Macroeconomics & Finance Introduction

Macro & Finance Thesis: Of all the business disciplines, macroeconomics is most closely connected with finance. Some business disciplines can be understood with minimal knowledge of business cycles not finance. Academia: Macroeconomic researchers publish in finance journals and finance researchers publish in macroeconomic journals. Private Sector: Macroeconomists most likely to be employed by commercial or investment banks.

Where’s the Connection? Intertemporal Decision making is central to both disciplines. Finance studies portfolio choices of savers (stocks, bonds, etc.) and their implications for asset prices. Corporate finance studies the determinants of the borrowing choices of firms. Savings decisions of households & investment decisions of firms central to business cycles. All decisions must be made now and have an impact on the future.

Other Connections Macroeconomists study government fiscal policy. Government major borrower (or saver) in financial markets. Macroeconomists study monetary policy. Monetary policy determines real value of financial pay-offs. 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.

Basic Concepts Measuring Output and Prices [corresponds to Chapter 2, “The Language of Macroeconomics: Data and Definitions”]

Students should be able to Construct a current dollar and a constant dollar quantity aggregate Construct a price index and a price deflator. Use the price index to convert a current dollar measure into constant dollars.

Quantity Aggregates We need to combine the many goods produced or consumed in an economy into one measure. All goods sold in an economy share a common unit of measure: the price at which they are sold. Quantity aggregates sum up some group of goods assigning a price as a value.

Current Dollar Aggregates The value assigned to a good in a current dollar (or nominal) aggregate is the price at which it was actually sold. Assume there are N goods that should be added together (indexed n = 1..N). The quantity of good n at time t is q t,n. The price of good n at time t is p t,n. The nominal aggregate at time t is

Constant Dollar Aggregates The value assigned to a good in a constant dollar (or real) aggregate is the price at which them same (or very similar) good was sold at a constant base year B The real aggregate at time t is The unit of measure is B year dollars. A B year dollar is the amount of goods that could have been bought with a dollar in B.

Gross Domestic Product (GDP) The most widely used quantity aggregate is GDP. GDP is the sum of the new, final goods produced within the domestic borders of an economy. Final goods are goods which are sold to their end- users and do not include intermediate goods which are sold from one firm to another for intermediate transformation into other goods. Nominal or current dollar GDP values final goods at the market price at which they were sold. Real or constant dollar GDP values final goods

Real GDP vs. Nominal GDP GoodsQuantityCurrent Price Bread (Loaf) 2084 Butter (Lb.) 5148 Nominal GDP 230Real GDP 120

Nominal GDP vs. Real GDP in Hong Kong

Quarterly GDP

Business Cycles

Seasons

Expenditure Measure of GDP The final goods that a country produces can be used for exports or for consumption by the domestic household sector, investment by the domestic corporate sector or for use by the government. Domestic consumption, investment and government can also be satisfied by imports. Output + Imports = Consumption + Investment + Government + Exports GDP = C + I + G + (EX-IM) = C + I + G +NX

Expenditure Categories in Hong Kong: 2001

Production Measure The final goods produced by an economy are the sum of value added in all firms. The value added of a firm is total sales (plus increase in inventories) minus spending on intermediate materials. If bread is a final good, the value of the bread is equal to sum of the value added at each stage of the production process.

Production Method GDP = T + NT GDP = Traded Goods + Nontraded Goods GDP = {Agriculture +Mining + Manufacturing} + {Utilities + Transport + Communication + FIRE + Trade (Retail & Wholesale) + Services}

Income Measure All value added is paid to someone in the economy. Either it is paid to workers or to creditors or, finally, as profits to the owners of firms. Add up all income from domestic sources and this should equal GDP.

Two Parts of Value Added: Labor Income Labor Compensation: Those revenues that are used to pay workers wages and other benefits.

Two Parts of Value Added: Capital Income Capital Income: Value added not paid to workers. Capital income roughly corresponds to the accounting category EBITDA: Earnings before Interest, Taxes. Depreciation and Amortization. Earnings is what is left after subtracting, interest, tax, and depreciation costs from capital income.  Earnings are either used to purchase new investment goods or are paid to the owners, as dividends, in the case of public corporations.

Value Added Labor Compensation Capital Income ( EBITDA ) Depreciation Corporate Taxes Interest Payments Retained Earnings Dividend Payments

What Share of Capital Income is paid to capitalists? Part of capital income is used to replace depreciated capital. Net National Product is GDP minus the depreciation allowance. The depreciation allowance in the USA is about 12% of GDP About 70% of income is paid to workers in most modern economies including the USA.

What Share of Capital Income is paid to capitalists? Pt. 2 Part of capital income must be paid to the government as taxes. In the USA direct corporate taxes are about 1.5% of GDP and indirect taxes and fees are another 1-2% Approximately the remaining 8-10% is available for retained earnings or dividends. Corporations must also pay interest. In the USA, the net interest payment is about 7% of GDP.

Equivalence The expenditure method, the production method, and the income method each measure the same thing. Expenditure on final goods equals the valued added by all the firms in the production chain. The value added by any firm is paid out as income either as wages or as interest or as profits.

Example Economy (People work as farmers, millers bakers, and storekeepers and eat bread) Agents ActivityValue Added Proprietor’s Income Expenditure Farmer Farmer sells $100 wheat to Miller $100. Miller Miller sells $200 flour to baker $200-$100 $100. Baker Baker sells $300 bread to storekeeper $300-$200 $100. Storekeep Storekeeper sells $400 bread to customers $400-$300 $100 $400

Price Indices Economists construct measures of the average dollar price of goods. To construct price indices, statistical agencies first choose a representative market basket of goods. Price index is

Price Deflators Another measure of prices are constructed using constant and current dollar quantity aggregates. Deflators are the ratio of current dollar aggregates to constant dollar aggregates.

Prices in Hong Kong

Adjusting for Inflation/Converting Current Price Series into Constant Price Series One may have a time series of a nominal aggregate, N t, (in current prices) without the microeconomic data necessary to construct a corresponding real aggregate. We can use some price index to “adjust for inflation” effectively converting into a real variable. 1. Select a reference or base year. 2. Series measured in base year dollars is

Real Series In the base period used by statistical authorities, price index should be 1. For example, if we had a series which measures the average wages of workers, W t, we could construct constant dollar or inflation adjusted or real wages by dividing by the price level

Advantages & Disadvantages of Price Measures Price indices use a fixed market basket of goods. Deflators are the relative price of a changing basket of goods. Deflators might be more representative of what people are buying. Price indices are much easier and cheaper and faster to calculate than quantity aggregates.

Growth Rates & Inflation For a variable X t, its % growth rate is calculated as The growth rate of prices is called inflation

Main Sources of Hong Kong Statistics There are two main sources of macroeconomic statistics. 1. Census and Statistics Department: National Income Accounts, CPI, Interest Rates, Employment, etc. See Frequently Requested Statistics 2. Hong Kong Monetary Authority: Money and Banking Statistics See Monthly Statistical Bulletin