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

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

The Role of Financial Marketsin the Economy

Andrew B. AbelOctober 1, 2001


Overview

I. Measuring Economic Activity

II. Fundamentals of National Income

Accounting

III. Financial Markets and Economic Activity


I. Measuring Economic Activity

A. Users of Economic Data

B. National Income Accounts

C. Employment Statistics

D. Price Levels and Inflation


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


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


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


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


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


U.S. Real GDP, 1869-1998

Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.


Annualized Growth Rate of Real GDP

-15

-10

-5

0

5

10

15

20

194

7-II

195

0-II

195

3-II

195

6-II

195

9-II

196

2-II

196

5-II

196

8-II

197

1-II

197

4-II

197

7-II

198

0-II

198

3-II

198

6-II

198

9-II

199

2-II

199

5-II

199

8-II

200

1-II

per

cen

t p

er y

ear

average = 3.5% per year


Problems inConstruction of GDP Data

• Identification of Final Goods• Quality Changes• Underground Economy• Seasonality


Deficiencies in Concept of GDP

• Ignores Use of Exhaustible Resources• Ignores Deterioration of Environment• Does Not Value Leisure• Government Services Valued at Cost• Aggregation


I.C. Employment Statistics

• Labor Force• Demographic changes• Participation rates

• Secular changes– women

• Cyclical changes– secondary earners

• Seasonal changes– teenagers


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 Employment SituationAugust 2001

millions % of LF % of adult popEmployed 134.393 95.1% 63.4%

(Employment ratio)

Unemployed 6.957 4.9% 3.3%(Unemployment rate)

Labor Force 141.350 100.0% 66.6%(Participation rate)

Not in Labor Force 70.785 33.4%

Adult Population 212.135 100.0%


U.S. Unemployment, 1890-1998



UnemploymentJan. 1987 - Aug. 2001

0

2

4

6

8

10

1987 1989 1991 1993 1995 1997 1999 2001

% o

f civ

ilian

labo

r fo

rce


Deficiencies with Overall Unemployment Rate

• Masks Differences Across Demographic Groups

• Qualifications of Job Seeker• Discouraged Workers• Does Not Measure Duration


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


U.S. Consumer Prices, 1800-1998



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


CPI Inflation in the US, 1801-1999

-20

-15

-10

-5

0

5

10

15

20

25

30

1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000

perc

ent p

er y

ear


CPI Inflation (12-month)

0

2

4

6

8

10

12

14

16

1960 1965 1970 1975 1980 1985 1990 1995 2000

perc

ent

per

year


Deficiencies of Price Level and Inflation Measures

• Substitution Bias• New Product Bias• Quality Change Bias• Outlet Bias


Example of Biases in the CPI Basket = 1 Coke + 1 Pepsi + 2 cans of paint

January February March

Price of Coke($/Coke)

1

Price of Pepsi($/Pepsi)

1

Price of paint($/can)

4

Price ofbasket ($)“Cost ofliving” ($)

