Macroeconomics & Finance

Introduction & Chapter 3

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.

Language of Macroeconomics: Data and Definitions

Chapter 3

Objectives

Use measures of prices and quantities to calculate economic aggregates.

Calculate the “real” aggregates. Use measures of prices and quantities to

calculate aggregate prices. Adjust nominal quantities into real quantities

using an arbitrary reference year.

Aggregation Problem

Most individual economic goods have a natural measure in terms of quantities (countable objects, weight, volume, etc.)

Use # of domestic currency units (i.e. dollars) that must be exchanged to purchase one unit of them as the price.

In macroeconomics we are concerned with measuring quantities of groups of goods that have no natural, common unit of measure.

We must combine (aggregate) these goods in some way.

Quantity Aggregates: Nominal

To group a set of goods n = 1…N calculate a weighted sum of the quantities of each good (quantity of good n =qn)

w1q1+w2q2+……wNqN

All market goods do share one unit of measure, the price at which they are sold (price of good n = pn).

To aggregate quantities, economists use prices as weights.

p1q1+p2q2+……+pNqN

Commonly Used Aggregates

Gross Domestic Product (GDP) is the output of (new) goods and services produced within a country in a given period of time.

– Most commonly used to measure productivity of a country. Gross National Product (GNP) is the output of (new) goods and

services produced by the nationals of a country. – Most useful for measuring the income of a countries residents

(since producers keep the income generated by the goods they produce).

GDP is a measure of the production of economic goods within the country and is measured through three methods.

Expenditure Method

The Expenditure Method Adds up the spending on new, final domestic goods.

Does not include spending on used goods or intermediate goods,

– Intermediate goods which are used in the same period to produce other goods (i.e.. Flour is an intermediate good of Bread).

Expenditure Categories– GDP = C + I + G + EX – IM– GDP = Consumption + Investment (including inventory

investment) + Government Consumption + Exports – Imports

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

140.00%

160.00%

% of GDP

HouseholdConsumption

Government Consumption

Investment Exports Imports

Production Method

Production Method – Add up all the value added of all domestic firms.

A firm’s value added is the difference between sales and cost of materials

GDP = T + NT – GDP = Traded Goods + Nontraded Goods– GDP = {Agriculture + Construction + Manufacturing} +

{Utilities + Transport + Communication + FIRE + Trade (Retail & Wholesale) + Services}

AF

F

Min

ing

Man

ufac

turin

g

Util

ities

Con

stru

ctio

n

Tra

de

Tra

nspo

rt

FIR

E

Ser

vice

s

Land

lord

1980

0

0.05

0.1

0.15

0.2

0.25

% of GDP

Production Account

1980

2001

Income Method

Income Method – Adds up all the income paid out by producers located within domestic borders.

Conceptually, income includes payments to labor and capital.

GDP = Worker Compensation + Net Interest Payments + Proprietor’s Income + Corporate Profits

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

Agents Activity Value

Added

Proprietor’s Income

Expenditure

Farmer Farmer sells $100 wheat to Miller

$100 $100 .

Miller Miller sells $200 flour to baker

$200-$100

$100

$100 .

Baker Baker sells $300 bread to storekeeper

$300-$200

$100

$100 .

Storekeep Storekeeper sells $400 bread to customers

$400-$300

$100

$100 $400

Time Series

Economists and government statisticians periodically (monthly, quarterly, annually) measure a large number of quantity aggregates.

Each series of aggregates is useful for comparing the state of the economy across time.

If we look at some quantity aggregate over time, there are two approaches to aggregation

1. Nominal Aggregation2. Real Aggregation

Nominal Aggregates

Nominal Aggregate: Use the contemporary price of each quantity as the weight at each point in time.

PQt = pt,1qt,1+pt,2qt,2+……+pt,Nqt,N

Measures the dollars spent on goods at different points of time.

Since number of dollars circulating in the economy frequently changes without underlying changes in production of goods, this can be a misleading measure.

Real Aggregates

Real Aggregates: Use the price of each good from one fixed year (the base year) as the weight at each point in time.

Qt = pB,1qt,1+pB,2qt,2+……+pB,Nqt,N

Since the weight on each type of good is constant across time, this measure captures changes in real production.

May be misleading if there are changes in relative prices of goods over time/ changes in sectoral allocation over time.

Choose base year close to period of interest so there are fewer sectoral shifts.

Nominal vs. Real GDP

0

200000

400000

600000

800000

1000000

1200000

1400000

65 70 75 80 85 90 95 00

Nominal GDP Real GDP (Base Year 2000)

HK

$ M

illio

n

Quarterly GDP

0

100000

200000

300000

400000

500000

1975 1980 1985 1990 1995 2000

Real GDP Trend Growth

HK

$ M

illio

n

Business Cycles

-.12

-.08

-.04

.00

.04

.08

1975 1980 1985 1990 1995 2000

Hong Kong Business Cycle

Seasons

-.10

-.05

.00

.05

.10

1975 1980 1985 1990 1995 2000

Seasonal Factors

Hong Kong Seasonal Fluctuations

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

http://www.info.gov.hk/censtatd/eng/hkstat/index1.html

2. Hong Kong Monetary Authority:Money and Banking StatisticsSee Monthly Statistical Bulletinhttp://www.info.gov.hk/hkma/eng/statistics/msb/index.htm