ELEC15- Engineering Economics & Finance Day 2 Session 2: Macroeconomics Dr. Wilton W.T. Fok [email protected] CYC 703

ELEC15- Engineering Economics & Finance

Day 2Session 2: Macroeconomics

Dr. Wilton W.T. [email protected]

CYC 703

Macroeconomics

• Contents– 2.1 Introduction to Macroeconomics– 2.2. Circular flow of economic activities– 2.3. Money multiplying effect– 2.4. Role of Government– 2.5. Adjusting the flow by the Interest Rate– 2.6. Recession and Interest Rate– 2.7. Main Macroeconomic Goals– 2.8. Measurement of economic growth– 2.9. Inflation and Consumer Price Index– 2.10. Measure of Employment Opportunities – 2.11. The Economic Cycle– 2.12. Currency Issues– 2.13. Renminbi Revaluation

2.7. Main Macroeconomic Goals

• 2.7.1. Main goals in Macroeconomic– 1. Economic Growth

• increased output of a nation’s goods and services – 2. Price Stability

• avoiding deflation or rapid inflation – 3. Full employment

• all who want to work have jobs


• With #1 “Economic Growth” and #3 “Full Employment”, we can have

• Benefits: – Increased standard of living – Increased employment – Increased income

• But at the same time, the wealth will move up prices of goods.

EconomicGrowthGoal #1

InterruptPrice Stability

Goal #2

Increased employment

Goal #2

Increased standard of living

Increased income


• All government wish to achieve all the 3 goals at the same time’

• However, unfortunately #2 is obviously opposing to #1 and #3, the goals cannot be achieved at the same time.

Consequently, a government aims for optimization.

Full employment

Price Stability

EconomicGrowth


• 2.7.2. Drawbacks of economic growth– Even when a government may maintain price stability

whilst achieving economic growth and full employment, yet because of spill-over effect, there are drawbacks:

• Pollution

• Strain on facilities/ Resources

• Distortion of Equilibrium and Equity

– to which economists and engineers must pay attention.


• Case Study 2.2: Economy growth in Pearl River Delta Region

• Positive Factors– More than 70 thousands HK

manufacturer moved to PRD– Employed more than 10 millions

of worker

• Negative Factors– High inflation rate 10%+– High pollution

2.8. Measurement of economic growth

• 2.8.1. Indicators on economic growth– There are various indicators to measure economic

growth:• GDP (gross domestic product)• GNP (gross national product)• PPP (Purchase Power Parity)


• 2.8.1 Gross domestic product (GDP)– GDP - Measure total value of production within boundary

of the territory.

– GNP (gross national product): • Measure total value of production globally among people of that

nation.

• When GDP rises, the economy is growing.


• GDP is one of the ways of measuring the size of its economy. • The GDP of a country is defined as:

– The total market value of all final goods and services produced within a country in a given period of time (usually a calendar year).

– GDP is also considered the sum of value added at every stage of production (the intermediate stages) of all final goods and services produced within a country in a given period of time.

• GDP FormulaGDP = consumption + investment +

(government spending) + (exports − imports)

= C + I + G + (X-M)


• "Gross" means depreciation of capital stock is not included. With depreciation, with net investment instead of gross investment, it is the Net Domestic Product (NDP)

GDP = C + I + G + (X-M)

• Consumption and investment in this equation are the expenditure on final goods and services.

• The exports minus imports part of the equation (often called cumulative exports) then adjusts this by subtracting the part of this expenditure not produced domestically (the imports), and adding back in domestic area (the exports).


• GDP’s components (expenditure approach)

Imports of Goods & Services

Exports & Re-exports of Goods & Services

Changes in inventories

minus

Government Consumption Expenditure

Household & non-profit expenditures

Domestic fixed capital formation, e.g. investment expenditure on

building, equipment, etc.


• Whilst growth of GDP is the expectation, and GDP increase is the general long term trend, Economy of a territory is sometimes up and sometimes down.

• The cyclical booms and recessions form business cycles.

• Opposite to growth, is recession: a decline in real GDP that lasts for two or more consecutive quarters.

Economy Growth

Economy Recession


• The Hong Kong economy expanded briskly in the second quarter of 2007, with GDP accelerating to a 6.6% growth in real terms over a year earlier, up from the 5.6% growth in the first quarter. This also followed a strong 6.8% growth in 2006. – Ref: The 2008 - 09 Budget Information Pack for the Financial Secretary’s

Consultations

HK GDP Growth


• US, UK, France, Germany, Japan and China are the nations with GDP > US$2000 Billion.