10 10

1

1

8

18

New, improved paint introduced in March

1110

10

1

2

4


II. Fundamentals of National Income Accounting

A. Measuring GDP1. Product approach

2. Income approach

3. Expenditure approach

B. SavingC. International TransactionsD. Saving Identity from Balance Sheets


II.A.1 Product Approach to Measuring GDP

1999 $billions % of GDPPrivate Industries 8140.8 87.5

Agriculture, Forestry, and Fishing 125.4 1.3

Mining 111.8 1.2 Construction 416.4 4.5

Manufacturing 1500.8 16.1

Transportation and Public Utilities 779.6 8.4

Wholesale Trade 643.3 6.9

Retail Trade 856.4 9.2

Finance, Insurance, Real Estate 1792.1 19.3

Services 1986.9 21.4

Statistical Discrepancy -71.9 -0.8Government 1158.4 12.5

Federal 375.4 4.0

State and Local 783.0 8.4

Gross Domestic Product (GDP) 9299.2 100.0


II.A.2 Income Approach to Measuring GDP

• Income• Wages• Proprietors' income• Rents• Interest• Profits


Income Approach to Measuring GDP in the United States

2001-II $billions % of GDP

Compensation of Employees 6010.2 58.9

Proprietors' Income 745.7 7.3

Rental Income of Persons 140.8 1.4

Corporate Profits 761.3 7.5

Net Interest 554.3 5.4

Total (equals National Income) 8212.3 80.5

plus: Indirect Business Taxes, etc. 634.2 6.2

equals: Net National Product 8846.5 86.7

plus: Consumption of Fixed Capital 1336.2 13.1

equals: Gross National Product (GNP) 10182.7 99.8

less: Factor Income Received from R.O.W. 350.4 3.4

plus: Factor Income Paid to R.O.W. 369.3 3.6

equals: Gross Domestic Product (GDP) 10201.6 100.0


II.A.3 Expenditure Approach to Measuring GDP

• Private Consumption• Private Investment• Government Purchases• Net Exports


U.S. GDPExpenditure Approach

2001-II $billions % of GDPPersonal Consumption Expend. 7047.4 69.1Gross Priv. Domestic Investment 1667.6 16.3Government Purchases 1837.1 18.0Net Exports -350.4 -3.4GDP 10201.6 100.0


Components of Real GDP, 1987-I to 2001-II

-2000

0

2000

4000

6000

8000

10000 1

987-

I

198

8-I

198

9-I

199

0-I

199

1-I

199

2-I

199

3-I

199

4-I

199

5-I

199

6-I

199

7-I

199

8-I

199

9-I

200

0-I

200

1-I

billi

on o

f 199

6 do

llars

GDP

C

I

NX

G


U.S. Consumption Expenditures

2001-II $billions % of ConsumptionDurable Goods 844.9 12.0Nondurable Goods 2062.9 29.3Services 4139.6 58.7Personal Consumption Expend. 7047.4 100.0


Components of Consumption, 1987-I to 2001-II

0500

1000150020002500300035004000

198

7-I

198

8-I

198

9-I

199

0-I

199

1-I

199

2-I

199

3-I

199

4-I

199

5-I

199

6-I

199

7-I

199

8-I

199

9-I

200

0-I

200

1-I

bil

lio

ns

of

1996

do

lla

rs

Durables

Nondurables

Services


U.S. Private Investment

2001-II $billions % of InvestmentFixed Investment 1704.3 102.2 Nonresidential 1259.0 75.5 Structures 336.7 20.2 Equipment and Software 922.3 55.3 Residential 445.3 26.7Change in Business Inventories -36.7 -2.2Gross Priv. Domestic Investment 1667.6 100.0


Components of Investment, 1987-I to 2001-II

-200

0

200

400

600

800

1000

1200 1

987-

I 1

988-

I 1

989-

I 1

990-

I 1

991-

I 1

992-

I 1

993-

I 1

994-

I 1

995-

I 1

996-

I 1

997-

I 1

998-

I 1

999-

I 2

000-

I 2

001-

I bil

lio

ns

of

1996

do

lla

rs Structures

Equipment andsoftware

Residential

Change in privateinventories


U.S. Government Purchases

2001-II $billions % of Govt. PurchasesFederal 609.7 33.2 National Defense 396.1 21.6 Nondefense 213.6 11.6State and Local 1227.4 66.8Total Government Purchases 1837.1 100.0


Components of Government Purchases1987-I to 2001-II

0200

400600800

10001200

198

7-I

198

8-I

198

9-I

199

0-I

199

1-I

199

2-I

199

3-I

199

4-I

199

5-I

199

6-I

199

7-I

199

8-I

199

9-I

200

0-I

200

1-I b

illi

on

s o

f 19

96 d

oll

ars

Federal-Nationaldefense

Federal Nondefense

State and local


U.S. Net Exports

2001-II $billions % of ExportsExports 1079.3 100.0 Goods 754.3 69.9 Services 325.0 30.1Imports 1429.7 132.5 Goods 1197.3 110.9 Services 232.4 21.5Net Exports -350.4 -32.5


