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Business, Government, and the World Economy
Introduction
Economic Quiz
What is the current unemployment rate?How many people are currently unemployed?What is the size of US nominal GDP?What was the rate of growth of US GDP in 2nd quarter?What is the yield on 10 year Treasury Bonds?What is the amount of debt owed by US as a % of GDP?
Economics
What is Economics?
The study of the allocation of scarce resources
Macroeconomics
Interrelationship of Aggregate Economic Variables
Output (Gross Domestic Product)ProductivityThe level of prices (Inflation)Interest ratesEmployment (& Unemployment)Value of currency (Foreign Exchange)
Macroeconomic Goals
Providing JobsEconomic Growth
Increasing ProductivityIncreasing Standard of Living
Stable PricesOthers?
Basic Assumptions
Markets work in the long-run“Equilibrium” prices and quantities can be achieved.
Short-run constraints can inhibit long-run equilibrium
Speed of Market AdjustmentGovernment PolicyExogenous Shocks
Government Policy
Monetary PolicyControlled by Federal Reserve Board
Fiscal PolicyFederal and StateTaxes, Government Spending etc.
Trade PolicyTariffs, quotas, etc.
Regulatory PolicyEnvironmental, occupational safety, equal opportunity laws, minimum wage etc..
Microeconomics vs. Macroeconomics
Microeconomics - economic decisions faced by individual firms and individual consumers.Microeconomic decisions are based upon macroeconomic data as are macroeconomic policy decisions. There are the same underlying variables impacting both types of decision making – there has to be a link.
Common Questions
Microeconomics Macroeconomics
How much R&D will a firm undertake
How much leisure time do individuals desire?
How many I-Pods should Apple produce?
Will consumers save or spend? How much will the country save in aggregate?
What is the level of interest rates?
What is the current price level?
How can productivity be increased?
How can Output (GDP) be increased?
What is the current level of Unemployment?
Aggregating Micro?
Macroeconomics is not simply the aggregation of individual results
Fallacy of composition - not every individual acts the same way and even if they did the aggregate result may not reflect the individual result. For example, increasing nominal level of wages in an attempt to increase income…
Factors impacting the link between micro and macro
Rigidities – Macroeconomic relationships are often slower to respond to changes than individual marketsLiquidity – Short run decisions may not be based on long run expectationsKnowledge – Information is asymmetricExpectations - Assumed relationships may be impacted by expected changes, as opposed to current events.
Positive – What does occur under a given set of conditions – As prices rise demand falls.Normative – what should occur – includes judgment – how should income be distributed?
Positive vs. NormativeEconomics
Basic Economic Assumptions
Laws of Supply and DemandUtility MaximizationMarkets Forces Work in the Long Run
Ceterius Paribus“Other things being equal”
Multiple economic variables often change at any given time.Most economic models keep the variables not under consideration constant. Therefore looking at only the relationship between two variables will often produce inaccurate analysis.
Economic Theory Changes
Economic theory can change over time – even theory that is supported by empirical evidence Example: The Phillips Curve
1960’s Philips Curve
0
1
2
3
4
5
6
2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7
Unemployment (Annual %)
Infl
ati
on
(A
nn
ua
l %
)
19611962
1963
1967
1966
19651964
1969
1968
Monetary Policy 1960’s
Focus on money market conditions. Use of Free reserves as indicator resulting in procyclical monetary policy.
0
2
4
6
8
10
12
14
16
3 4 5 6 7 8 9
Unemployment (Annual %)
Infl
ati
on
(A
nn
ua
l %
)
1970
1977
1976
1975
1974
1973
1972
1971
1978
1979
1980
1970’s Phillips Curve ?
1996-2005 Phillips Curve?
0
0.5
1
1.5
2
2.5
3
3.5
4
3 3.5 4 4.5 5 5.5 6 6.5
Unemployment (Annual %)
Infl
ati
on
(A
nn
ua
l %
)
2005
1996
1997
1998
1999
2000
2001
2002
2003
2004
The Phillips Curve
Has been modified to look at expectations of inflation as opposed to the level of inflationTradeoff between inflation and unemployment is still a common discussion / stylized fact in the media and economic debates.
Measuring Economic OutputThe Key Variable: GDP
Gross Domestic Product The market value of all final goods and services produced in a country during a given time frame.