Source: http://en.wikipedia.org/wiki/GDP


• Are Chinese really rich?

• GDP Per capita– GDP/ population within territory

• GNP Per capita– GNP/ population of nation


• But the population in China is over 1.3Billion!

<0.5 10 20 30 35 US$’000

Source: http://en.wikipedia.org/wiki/GDP


• Real GDP– Usually, the rise is adjusted against inflation. The factor is called GDP

deflator. The adjusted figure is Real GDP. – Real GDP is a macroeconomic measure of the size of an economy

adjusted for price changes and inflation.

– Real GDP growth on an annual basis is the nominal GDP growth rate adjusted for inflation and expressed as a percentage.

Real GDP Growth = Nominal GDP growth - Inflation Rate

Because Real GDP is adjusted for changes in prices and inflation throughout the year, it can be thought of in terms of 'purchasing power.'


• Example:– In 2007, Hong Kong Nominal GDP Growth was 7.2% while the inflation rate

is 1.6%. What’s the Real GDP Growth?

Real GDP Growth = Nominal GDP growth - Inflation Rate

= 7.2% - 1.6% = 6.6%

6.6%

Ref: The 2008 - 09 Budget Information Pack for the Financial Secretary’s Consultations


• Q. We understand that in the year 2003 when Hong Kong has the SARS crisis, the economy was poorly performed, then why Hong Kong has a real GDP growth in that year?


• Q. We understand that in the year 2003 when Hong Kong has the SARS crisis, the economy was poorly performed, then why Hong Kong has a real GDP growth in that year?

– Normal GDP = -0.5%– Inflation = -3.5%– Real GDP = +3%

– Because when the inflation rate is more negative (Deflation) than the Nominal GDP growth, then Real GDP Growth (= Nominal GDP growth - Inflation Rate) could still be positive

2.9. Inflation and Consumer Index

• 2.9.1. Inflation– Inflation is defined as the increase in the price of some set of

goods and services in a given economy over a period of time.– It is measured as the percentage rate of change of a price index.

• Possible causes of inflation:– caused by high rates of growth of the money supply– Increase in the real demand or supply of goods and services,

and sometimes to changes in the supply or demand for money.

2.9. Inflation and Consumer Index

• 2 types of inflations: – Demand-pull inflation

• when demand greater than supply • offers incentives to suppliers to produce more, thus

increase GDP (but not necessarily real GDP if the inflation so produced offset it completely).

• Producers can earn more profit (when cost is relativity unchanged)

• E.g. Pork price

– Cost-push • when production costs increase • may not offer incentives to suppliers to produce more• Consumers pay more (while producers could not gain

much from such kind of inflation)• E.g. Bus service, electricity supply (when cost of fuel

increased)

$$$

Demand

Cost

2.9. Inflation and Price Index

• 2.9.2 Consumer Price Index (CPI)– CPI shows average changes of inflation with time, usually a year. A

base year has to be chosen as the 100% reference. CPI of HK was 100 at 10/99 – 9/00.

• In HK, we have CPI(A), CPI(B), CPI(C). – CPI(A) measures expenditure pattern of the households (50%

population) with lower income.

– CPI(B) measures the next 30%

– CPI(C) measures the next 10%

• CPI also categories with food, housing, fuel, goods & services, transport, etc.


• 2.9.2 Consumer Price Index (CPI)– Normally the changes in CPI over a year instead

of CPIs are declared, because the changes by percentages mathematically represent the respective inflation rates within a year.

– Theoretically, a nation may have deflation, but is not as common as inflation. Note from the above, Hong Kong did have deflation in recent years, and has recovered from it.

• Hong Kong did have deflation in recent years, and has recovered from it.


• Hong Kong CPI from 1997 to 2007

Dot.com bubble

SARS

Driven by China Economic Growth

Asian Financial Crisis

Ref: The 2008 - 09 Budget Information Pack for the Financial Secretary’s Consultations


• Q. Deflation means price is lowered day by day. Apparently households are happy. But in reality, why not?

During deflation, people hesitate to spend

They prefer saving

Firms cannot make profit and

pay wages

Further discourage spending

Slow down the economic flow (Or even recession)


• 2.9.3 Producer Price Index (PPI)– Some nations have PPI (producer price index)

which measures prices paid by producers or wholesalers.