Trade in Goods and Services, 1987-I to 2001-II

-1500

-1000

-500

0

500

1000 1

987-

I 1

988-

I 1

989-

I 1

990-

I 1

991-

I 1

992-

I 1

993-

I 1

994-

I 1

995-

I 1

996-

I 1

997-

I 1

998-

I 1

999-

I 2

000-

I 2

001-

I

bil

lio

ns

of

1996

do

lla

rs

Exports: Goods

Exports: Services

Imports: Goods

Imports: Services


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


Saving Identity

• National Saving = Income - Consumption - Government Purchases

• Income = Consumption + Investment + Government Purchases + Current Account

• National Saving = Investment + Current Account


Graphical View of Saving Identity

Consumption

Current account

GovernmentPurchases

InvestmentNationalSaving

Consumption

GD

P

GD

P

GovernmentPurchases


Saving in the United States2001-II $billions % of GDPGross Private Saving 1314.4 12.9 Personal 81.5 0.8 Business 1232.9 12.1

Gross Government Saving 432.1 4.2 Federal saving 288.8 2.8 State and local saving 143.4 1.4

Total National Saving 1746.5 17.1

Investment 2013.7 19.7 Private 1667.6 16.3 Federal 99.9 1.0 State and local 246.2 2.4Current Account Balance -416.0 -4.1Investment + Current Account Balance 1597.7 15.7

Statistical Discrepancy -148.7 -1.5


Government Saving in the U.S.

2001-II $billionsGross Government Saving 432.2 Federal saving 288.8 Receipts 2092.7 Current expenditures 1903.4 Current surplus 189.3 Consumption of fixed capital 99.5 State and local saving 143.4 Receipts 1294.2 Current expenditures 1272.7 Current surplus 21.5 Consumption of fixed capital 121.9


Saving Identity in the U.S.



Investment includes government and private investment

Saving Identity, 1987-I to 2001-II

-10

-5

0

5

10

15

20

25 1

987-

I

198

8-I

198

9-I

199

0-I

199

1-I

199

2-I

199

3-I

199

4-I

199

5-I

199

6-I

199

7-I

199

8-I

199

9-I

200

0-I

200

1-I

perc

ent

of G

DP Private Saving

Government Saving

Current Account

Investment


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


Current Account

• Trade Balance = Exports minus Imports• Current Account Balance

• Trade balance plus• Net factor income from abroad

• Remittances and unilateral transfers


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


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


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


Net Exports

• Exports• Effect of exchange rate• Effect of foreign income

• Imports• Effect of exchange rate• Effect of domestic income• Tariffs


The J curve

• Exchange rate falls• Exports increase• Imports/exchange rate increases initially

• Real value of imports increases initially

• Net exports fall initially

Net Exports = Exports - Imports

Exchange rate


© 1998, Addison Wesley Longman, Inc.


The J Curve: An ExampleInitial

SituationShortRun

LongRun

Real Exchange Rate, e(VCRs/car)

10 8 8

Exports, X(cars)

60 65 75

Imports, IM(VCRs)

800 720 640

Real Imports, IM/e(cars)Real Net Exports, X - IM/e(cars)

80

-20

90

-25

80

-5


Real Exchange Rate & NX (Quarterly)

0

20

40

60

80

100

120

140

160

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Rea

l exc

hang

e ra

te in

dex

-5

-4

-3

-2

-1

0

1

2

NX

as

perc

ent

of G

DP

e

NX/GDP


III. Financial Markets and Economic Activity

A. Broad Asset CategoriesB. Rates of Return and Asset PricingC. Asset DemandsD. Asset Supplies


III.A. Broad Asset Categories

• Money• Bonds• Equity


Money

• Medium of Exchange• Store of Value • Unit of Account


Bonds

• Claims to Predetermined Schedule of Payments

• Term Structure of Interest Rates• Risk Premia Vary with Issuer and with

Seniority of Debt


Equity

• Claim on Physical Capital• Rate of Return

• Dividend• Capital gains or losses


III.B. Rates of Return andAsset 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"


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


Bond and Capital Demand

• Increasing in Own Rate of Return • Decreasing in Other Interest Rates

• Assets are substitutes

• Increasing in Wealth


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

Documents

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