Macroeconomic IndicatorsWhat They Are & How to Use Them

Chapter 19, 20, 35

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%).

Oyer, The Making of an Investment Banker: Macroeconomic Shocks, Career Choice, and Lifetime Income http://www.nber.org/papers/w12059

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.

Suggested Supplementary Reading

• Ebook: Peter Kennedy Macroeconomic Essentials: Understanding Economics in the News

• HKTDC Economic Forum

Local Research on Hong Kong 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.

Data

• The U.N. maintains an easy to use statistical database with annual data for a wide variety of countries UN Main Aggregates Database

• Quarterly GDP data usually available from national statistical agencies.– HK: Census & Statistics Department NIPA Tables– USA: Federal Reserve St. Louis FRED

Three Methods for Calculating GDP

1. Production Method - The value added created in all the sectors of the economy.

2. Expenditure Method - The sum of the domestic spending on final goods (less domestic demand satisfied by imports).

3. Income Method – The Wage, Rent, Interest and Profit Income generated by the domestic economy.

Production Method

• At the plant level, Value added = Sales + Change in inventories

- materials, intermediate inputs and energy costs.

• Value added at the firm level is directly taxed in the EU (VAT)

• GDP is the sum of VA across establishments.

• The value of a final good is equal to the value added at each stage of production.

Ag

ricu

lture

Min

ing

Ma

nu

fact

uri

ng

Util

itie

s

Co

nst

ruct

ion

Tra

de

Tra

nsp

ort

FIR

E

Se

rvic

es

La

nd

lord

19802006 #

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

Hong Kong: Value Added by Sector

Hong Kong Census and Statistics

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)

Some Asian Expenditure Shares: 2008

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

Household Government Investment Exports Imports

PRC Japan Korea

Some Asian Expenditure Shares

Household GovernmentConsumption ConsumptionInvestmentExports Imports

China, People's Republic of 37.29% 13.84% 47.15% 37.81% 33.21%China: Hong Kong SAR 60.54% 8.34% 19.51% 212.33% 201.45%Japan 57.81% 18.53% 23.08% 17.43% 17.29%Republic of Korea 54.46% 15.27% 29.27% 52.86% 54.10%Singapore 41.00% 10.69% 28.49% 234.34% 215.27%

Source: United Nations Main Aggregates Database

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.

Earnings or Income Approach to Measuring GDP

• Measuring overall economic activity by adding the earnings or income generated by selling the output produced in the economy. (Not calculated for HK on an annual basis.)

GDP = compensation of employees + proprietor’s income + rental income +

corporate profits + net interestCopyright © 2010 Pearson Education, Inc.

Publishing as Prentice Hall 17

National Income• Compensation of employees: the wages and salaries and

the fringe benefits paid by employers to employees.• Proprietors’ income: the income of unincorporated

businesses, such as medical practices, law firms, small farms, and retail stores.

• Rental income : the income households receive from the rental of their property.

• Corporate profits: the excess of revenues over costs for the incorporated business sector of the economy.

• Net interest: the interest private businesses pay to households for lending money to the firms minus the interest businesses receive plus interest earned from foreigners.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

18

National IncomeCOMPONENT

VALUE IN BILLIONS OF DOLLARS(% OF NATIONAL INCOME)

GROSS DOMESTIC PRODUCT 13,807.5

Less: Depreciation expenditures 1,618.0

Less: Statistical discrepancy 81.4

EQUALS: NATIONAL INCOME 12,270.9

Compensation of employees 7,812.3 (63.6)

Proprietor’s income 1,056.2 (8.6)

Rental income 40.0 (0.3)

Corporate profits 1,642.4 (13.4)

Net interest 664.4 (5.4)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

19

High Concept

Income =

Expenditure =

Value Added

High Concept

• Value of a final good expenditure is equal to value added at each stage of production. (Expenditure = Value Added)

• Value Added would be paid to workers, creditors, or kept as profits. (Income = Value Added)

GNP vs. GDP

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

GNP GDP

Gross National Product Gross Domestic Product

= income earned by domestic residents

= income created within national borders.

GNP = GDP +NFI

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

%

1993 1995 1997 1999 2001 2003 2005 2007#

Hong Kong NFI/GDP

Hong Kong Census and Statistics

Compare Macau and the Philippines GDP or GNP

• Macau produces a lot of profits paid to overseas owners of casinos.

• Philippines workers earn a lot of income overseas.

• Which is larger Philippines’ GDP or Philippines GNP?

• Does Macau have greater GDP or GNP?

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.

Solved ProblemReal GDP: 2005 (2004 Base Year)

2005 2004

P Q P Q

Kitkat 8 150 6 135

M&Ms 10 150 4 135

Nominal GDP

Real GDP

USA

0.0

2000.0

4000.0

6000.0

8000.0

10000.0

12000.0

14000.0

16000.0

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Bill

ion

US

$

Nominal GDP Real GDP

Real GDP vs. Nominal GDPSt. Louis Federal Reserve

Price Indices: Pt

• Two most commonly used price indices are GDP Deflator and Consumer Price Index (CPI)

• The GDP deflator is the ratio of nominal GDP to Real GDP (multiplied by 100).

100

100

Nominal GDPP GDP Deflator

Real GDP

GDPP

Y

Consumer Price Index

• 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).

100t

Cost of Market Basket in year tCPI

Cost of Market Basket in Base year

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

CPI

GDP Deflator

Hong Kong’s History of Prices

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.

Example

• What is the inflation rate in Candyland in 2005?

Adjusting for Inflation

• We can use some price index to “adjust for inflation” effectively converting a variable measured in money (nominal 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.

Converting Current Price Series into Constant Price Series

• Series to be adjusted for inflation: Nt

• Contemporaneous price level (Pt) and comparable price level in reference year (PRef)

• Series adjusted for inflation – (i.e. how much that the goods that you could have bought with N in year t would cost in year Ref.)

RefRef$t 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 September 2009 : HK$173,762 /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 109.2 in December 2009.

• Calculate:

• In real terms, luxury housing in 2009 is almost 3 times as expensive as in 1982!

Real Ref 109.214,742 57,493.8

38t tt

PN N

P

Example

• Compare the box office take of “Shrek 2” and “Sound of Music” in 2004 dollars.

Movie Year Box Office PShrek 2 2004 436,471,036 189

Sound of Music 1965 163,214,286 32

Learning Outcomes

• Students should be able to:

• Calculate simple real aggregates like real GDP.

• Use price indices to calculate inflation rates and real interest rates.

• Adjust nominal series for inflation.