Components of GDPY = C + I + G + NX
Personal Consumption Expenditure (C)Items purchased by consumers
Gross Private Domestic Investment (I)Spending by business, construction, and inventory investment
Government Purchases (G)Total federal state and local government purchases
Net Exports (F or NX)Exports minus Imports
Personal Consumption Expenditures
Approximately 72% of GDP*Item % of
GDPDescription
Durable Goods 10% Goods that last > 3 yearsCars, appliances, furniture
Non-Durable Goods
20% Goods usable < 3 yearsFuel, food, clothes
Services 41% Intangible tasks by specialistsRepairs, hair styling, cleaning
www.bea.gov 1st qtr 2011
Gross Private Domestic Investment
Approximately 12% of GDP:Fixed Investment
Nonresidential (Structures and Equipment) Residential
InventoriesGDP should account for everything producedChange in inventories, is an important number to watch (not the level).
Government Spending and Net Exports
Government Spending: About 18% of GDPFederal - 7%: Defense vs. Non defenseState and Local 11%
Net Exports (Exports - Imports)Exports 11.6%Imports 14.3%.
Trends in GDP Components
Current Values1st Quarter 2010
Gross Domestic Product $14,597.7 Billion
Real Gross Domestic Product $13,216.5 BillionPercentage change from previous quarter (annual rate)2010 Qtr 2 2.4%2010 Qtr 1 3.7% 2009 Qtr 1 5%
Contributors to GDP1st qtr 2010
PositiveConsumption 1.15%Business Investment 3.14%
NegativeNet Exports -2.78%
Three Markets
Good MarketsConsumption, Business Investment, and Saving.
Asset MarketFinancial AssetsMoney
Labor MarketLevel of Employment and Wages
General Equilibrium
Adjustment of Interest Rates and Prices result in the Simultaneous Equilibrium of the Goods, Asset, and Labor Markets (general equilibrium). Interest rates and prices impact the amount of Government Purchases and Net Exports as well (and they also influence the equilibrium in each market)Therefore changes in any of the three markets can impact the level of GDP and the components of GDP.
Macro Interactions
GDPC+I+G+NX
Goods MarketConsumption, Saving, and
Investment
Asset Market
Government
Purchases
Net Exports / Interaction with Global Economy
Labor MarketWages and Employment
Interest Rates &Prices
Outline of the Class
Introduction (current state of the economy and the language of economics)Useful Mathematical ToolsLabor, Goods, and Asset MarketsGeneral Equilibrium (combining the three markets into one model of the economy)Applying and using the model to understand the economic environment and make better business decisions.
Goals of the Class
Students should improve their understanding of:
Basic theoretical macroeconomic models and the issues surrounding their usefulness.How macroeconomic performance is measured by commonly used economic indicators.How changes in macroeconomic performance relates to the theoretical models and therefore impacts decision making in the business world.
Some Basic Economic Language
Annual RatesRates of ChangeBusiness CyclesConsensus SurveyMoving AverageNominal vs. Real DollarsRevisions and BenchmarksSeasonal Adjustments
Economic Indicators
LeadingIndicators that move ahead of the total economy (ahead of GDP).
CoincidentIndicators that move with the level of GDP.
LaggingIndicators that move following GDP.
Capacity Utilization vs. GDP1967-2007
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
0.2
CU
GDP
The Current State of the Economy
The lingering effect of the financial crisisCauses of the crisisThe Great Recession
Current conditions - slowdown or double dip?
European Debt US deficit debateUS housing market
The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending Decreased Business Investment
Who’s to Blame?
Economic Environme
nt Congress Consumers
Mortgage Originators Regulators Wall Street
GSEs Rating Agencies
International
Flows
How Financial Markets Enabled“Keeping up with the Joneses”
New Products
Poor Underwriting
Public Policies Unintended Consequences
Low Rates and International Capital Flows
Products
Underwriting
Policy
Markets
Mortgage Market Developments
Securitization and new participantsGraham Leach Bliley Financial Modernization Act of 1999Increased Use of Mortgage Brokers2000 Commodity Futures Modernization Act
Increased Access to CreditSubprime, Alt A, Option ARMs
Products
Underwriting
Policy
Markets
Securitization
Loan Bank B
Financial IntermediaryBuys Loans, Forms a “Pool”
and Issues MBS
Loan Bank A Loan Bank Z
Insurance Firm, Banks, Pension Funds etc.Buy MBS – Cash Flows “Guaranteed” by Original Mortgages
Products
Underwriting
Policy
Markets
Average Size of Subprime Loans
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans, over
50% to total subprime
Products
Underwriting
Policy
Markets
Credit Quality of Subprime Loans Originated each year
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans,
over 50% to total subprime
Products
Underwriting
Policy
Markets
Structure of Subprime Loans Originated each year
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans,
over 50% to total subprime
Products
Underwriting
Policy
Markets
Impact of Subprime Loans on Home Ownership
"SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007
Products
Underwriting
Policy
Markets
NY Times October 4 "Pressured to Take More Risk Fannie Hit a Tipping Point"
Fannie Mae’sGuarantee of Alt A Loans
0
50
100
150
200
250
300
$ B
illions o
f Alt
A L
oans G
uara
nte
ed
2005$58
Billion Added
2006$87
BillionAdded
2007$79
BillionAdded
2004 & Before$77 Billion Total
Products
Underwriting
Policy
Markets
Blaming Fannie and Freddie?