– PPI measures average changes in prices received by domestic producers for their output.

– PPI is one of the oldest continuous systems of statistical data measured by the Federal Government (since 1891!)


• 2.9.3.1 Calculating PPI Index Changes– Movements of price indexes from one month to another usually should

be expressed as % changes, rather than as absolute changes in index points

– Each index measures price changes from a reference period defined to equal 100.0. The current standard base period for most commodity-oriented PPI series is 1982.


• 2.9.3.1. Calculating PPI Index Changes– E.g.1

• An increase of 20% from the base period in the Producer Price Index is 120.0

– i.e. “Prices received by domestic producers of a systematic sample of finished goods have risen from $100 in 1982 to $120 today.”

– E.g.2 a current index of 133.3 indicates:• Prices received by producers of finished goods

today are one-third higher than what they were in 1982.


• 2.9.3.2. How PPI differs from CPI– Because the two indices are similar in fashion, a change in

the PPI often anticipates a change in the CPI.

Because of these differences, each uses prices from a different set of commodities and services

Measure the changes in the cost of living.

Measure cost of production; to get a real

picture of production outputPPI CPI


• 2.9.4. Purchasing Power Parity (PPP)

– The idea: in an efficient market, identical goods must have only one price.

– In long-term equilibrium: exchange rate of 2 currencies should equalize their purchasing power.

– PPP is often used to compare the standards of living between countries• rather than a per-capita gross domestic products comparison at market

exchange rates.


• Differences between PPP and market exchange rates:– E.g.1. PPP of RMB vs US$

• In 2003, US$1.00 was equivalent to about RMB1.80 by PPP• But the nominal exchange rate that put US$1.00 equal to RMB7.6 • This discrepancy has large implications:

– GDP per capita in the China is about US$1,800 while on a PPP basis it is about US$7,204.

– This is frequently used to assert that China is the world's second-largest economy

(Source: the World Bank's World Development Indicators 2005)

– E.g.2. PPP and GDP in Japan• Japan's nominal GDP per capita is around US$37,600, but its PPP

figure is only US$30,615.


• Big Mac Index– An example of measure of PPP– Compare the prices of a Big Mac in different countries.– If a Big Mac costs US$4 in the U.S. and GBP£3 in Britain, the PPP

exchange rate would be £3 for $4.– The Big Mac Index is presumably useful because it is based on a well-

known good whose final price, easily tracked in many countries, includes different input costs such as:

• Agricultural commodities (beef, bread, lettuce, tomatoes), • Labor (blue and white collar), • Advertising,• Rent and real estate costs,• Transportation, etc.

– Although it is not perfect (Big Mac may not be a necessity), the index still offers significant insight and an easy to understand example of PPP.

£3 for $4.


• 2.9.5 Inflation rate relates to Money Supply. – Deflation often pegs with a recession (But not always!)

– Deflation may be a warning signal for recession, nonetheless it is usually delayed after recession.

– All nations welcome a mild inflation in their territories. • Firstly inflation is a natural reflection of nominal GDP growth.

• Secondly, inflation speeds up household consumption decisions.


• Inflation – a spill-over effect– When inflation by demand-pull persists, or the growth of

GDP is too fast (a reference norm for developed nations is >2%), then usually: apply fundamental adjusting tool - to raise interest rates.

• Recall – How can we control inflation by adjusting the interest rate?


• When the interest rate is increased, then – 1. borrowing cost by firms is increased – 2. borrowing cost by households is increased – 3. saving incentive is enhanced – 4. opportunity cost is raised – 5. flow of money in circular flow is slowed down – 6. less investment and less spending – 7. economy is cooled down – 8. double coincidence of wants is fewer – 9. inflation is controlled or depressed

~

R

Supplies LoadingInterest rate Saving Flow rate Inflation drop


• 2.9.6 Why do we have to control inflation? – During inflation, if wages and interest rates are

not adjusted, it will reduce purchasing power.– It will also deteriorate power of those relying on

saving or pension.– Impact of high inflation rate to the poor is

more significant than to the rich! Although increasing interest rates may slow

down GDP; lower down wages and deteriorate employment opportunities

– Increase in interest rate is a trade-off decision.

2.10. Measure of Employment Opportunities

• 2.10.1. Unemployment– Unemployment is the state in which a person is without work,

available to work, and is currently seeking work.

• 2.10.2. Unemployment rate– Unemployment rate measures the percentage of total

available labour that is not working but is actively looking for work.

