1. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 20011 The Role of Financial Markets in the Economy Andrew B. Abel October 1, 2001

2. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 20012 Overview I. Measuring Economic Activity II. Fundamentals of National Income Accounting III. Financial Markets and Economic Activity

3. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 20013 I. Measuring Economic Activity A. Users of Economic Data B. National Income Accounts C. Employment Statistics D. Price Levels and Inflation

4. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 20014 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

5. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 20015 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

6. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 20016 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

7. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 20017 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

8. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 20018 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

9. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 20019 U.S. Real GDP, 1869-1998 Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

10. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200110 average = 3.5% per year

11. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200111 Problems in Construction of GDP Data Identification of Final Goods Quality Changes Underground Economy Seasonality

12. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200112 Deficiencies in Concept of GDP Ignores Use of Exhaustible Resources Ignores Deterioration of Environment Does Not Value Leisure Government Services Valued at Cost Aggregation

13. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200113 I.C. Employment Statistics Labor Force Demographic changes Participation rates Secular changes –women Cyclical changes –secondary earners Seasonal changes –teenagers

14. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200114 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

15. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200115 The Employment Situation August 2001

16. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200116 U.S. Unemployment, 1890-1998 Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

17. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200117

18. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200118 Deficiencies with Overall Unemployment Rate Masks Differences Across Demographic Groups Qualifications of Job Seeker Discouraged Workers Does Not Measure Duration

19. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200119 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

20. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200120 U.S. Consumer Prices, 1800-1998 Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

21. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200121 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

22. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200122 percent per year

23. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200123

24. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200124 Deficiencies of Price Level and Inflation Measures Substitution Bias New Product Bias Quality Change Bias Outlet Bias

25. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200125 Example of Biases in the CPI Basket = 1 Coke + 1 Pepsi + 2 cans of paint 10 1 1 8 18 New, improved paint introduced in March 1110 1 2 4

26. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200126 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

27. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200127 II.A.1 Product Approach to Measuring GDP

28. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200128 II.A.2 Income Approach to Measuring GDP Income Wages Proprietors' income Rents Interest Profits

29. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200129 Income Approach to Measuring GDP in the United States

30. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200130 II.A.3 Expenditure Approach to Measuring GDP Private Consumption Private Investment Government Purchases Net Exports

31. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200131 U.S. GDP Expenditure Approach

32. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200132

33. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200133 U.S. Consumption Expenditures

34. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200134

35. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200135 U.S. Private Investment

36. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200136

37. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200137 U.S. Government Purchases

38. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200138

39. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200139 U.S. Net Exports

40. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200140

41. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200141 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

42. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200142 Saving Identity National Saving = Income - Consumption - Government Purchases Income = Consumption + Investment + Government Purchases + Current Account National Saving = Investment + Current Account

43. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200143 Graphical View of Saving Identity Consumption Current account Government Purchases Investment National Saving Consumption GDP Government Purchases

44. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200144 Saving in the United States

45. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200145 Government Saving in the U.S.

46. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200146 Saving Identity in the U.S. Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

47. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200147 Investment includes government and private investment

48. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200148 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

49. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200149 Current Account Trade Balance = Exports minus Imports Current Account Balance Trade balance plus Net factor income from abroad Remittances and unilateral transfers

50. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200150 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

51. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200151 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

52. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200152 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

53. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200153 Net Exports Exports Effect of exchange rate Effect of foreign income Imports Effect of exchange rate Effect of domestic income Tariffs

54. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200154 The J curve Exchange rate falls Exports increase Imports/exchange rate increases initially Real value of imports increases initially Net exports fall initially

55. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200155 © 1998, Addison Wesley Longman, Inc.

56. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200156 The J Curve: An Example 80 -20 90 -25 80 -5

57. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200157

58. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200158 III. Financial Markets and Economic Activity A. Broad Asset Categories B. Rates of Return and Asset Pricing C. Asset Demands D. Asset Supplies

59. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200159 III.A. Broad Asset Categories Money Bonds Equity

60. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200160 Money Medium of Exchange Store of Value Unit of Account

61. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200161 Bonds Claims to Predetermined Schedule of Payments Term Structure of Interest Rates Risk Premia Vary with Issuer and with Seniority of Debt

62. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200162 Equity Claim on Physical Capital Rate of Return Dividend Capital gains or losses

63. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200163 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"

64. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200164 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

65. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200165 Bond and Capital Demand Increasing in Own Rate of Return Decreasing in Other Interest Rates Assets are substitutes Increasing in Wealth

66. The Role of Financial Markets in the Economy, Andrew Abel, October 1, 200166 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