No - Fannie and Freddie were small relative to the entire market.
Combined Subprime Purchases (% of Market)**Consumer demand created rapid prince increase
Yes – Overall Size put them at risk for any Mortgage Market problem
Securitizing more risky loans opened door for Private securitization
Gramlich, E. "Subprime Loans: America's Latest Boom an Bust" 2007 ** "how HUD Mortgage Policy Fed the Crisis", Washington Post June 10, 2008
Products
Underwriting
Policy
Markets
International Capital Flows
Consumer Spending On Exports
Increased Foreign Holdings of $
Increased Inflow of Dollars Helps Keep Long Term Rates Low
Products
Underwriting
Policy
Markets
“The Perfect Storm” 2004 - 2007
Domestic and global institutions buy MBS in attempt to increase margins on “safe” securities, incorrectly rated.
Institutions use higher debt levels for securitization.
Underwriting standards deteriorate.
Increased interest rate environment makes loans more likely to default
Increasing Home Prices encourage consumers to overextend and speculate in housing market
Products
Underwriting
Policy
Markets
Home Sales and Home Prices
Non Agency Mortgage Foreclosure Rates
Response of Consumers
Increased access to credit and delusional optimism resulted in:
Short-Term Speculative FocusBorrowing More and Saving Less
Case Study: Natalie Brandon
1985 Buys $105,000 house 30 Year fixed rate loan Payment = $770
2000-2006Paid penalties to Refi 5 times in 5 years Yearly income = $100,000 2006 New Loan $625,500 2/28 7.99% teaserPayment = $4,585
Fall 2007Home Value = $450,000Attempt to Refi for 40 years at 6% Fails
Borrowing More & Saving Less
Equity Prices Compared to Past Recessions
Consumer Credit Outstanding Compared to Past Recessions
Impact of the Crisis
Increase in Precautionary Saving
Lost Wealth from Equity Declines
High Unemployment
Consumer Confidence hits Record Lows
Precautionary Saving
All Silents Boomers Gen X Gen YLess than 2 weeks 28% 11% 25% 31% 32%2 weeks to a month 22% 17% 21% 21% 27%2 to 3 months 22% 23% 24% 19% 22%4 to 6 months 14% 15% 11% 17% 12%7 months to a year 5% 7% 5% 6% 2%More than a year 10% 27% 14% 5% 6%
If you were to lose your job, for how long could you afford to be out of work and still meet your financial obligations including monthly expenses?
The 2009 MetLife Study of the American Dream
Confidence in Having Enough Money to Live Comfortably Throughout Retirement
Years
0
5
10
15
20
25
30
1993 1995 1997 1999 2001 2003 2005 2007 2009
% o
f R
esp
on
den
ts
Very Confident Not at all Confident
“The Pressure I feel to buy more and better material possessions is greater than ever”
Metlife
26%
46%
10%
25%
18%
39%
29%
53%
47%
66%
74%
54%
90%
75%
82%
61%
71%
47%
53%
34%Gen 06
Y 09
Baby 06
Boom 09
All 06
09
Gen 06 X 09
Silent 0609
Agree Disagree
Buyers Remorse
62%
79%
66%
54%
51%
38%
21%
34%
46%
49%
I have no regrets about the major purchases that I have made over the past few years
I regret making major purchases and wish I would have saved more over the past few years
Gen Y
Gen X
Boomers
Silents
All
The Crystal Ball – The Big Picture
How will Consumers Respond?Precautionary or Long Term Savings?Lost Faith in Investment Planning?View of home ownership
Corporate EarningsFinancial Markets and Regulation
Regulatory ChangesLong Term Inflation FearsMonetary and Fiscal PolicyInterest Rates
The Current State of the Economy
Slowdown or Double Dip?Federal Reserve PolicyFiscal PolicyGlobal Headwinds
Some Troubling Signs
Manufacturing
Consumer Spending / Confidence
Housing
Unemployment
Employment: Non Farm Payrolls
Employment: Non Farm Payrolls
Consumer Credit Outstanding
Consumer Credit Outstanding