Macroeconomics Measurement, Business Cycles and Growth

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MacroeconomicsMeasurement, Business Cycles and
Growth

• KW Reading
• Chap. 23, 24,

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Why should financial analysts care about
macroeconomics

• Macroeconomy can affect your career!
• A recent study of Stanford MBAs between 1968 and
  1997 found that the state of the national economy
  at the time of graduation affected the average
  salary up to 20 years later (plus or minus about
  10).

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Monetary policy affects financial markets.
Euro rate rise puts heat on the Fed after the
central banks of the euro region and the United
Kingdom raised interest rates to restrain
inflation after economic growth accelerated.
Stocks and bonds fell as investors bet borrowing
costs are headed higher. 8/4/2006

• Hang Seng slide continues
• Hong Kong's stocks dropped for a fourth time
• in five days after a US central banker said the
  Federal Reserve may need to raise interest rates
  further. 8/24/06

US rate pause buoys AsiaMost Asian bourses
gained ground Wednesday in reaction to the US
Federal Reserve's decision to keep interest rates
unchanged. 8/10/2006
Fed rate hopes lift regionAsian markets rose
Wednesday in anticipation that the latest US
economic data would persuade the Federal Reserve
to keep US interest rates on hold. 8/17/2006
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Other Connections

• Macroeconomists study government fiscal policy.
  Government major borrower (or saver) in financial
  markets.
• Values of financial assets a major determinants
  of decisions of consumers.
• Financial theory emphasizes diversified
  portfolios whose performance depends on aggregate
  performance of the economy.

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Quantity Aggregates

• To understand the macroeconomy, we need to
  measure it.
• Chief measure of economy is the level of
  production
• We need to combine the many goods produced or
  consumed in an economy into one measure.

?
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Gross Domestic Product (GDP)
All goods sold in an economy share a common unit
of measure the price at which they are sold.
Sum up the value of goods

• GDP is the sum of the value of new, final goods
  produced within the domestic borders of an
  economy.

Final goods are goods sold to their end-users
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GDP does not include

• Intermediate goods which are sold from one firm
  to another for immediate transformation into
  other goods.
• financial transactions like buying stocks.
• purchases of used goods which have been sold
  before.
• goods produced overseas by domestic firms.

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Three Methods for Calculating GDP

1. Expenditure Method - The sum of the domestic
   spending on final goods (less domestic demand
   satisfied by imports).
2. Production Method - The value added created in
   all the sectors of the economy.
3. Income Method The Wage, Rent, Interest and
   Profit Income generated by the domestic economy.

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Expenditure Method
C Consumption Consumer durables, non-durables, services
I Investment Structures (incl. Residential), Equipment, and Inventory
G Government Consumption Government Spending on Goods, Services, and Salaries.
X - EXports Goods Services Shipped Abroad
IM IMports Goods Services from Abroad
GDP A NX (C I G) (X IM)
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Expenditure Categories in Hong Kong 2001
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Japanese Expenditure
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Production Method

• Value added
• Sales Change in inventories
• - materials, intermediate inputs and energy
  costs.
• The value of a final good is equal to the value
  added at each stage of production.
• Expenditure method Production Method.

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Production structure in HK have changed over
time.
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Income Method

• Survey domestic residents and calculate their
  wage income, interest income, rental income plus
  the income of proprietors of small firms plus the
  profits depreciation of the corporate sector.
• Subtract net international income flows.
• Not calculated for HK

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Income Method, Japan 2003
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GNP vs. GDP
GDP GNP
Gross National Product Gross Domestic Product
income earned by domestic residents income created within national borders.
GNP GDP NFI GNP GDP NFI

• Net Factor Income NFI is income earned on
  overseas work or investments minus income
  generated domestically but paid to foreigners.

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Comparing GDP levels across time

• GDP measures the value of the goods produced by
  an economy by using the market price of each good
  to assign it a value.
• Problem Prices of goods in terms of money are
  changing overtime making comparisons in overall
  value difficult.
• Bias Money prices are growing over time as money
  supply grows.
• Solution Choose a Base Years prices as a fixed
  yardstick of value for different goods.

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Real GDP Yt

• GDP aka Nominal GDP aka Current Dollar GDP is the
  weighted sum of the number of goods produced
  using their current prices as the weight.
• Real GDP aka Constant Dollar GDP aka GDP adjusted
  for inflation is the weighted sum of the number
  of goods produces using the Base Year prices as
  yardsticks.

