The Role of Financial Markets in the Economy, Andrew Abel, October 1, The Role of Financial Markets in the Economy Andrew B. Abel October 1, 2001

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Overview I. Measuring Economic Activity II. Fundamentals of National Income Accounting III. Financial Markets and Economic Activity

The Role of Financial Markets in the Economy, Andrew Abel, October 1, I. Measuring Economic Activity A. Users of Economic Data B. National Income Accounts C. Employment Statistics D. Price Levels and Inflation

The Role of Financial Markets in the Economy, Andrew Abel, October 1, I.A. Users of Economic Data Policy Makers Guide the direction of policy Businesses Forecast demand, costs of materials, and cost of funds Tax consequences of inflation Exchange rates

The Role of Financial Markets in the Economy, Andrew Abel, October 1, I.A. Users of Economic Data (cont’d) Labor Unions Need to know unemployment rate and inflation rate when negotiating contracts COLA's Voters Political business cycle Financial Managers Interest rates, exchange rates

The Role of Financial Markets in the Economy, Andrew Abel, October 1, I.B. National Income Accounts Gross Domestic Product (GDP) Definition: Market value of final goods and services produced within a country over a period of time market value final goods and services –excludes intermediate goods and services –avoids double counting –equivalent to value-added

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Example: Value Added Sugar production = $40M $15M sold to households $25M sold to soft drink producers Soft drink production = $35M GDP Value of final goods Value added $15M of sugar + $35M soft drinks = $50M $40M of sugar + $10M soft drinks = $50M

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Definition of GDP (cont’d) Produced... over a period of time Excludes trades of assets new vs. existing homes includes commissions on trades of assets Typically annualized Produced in a country Produced inside the U.S. GNP: produced by domestic factors of production anywhere in the world GNP = GDP plus receipts of factor income from rest of world minus payments of factor income to rest of world

The Role of Financial Markets in the Economy, Andrew Abel, October 1, U.S. Real GDP, Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

The Role of Financial Markets in the Economy, Andrew Abel, October 1, average = 3.5% per year

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Problems in Construction of GDP Data Identification of Final Goods Quality Changes Underground Economy Seasonality

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Deficiencies in Concept of GDP Ignores Use of Exhaustible Resources Ignores Deterioration of Environment Does Not Value Leisure Government Services Valued at Cost Aggregation

The Role of Financial Markets in the Economy, Andrew Abel, October 1, I.C. Employment Statistics Labor Force Demographic changes Participation rates Secular changes –women Cyclical changes –secondary earners Seasonal changes –teenagers

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Employment Surveys Household Survey (counts people) Employed Unemployed actively seeking work Not in Labor Force Establishment Survey (counts jobs) Cannot be used to measure unemployment

The Role of Financial Markets in the Economy, Andrew Abel, October 1, The Employment Situation August 2001

The Role of Financial Markets in the Economy, Andrew Abel, October 1, U.S. Unemployment, Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

The Role of Financial Markets in the Economy, Andrew Abel, October 1,

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Deficiencies with Overall Unemployment Rate Masks Differences Across Demographic Groups Qualifications of Job Seeker Discouraged Workers Does Not Measure Duration

The Role of Financial Markets in the Economy, Andrew Abel, October 1, I.D. Price Levels and Inflation Major Price Indices Implicit price deflator to deflate nominal GDP CPI - urban household of four PPI Trade-weighted dollar

The Role of Financial Markets in the Economy, Andrew Abel, October 1, U.S. Consumer Prices, Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Inflation Definition: General and Continual Upward Movement in Prices General: not a single good Continual: not a once-and-for-all change Important Distinctions Price level vs. inflation Deflation vs. disinflation

The Role of Financial Markets in the Economy, Andrew Abel, October 1, percent per year

The Role of Financial Markets in the Economy, Andrew Abel, October 1,

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Deficiencies of Price Level and Inflation Measures Substitution Bias New Product Bias Quality Change Bias Outlet Bias

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Example of Biases in the CPI Basket = 1 Coke + 1 Pepsi + 2 cans of paint New, improved paint introduced in March

The Role of Financial Markets in the Economy, Andrew Abel, October 1, II. Fundamentals of National Income Accounting A. Measuring GDP 1. Product approach 2. Income approach 3. Expenditure approach B. Saving C. International Transactions D. Saving Identity from Balance Sheets

The Role of Financial Markets in the Economy, Andrew Abel, October 1, II.A.1 Product Approach to Measuring GDP

The Role of Financial Markets in the Economy, Andrew Abel, October 1, II.A.2 Income Approach to Measuring GDP Income Wages Proprietors' income Rents Interest Profits

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Income Approach to Measuring GDP in the United States

The Role of Financial Markets in the Economy, Andrew Abel, October 1, II.A.3 Expenditure Approach to Measuring GDP Private Consumption Private Investment Government Purchases Net Exports

The Role of Financial Markets in the Economy, Andrew Abel, October 1, U.S. GDP Expenditure Approach

