MacroeconomicsMeasurement, Business Cycles and

Growth

KW Reading

Chap. 23, 24,

Why should financial analysts care about macroeconomics

• Macroeconomy can affect your career!

• A recent study of Stanford MBA’s 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%).

Monetary policy affects financial markets.

Hang Seng slide continues Hong Kong's stocks dropped for a fourth timein five days after a US central banker said the

Federal Reserve may need to raise interest rates further. 8/24/06

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

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

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

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.

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.

++

++

=?

Gross Domestic Product (GDP)

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

All goods sold in an economy share a common unit of measure: the price at which they are sold.

Final goods are goods sold to their end-users

Sum up the value of goods

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.

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.

Expenditure MethodC

+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)

Expenditure Categories in Hong Kong: 2001

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

140.00%

160.00%

% of GDP

HouseholdConsumption

Government Consumption

Investment Exports Imports

Japanese ExpenditureFiscal Year 2003(Billion Yen)

Items

Actual final consumption of households [C] 332,970.6 66.43% Government actual final consumption [G] 38,578.9 7.70% Gross domestic fixed capital formation [I] 120,238.8 23.99% Of which intangible fixed assets 10,810.2 2.16% Changes in inventories 270.0 0.05% Exports of goods and services [X] 60,375.7 12.04% (less) Imports of goods and services (51,180.5) 10.21%

Gross domestic expenditure 501,253.5 100.00%

(cf) Incomes from the rest of the world 12,787.4 (less) Income � � to the rest of the world 4,001.1 Gross national income 510,039.8

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.

AF

F

Min

ing

Man

ufac

turin

g

Util

ities

Con

stru

ctio

n

Tra

de

Tra

nspo

rt

FIR

E

Ser

vice

s

Land

lord

1980

0

0.05

0.1

0.15

0.2

0.25

% of GDP

Production Account

1980

2001

Production structure in HK have changed over time.

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

Income Method, Japan 2003

(1) Generation of Income AccountCalendar Year(Billion Yen)

Items 2003

Compensation of employees ,payable 265,484.8 53.70% (1) Wages and salaries 223,445.0 45.20% (2) Employers' social contributions 42,039.8 8.50%Taxes on production (less) Subsidies 36,562.4 7.40%Proprieters Income 19,884.5 4.02%Corporate Profits and Interest Payments 71,160.3 14.39%Depreciation 101,301.0 20.49% (regrouped) Value added ,gross/gross domestic product 494,393.0 100.00%

GNP vs. GDP

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

GDP GNP

Gross National Product Gross Domestic Product

= income earned by domestic residents

= income created within national borders.

GNP = GDP +NFI

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 Year’s prices as a fixed yardstick of value for different goods.

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.

Real GDP: Candyland, Base Year 2004

2005 2004

P Q P Q

Kitkat 8 150 6 135

M&Ms 10 150 4 135

Nominal GDP 2700 1350

Real GDP 1500 1350

Hong Kong

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1,800,000

1961 1966 1971 1976 1981 1986 1991 1996 2001

Mill

. HK

$

Nominal GDP Real GDP

Average

Growth

Nominal GDP 11.87%

Real GDP 6.64%

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).

Nominal GDP GDPP GDP Deflator

Real GDP Y

CPI vs. GDP Deflator

0

20

40

60

80

100

120

CPI

GDP Deflator

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.

Q: What is Inflation?A: The Growth Rate of Price Level

1

1

100%t t

t

P PInflation Rate x

P

Inflation: prices are growing

Disinflation: inflation is slowing down but still positive

Deflation: inflation is negative and prices are actually dropping.

Inflation: HK GDP Deflator

Inflation

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

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.

Real Reft t

t

PN N

P

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 : HK$112,012/m2

– in December 1982: HK$14,742/m2

• How much did an apartment cost back then when expressed in today’s dollars?

Housing Price: Hong Kong Island

• The Hong Kong CPI (2000=100) 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!

Real Ref 94.514,742 39,242.79

35.5t tt

PN N

P

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.

Peaks & Troughs HKDetrended Output

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

Trough Trough

Trough

Trough

Trough

PeakPeak

Peak Peak

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

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.

In recent periods, consumption has been as volatile as output

-.12

-.08

-.04

.00

.04

.08

.12

1975 1980 1985 1990 1995 2000

CONSUMPTION Detrended GDP

Large Swings in Investment

-.5

-.4

-.3

-.2

-.1

.0

.1

.2

1975 1980 1985 1990 1995 2000

INVESTMENT Detrended GDP

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.

Corporate Profits and the Business Cycle

-.20

-.15

-.10

-.05

.00

.05

.10

.15

.20

80 82 84 86 88 90 92 94 96 98

Detrrended GDP Corporate Profits

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)

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

10

20

30

40

50

60

-.08

-.04

.00

.04

.08

1990 1992 1994 1996 1998 2000 2002 2004 2006

Hang Seng Price/Dividend RatioDetrended GDP

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

100%Unemployed

UREmployed Unemployed

Unemployment Rates: A lagging indicator

-8

-4

0

4

8

12

96 97 98 99 00 01 02 03 04 05 06

Unemployment Rate Detrended Output

Inflation and the Recent Business Cycle

-.08

-.06

-.04

-.02

.00

.02

.04

.06

.08

96 97 98 99 00 01 02 03 04 05 06

CPI Inflation Detrended GDP

Students should be able to

• Define GDP and its components, describe expenditures that belong in GDP from those that don’t.

• 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.