Unemployment rate = No. of unemployed workers Total civilian labor force

– Unemployment rate is used in economic studies and economic indexes

– In the past ten years, unemployment rate of HK was between 1.7% and 8.7%.


• Unemployment rate in HK– The seasonally adjusted unemployment rate fell distinctly from the peak of

8.5% in mid-2003 to 4.1% in the third quarter of 2007, the lowest level since mid-1998.

– Ref: The 2008 - 09 Budget Information Pack for the Financial Secretary’s Consultations

AsianFinancialCrisis

SARS

HK Unemployment rate 3.4%Record low in the last decadeSource: Wenweipo 18 Jan 2008


• Unemployment rate in the United States

Source: http://en.wikipedia.org/wiki/Unemployment

Let’s compare US and HK in the last decade


• Comparing HK vs US– Both place follow a

similar pattern

– (A) Local minimum in 2000-2001

• Then climb up after 911

– (B) Local maximum in 2003-2004

• Then slide down after SARS was over

(A)

(B)


• Comparing with other areas unemployment rate in Hong Kong is still very low.

Source: http://en.wikipedia.org/wiki/Unemployment


• 2.10.3. Types of Unemployment: – Frictional: normal short-term waits

– Structural: mismatch of skill in the society

– Cyclical: due to downturn of economic growth

– Seasonal: due to seasonal demand pattern


• 2.10.4. Unemployment rate and economic growth– High unemployment rate means low utilization of labour, thus lower production

possibility.

– It lowers economic growth. As income also gets less, demand drops and further erodes economic growth.

– The firms may not have enough profit to keep labour, and may lay off additional labour. The whole process can be a vicious spiral cycle.

– Similarly, low utilization of machines and facilities may also affect production possibility and economic growth.

HighUnemployment

Lack of firmIncome to keep

labour

Low EconomicGrowth

Lay off labour


• 2.10.4. Unemployment rate and economic growth

– In the past, when inflation occurs in Hong Kong, unemployment was inversely proportional to inflation

When unemployment is high, then deflation start


• 2.10.4. Unemployment rate and economic growth

• In both extreme:– Very high unemployment

Economy slow down Government lower interest Deflation

– 0% unemployment• is not necessarily a good thing if it shall induce very high inflation.

• Extreme inflation may effect a quick down-turn and reversal of economy.

2.11. The economic cycle

Government reduce interest rate to simulate economy growth again

Economy growth

Labour shortage

Wage increase (Supply & demand)

Cost and hence price increased

Inflation

Government increase interest

rateCost of business operation increase

Cost of spending increase

(Relatively)

Saving increase and spending

decrease

Economy cool down

Some companies close and lay-of

employee

Unemployment slow down the consumer

market

2.12 Currency issues

• 2.12.1 Currency and Exchange Rate

• Currency– It is a unit of exchange, facilitating the transfer of goods and/or

services.

– It is one form of money, where money is anything that serves as a medium of exchange, a store of value, and a standard of value.

– It is the dominant medium of exchange.

• Exchange rates– Exchange rates are the prices at which currencies (and the goods

and services of individual currency zones) can be exchanged against each other.

– It facilitate trade between countries with different currency

• In most cases, each country has monopoly control over the supply and production of its own currency which effect the Exchange rate.

2.12 Currency issues• 2.12.2. Foreign Currency Reserve

– The stock of foreign assets held by a government as investments– As at Jan 2008, the Reserve in HK is HK$464.6 Billion

• (Gained HK$142.2 Billion in 2007, i/e/ HK$20,300 per citizen)

– Functions• to support and stabilize the exchange rate of the domestic currency

(HK$: US$ is fixed at 7.8), by:– purchase back the issued currency so as to stabilize the issued

currency from excessive volatility and protect the monetary system from shock, e.g. the Asian Financial Crisis in 1997,

• Used for making payments in foreign currencies without the need to sell the domestic currency in the market

– Large reserves are often seen as a strength, as it indicates the backing a currency has.

– Low or falling reserves may be indicative of an imminent bank run on the currency or default, such as in a currency crisis.