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Real GDP Candyland, Base Year 2004
2005 2005 2004 2004
P Q P Q
Kitkat 8 150 6 135
MMs 10 150 4 135
Nominal GDP 2700 1350
Real GDP 1500 1350
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Price Indices Pt

• Two most commonly used price indices are GDP
  Deflator and Consumer Price Index (CPI)
• The CPI is the price of a representative market
  basket of goods relative to the price of that
  same basket during a benchmark/base year
  (multiplied by 100).
• The GDP deflator is the ratio of nominal GDP to
  Real GDP (multiplied by 100).

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CPI vs. GDP Deflator
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CPI vs. GDP Deflator

• CPI is calculated monthly, GDP deflator is
  calculated quarterly.
• CPI measures the price of consumer goods. GDP
  deflator measures the price of all goods produced
  including investment or government goods.
• CPI measures the change in price of a constant
  market basket. Market basket of GDP deflator
  changes as goods produced changes.

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Q What is Inflation?A The Growth Rate of Price
Level
Inflation prices are growing Disinflation
inflation is slowing down but still
positive Deflation inflation is negative and
prices are actually dropping.
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Inflation HK GDP Deflator
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Adjusting for Inflation/Converting Current Price
Series into Constant Price Series

• One may have a time series of an aggregate, Nt,
  (in current prices)
• We can use some price index to adjust for
  inflation effectively converting into a variable
  measured in the prices of some reference year.
• Real series measures the value of goods that
  could have been purchased with that amount of
  money in the reference year.

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Housing Price Hong Kong Island

• Compare the price of housing in HK average price
  of an apartment on HK Island with an area between
  100m2 and 160m2
• in December 2005 HK112,012/m2
• in December 1982 HK14,742/m2
• How much did an apartment cost back then when
  expressed in todays dollars?

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Housing Price Hong Kong Island

• The Hong Kong CPI (2000100) was 35.5 in December
  1982 and 94.5 in December 2005.
• Calculate
• In real, terms, housing today is almost 3 times
  as expensive as in 1982!

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Recessions and Expansions

• Business cycle positions are sometimes
  characterized as booms and recessions.
• These names have many definitions
• An expansion occurs roughly when real output is
  above the trend growth path (detrended output is
  positive).
• A recession occurs roughly when real output is
  below trend growth.
• In the USA, recessions are sometimes defined as 2
  consecutive periods of negative growth.

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Peaks Troughs HK
Peak
Peak
Peak
Peak
Trough
Trough
Trough
Trough
Trough
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Expansions Recessions
When GDP is Above Trend When GDP is Below Trend
Extreme
Peak Trough
Indicators
Procyclical increase during expansions Countercyclical increase during recessions
Leading Predict movements in GDP
Coincident Move together with GDP
Lagging Follow movements in GDP
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Business Cycles Sub-CategoriesExpenditure

• Consumption and Investment co-move with output.
• Investment is more volatile than output.
  Investment tends to increase more than output
  during a boom and fall more during a recession.
• Typically, consumption is less volatile than
  output because people tend to use their savings
  to smooth fluctuations in income.
• Consumer durables are most volatile part of
  consumption.

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In recent periods, consumption has been as
volatile as output
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Large Swings in Investment
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Corporate Profits

• We find that corporate profits are strongly
  pro-cyclical and volatile.
• When the economy is doing well, corporations tend
  to earn high real profits.
• Corporate profits fluctuate far more than the
  economy as a whole.

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Corporate Profits and the Business Cycle
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Using financial market data to predict business
cycles

• It has been joked that stock markets have
  predicted 7 out of the last 5 recession.
• (In Hong Kong there does seem to be a moderately
  strong, positive correlation between cyclical
  variation in stock prices and business cycles)
• In the USA, some financial market indicators have
  been shown to predict business cycles.
• Default Spread Interest rates on lower rated
  bonds vs. Interest rates on better rated bonds.
• Term Spread Interest rates on long-term bonds
  vs. short-term bonds (when this is inverted,
  recession is likely)

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Stock Market tends to co-move positively with the
business cycle.
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Unemployment Rates

• The population resides in 1 of 3 categories
• Employed Currently working.
• Not in the Labor Force Not working and not
  actively seeking work
• Unemployed Not working but seeking work.
• Unemployment Rate

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Unemployment Rates A lagging indicator
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Inflation and the Recent Business Cycle
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Students should be able to

• Define GDP and its components, describe
  expenditures that belong in GDP from those that
  dont.
• Calculate GDP and real GDP given data on
  disaggregated prices and quantities.
• Distinguish main price indices and define the
  inflation rate.
• Use price indices to convert nominal quantities
  into the dollars of another year.
• Define the unemployment rate
• Describe business cycle expansions and
  contractions and the behavior of the economy
  during business cycles.