The Role of Financial Markets in the Economy, Andrew Abel, October 1,

The Role of Financial Markets in the Economy, Andrew Abel, October 1, U.S. Consumption Expenditures

The Role of Financial Markets in the Economy, Andrew Abel, October 1,

The Role of Financial Markets in the Economy, Andrew Abel, October 1, U.S. Private Investment

The Role of Financial Markets in the Economy, Andrew Abel, October 1,

The Role of Financial Markets in the Economy, Andrew Abel, October 1, U.S. Government Purchases

The Role of Financial Markets in the Economy, Andrew Abel, October 1,

The Role of Financial Markets in the Economy, Andrew Abel, October 1, U.S. Net Exports

The Role of Financial Markets in the Economy, Andrew Abel, October 1,

The Role of Financial Markets in the Economy, Andrew Abel, October 1, II.B. Saving Private Saving = Income + Transfers - Taxes - Consumption Government Saving = Taxes - Transfers - Government Purchases Surplus, if positive Deficit, if negative National Saving = Private Saving + Government Saving equals Income minus Consumption minus Government Purchases

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Saving Identity National Saving = Income - Consumption - Government Purchases Income = Consumption + Investment + Government Purchases + Current Account National Saving = Investment + Current Account

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Graphical View of Saving Identity Consumption Current account Government Purchases Investment National Saving Consumption GDP Government Purchases

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Saving in the United States

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Government Saving in the U.S.

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Saving Identity in the U.S. Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Investment includes government and private investment

The Role of Financial Markets in the Economy, Andrew Abel, October 1, II.C. International Transactions Basic Principles Credit items: generate flow of funds into the country Debit items: generate flow of funds out of the country

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Current Account Trade Balance = Exports minus Imports Current Account Balance Trade balance plus Net factor income from abroad Remittances and unilateral transfers

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Financial Account Financial Inflow Sale of U.S. securities to foreigners Financial Outflow Purchase of foreign securities by U.S. residents Financial Account Balance Financial inflow minus financial outflow Exports of securities minus imports of securities

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Balance of Payments Current Account + Financial Account = 0 Ignore (tiny) Capital Account Balance of Payments Current account balance plus private financial account balance Floating Exchange Rates ”Clean" vs. "dirty" floating Clean floating  balance of payments = 0

The Role of Financial Markets in the Economy, Andrew Abel, October 1, II.D. Saving Identity from Balance Sheets Components of Private Saving Increase in holding of capital investment Increase in holding of government securities government deficit Increase in net holding of foreign assets financial account deficit equivalently, current account surplus

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Net Exports Exports Effect of exchange rate Effect of foreign income Imports Effect of exchange rate Effect of domestic income Tariffs

The Role of Financial Markets in the Economy, Andrew Abel, October 1, The J curve Exchange rate falls Exports increase Imports/exchange rate increases initially Real value of imports increases initially Net exports fall initially

The Role of Financial Markets in the Economy, Andrew Abel, October 1, © 1998, Addison Wesley Longman, Inc.

The Role of Financial Markets in the Economy, Andrew Abel, October 1, The J Curve: An Example

The Role of Financial Markets in the Economy, Andrew Abel, October 1,

The Role of Financial Markets in the Economy, Andrew Abel, October 1, III. Financial Markets and Economic Activity A. Broad Asset Categories B. Rates of Return and Asset Pricing C. Asset Demands D. Asset Supplies

The Role of Financial Markets in the Economy, Andrew Abel, October 1, III.A. Broad Asset Categories Money Bonds Equity

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Money Medium of Exchange Store of Value Unit of Account

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Bonds Claims to Predetermined Schedule of Payments Term Structure of Interest Rates Risk Premia Vary with Issuer and with Seniority of Debt

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Equity Claim on Physical Capital Rate of Return Dividend Capital gains or losses

The Role of Financial Markets in the Economy, Andrew Abel, October 1, III.B. Rates of Return and Asset Pricing Ex Ante vs. Ex Post Rate of Return Higher Initial Price Implies Lower Rate of Return Tendency for Ex Ante Rates of Return to Move Together "the interest rate"

The Role of Financial Markets in the Economy, Andrew Abel, October 1, III.C. Asset Demands Money demand Transactions motive increasing with income decreasing with interest rate Precautionary motive decreasing with interest rate Speculative or portfolio motive increasing with wealth decreasing with interest rate tenuous for non-interest paying money

The Role of Financial Markets in the Economy, Andrew Abel, October 1, Bond and Capital Demand Increasing in Own Rate of Return Decreasing in Other Interest Rates Assets are substitutes Increasing in Wealth

The Role of Financial Markets in the Economy, Andrew Abel, October 1, III.D. Asset Supplies Money Monetary policy by the Federal Reserve Government Bonds Fiscal policy implemented by the Treasury Physical Capital Created by investment Net Foreign Assets Generated by current account surplus