7.75

7.80

7.85When HK dollar is low, then spend the foreign reserve and buy back HK$ limit the HK$ supply

Appreciation

Depreciation

When HK dollar is high, then spend HK$ to buy foreign currencies Increase the HK$ supply


• 2.12.3. Case Study 2.3: Japanese Yen Appreciation in 80’s– In mid 80’s US forced Japanese Yen to appreciated Japanese goods were more expensive and less attractive Export reduced, Less foreign income Japan’s economy faced recession for more than a decade

Source: http://www.forecasts.org/data/data/EXJPUS.htm

0

50

100

150

200

250

300

350

400

71 76 81 86 91 96 01 06

Yen (to 1 US$)

Recession

1985-86Dropped from 250 to 150 in 1 year


• 2.12.3. Case Study 2.3: Japanese Yen Appreciation in 80’s

– Lesson learned:• In general, a Strong currency policy will weaken the export

competitiveness• If currency appreciate too fast, then…

– Less foreign visitors– Local manufacturers suffer because the selling price will be relatively

dropped (as most contract are signed in US$)– Once enter into recession, it takes long time to recover

2.13 RMB Revaluation

• 2.13.1. Background– On 21st July 2005, the Central Bank in China announced

that RMB de-linked with US$ and linked with a basket of foreign currency

– RMB appreciate by 2% immediately on the same day• Before 2005: HK$100 = RMB105

• As at Jan 2008, RMB100 = HK$108

• Appreciated by >13%


• 2.13.2 Case Study 2.4: Revaluation of Renminbi and China-US trade relationship (Showed on TVB Pearl 20 Nov 2007)

Source: http://www.youtube.com/watch?v=SzF3jMYfVWo

Interview with Andrew Freris, Cheif Economist, BNP Paribas


• 2.13.2 Case Study 2.4: Summaries from the interview– RMB was artificially weak in the past because the China

government control the currency rate

– Deficit of US trade balance • The deficit was US$730 billion

• China trade account for US$200 billion

• US politicians complaints that many local workers lost jobs because of the import from China.

Net tradeUS$200 billion

80%

Trade balanced from other countries: US$530 billion


• 2.13.2 Case Study 2.4: Summaries – Can RMB Revaluation solve the bilateral trade

surplus?• Probably NOT! Because even though China stop exporting

to the US, US will get import from other developing countries

• The US is not the only place where China trade with, US only account for 20% of the overall China export (How about other 80% export if RMB is revaluate significantly)

– In fact, Low RMB currency rate keeps those “Made-in-China” product cheap

Benefits to all consumers (all US population: 200 million)

– Now, RMB revalued and resulted in inflation• Normally, US Government can increase the interest rate to

suppress inflation. However, it may drive US into recession!

"The conflict contains a very substantial amount of politics and relatively little economics"


• 2.13.3. Impact of RMB Revaluation to the investment market– Attract hot money flow into Hong Kong (Money cannot be easily

flowed into China)

– Bank interest rate drop (Lower to zero, or negative interest rate)

– Therefore the hot money push up the Shanghai Stock Market and and Hang Seng Index since 2005


• 2.13.4. Impact to the manufacturers in China– Short-term

• Since many order pricings are signed in US$ (Fixed in US$, so their income will be relatively dropped)

• It is not easy for manufacturer to rise price immediately• Production cost:

– Imported resources: raw materials (relatively cheaper)– Local resources: Labor, electricity (relatively more expensive)

• Overall effect weaken the competitiveness of those “Made-in-China” product

Some factories may close down!


• 2.13.4. Impact to manufacturers in China– Long-term

• As all manufactures from all industries are affected by the same problems: RMB appreciation

– Weak manufacturers will close down Less supply– Strong manufactures will improve their product quality and

rise the selling price

– Eventually, the free market will adjust itself and the product price will reach another equilibrium

Time

RelativeSelling Price

(A) Relative price will drop (Relatively) when RMB appreciated

A

B

C(B) Price rises together

(C) Reach a new equilibrium point


• 2.13.5. Impact to retailers in China– For those retailers selling imported product (e.g. deluxe products)

– Short-term effect• Import cost reduced

– More rooms for price reduction create more sales

– Maintain the selling price gain more profit margin

• In both ways, the retailers could gain more profits!

– Long-term effect• Due to fair market competition, an unreasonable high profit margin cannot be

maintained for a long time Profit margin drop Reach a new equilibrium

Summaries on Macroeconomics

• Circular flow of money• Money multiplying effect• GDP• Interest rate• Inflation• CPI• PPP• PPI• Unemployment rate• Recession• Currency

Documents

ELEC15- Engineering Economics & Finance Day 2 Session 2: Macroeconomics Dr. Wilton W.T. Fok [email protected] CYC 703