgroup of exceptional performers among the poor countries.

Development economics

Spawned by the end of the colonial era in the 1950s and 1960s, a whole branch of economic theory grew up around the question of how to promote economic development in poor countries. The proposition on which development economics was built was that poor countries were intrinsically different from rich ones and so needed their own set of economic models. Some development economists argued, for instance, that the self-interested, rational individual (homo economicus) did not exist in traditional tribal societies. They claimed that because many poor countries had large agricultural populations and were often dependent on a few commodity exports for foreign exchange earnings, economic policies that suited rich countries would not work for them. With hindsight, much of this was misguided, and policies based on it had disastrous effects. Development economists believed that the state had to play a big role in fostering modernisation. Instead, the result was huge, inefficient ­bureaucracies riddled with corruption, massive budget deficits and rampant inflation. During the 1990s, most governments of developing countries started to reverse these policies and undo the damage they had done by introducing policies based on similar economic models to those that had worked in rich countries. However, the sequencing of these new policies seemed to make a big difference to how well they worked. Doing the right things in the right order is crucial.

Diminishing returns

The more you have, the smaller is the extra benefit you get from having even more; also known as diseconomies of scale (see economies of scale). For instance, when workers have a lot of capital giving them a little more may not increase their productivity anywhere near as much as would giving the same amount to workers who currently have little or no capital. This underpins the catch-up effect, whereby there is (supposedly) convergence between the rates of growth of developing countries and developed ones. In the new economy, some economists argue, capital may not suffer from diminishing returns, or at least the amount of diminishing will be much smaller. There may even be ever increasing returns.

Direct taxation

Taxes levied on the income or wealth of an individual or company. Contrast with indirect taxation. In much of the world, direct tax rates fell during the 1980s and 1990s, partly because some economists argued that high rates of tax on income discouraged people from working, and that high rates of tax on profit encouraged companies to move to countries with lower rates. Furthermore, high rates of income tax were viewed as politically unpopular. Even so, although rates were cut, because both personal income and corporate profits grew steadily throughout this period the total amount collected via direct taxation continued to rise. Economists often disagree about which of direct taxes or indirect taxes are the least inefficient method of taxation.

Discount rate

The rate of interest charged by a central bank when lending to other financial institutions. It also refers to a rate of interest used when calculating discounted cashflow.

Discounted cash flow

How much less is a sum of money due in the future worth today? The answer is found by ­discounting the future cashflow, using an interest rate that reflects the fact that money in future is worth less than money now, because money now could be invested and earn interest, whereas future money cannot. Firms use discounted cashflow to judge whether an investment project is worthwhile. The interest rate is a means of reflecting the opportunity cost of tying up money in the investment project. To test whether an investment makes economic sense the income must be discounted so that it can be measured against the costs. If the present value of the benefits exceeds the costs, the investment is a good one.

Disequilibrium

When supply and demand in a market are not in balance. Contrast with equilibrium.

Disinflation

A fall in the rate of inflation. This means a slower increase in prices but not a fall in prices, which is known as deflation.

Disintermediation

Cutting out the middleman. Disintermediation has become a buzz word in financial services in particular, as competitive and technological changes have done away with the need for established intermediaries. Banks have seen much of their business slip away, such as lending to companies that now tap capital markets direct. New economy ­theorists argued that many retailers would be disintermediated as the internet enabled customers to transact directly with producers without needing to visit a shop. But this has happened more slowly than they predicted.

Diversification

Not putting all your eggs in one basket. Investors are encouraged to do this by modern portfolio theory, as holding several different shares and other assets helps to reduce risk. At the sharp end of business, however, diversification is somewhat out of fashion. Economic studies of diversifying corporate mergers have found that these often hurt the shareholders of the acquiring firm; by contrast, diversified firms that have sold off non-core businesses have typically made their shareholders much better off.

Dividend

The part of a company’s profit distributed to shareholders. Unlike interest on debt, the payment of a dividend is not automatic. It is decided by the company’s managers, subject to the approval of the company’s owners (shareholders). However, when a company cuts its dividend, this usually triggers a sharp fall in its share price by more than would be appear to be justified by the reduced dividend. Economists theorise that this is because a dividend cut signals to shareholders that the company is in a bad way, with more bad news to follow.

Division of labour

People are better off specialising than trying to be jacks of all trades and ending up masters of none. The logic of dividing the workforce into different crafts and professions is the same as that underpinning the case for free trade: everybody benefits from doing those things in which they have a comparative advantage and using income from doing so to meet their other needs.

Dollarisation

When a country's own money is replaced as its citizens' preferred currency by the us dollar. This can be a deliberate government policy or the result of many private choices by buyers and sellers (for instance, at the first sign of trouble, investors across latin america generally flee into dollars). When it is government policy, dollarisation is, in essence, a beefed up currency board.

The appeal of dollarisation is that the value of the dollar is more stable than the distrusted local currency, which may well have a history of suddenly falling in value. By eliminating all possible risk of devaluation against the dollar, the cost of local companies' and the government's borrowing in international markets is reduced, as the currency risk is removed. A big downside is that the country hands over control of monetary policy to the federal reserve, and the right interest rate for the united states may not be appropriate for the dollarised country, if that country and the united states do not constitute an optimal currency area. This is one reason that in some countries the local currency has been displaced by another fairly stable currency, such as, in some central european economies, the euro (and before that the d-mark).

Dominant firm

A firm with the ability to set prices in its market (see monopoly, oligopoly and antitrust).

Dumping

Selling something for less than the cost of producing it. This may be used by a dominant firm to attack rivals, a strategy known to antitrust authorities as predatory pricing. Participants in international trade are often accused of dumping by domestic firms charging more than rival imports. Countries can slap duties on cheap imports that they judge are being dumped in their markets. Often this amounts to thinly disguised protectionism against more efficient foreign firms.

In practice, genuine predatory pricing is rare - certainly much rarer than anti-dumping actions - because it relies on the unlikely ability of a single producer to dominate a world market. In any case, consumers gain from lower prices; so do companies that can buy their supplies more cheaply abroad.