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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
Overview
I. Measuring Economic Activity
II. Fundamentals of National Income
Accounting
III. Financial Markets and Economic Activity
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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I. Measuring Economic Activity
A. Users of Economic Data
B. National Income Accounts
C. Employment Statistics
D. Price Levels and Inflation
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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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
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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
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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
$15M of sugar + $35M soft drinks = $50M
• Value added
$40M of sugar + $10M soft drinks = $50M
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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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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U.S. Real GDP, 1869-1998
Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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Annualized Growth Rate of Real GDP
20
15
5
-10
-15
average = 3.5% per year
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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2001-II
1998-II
1995-II
1992-II
1989-II
1986-II
1983-II
1980-II
1977-II
1974-II
1971-II
1968-II
1965-II
1962-II
1959-II
1956-II
1953-II
-5
1950-II
0
1947-II
percent per year
10
Problems in
Construction of GDP Data
•
•
•
•
Identification of Final Goods
Quality Changes
Underground Economy
Seasonality
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Deficiencies in Concept of GDP
•
•
•
•
•
Ignores Use of Exhaustible Resources
Ignores Deterioration of Environment
Does Not Value Leisure
Government Services Valued at Cost
Aggregation
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I.C. Employment Statistics
• Labor Force
• Demographic changes
• Participation rates
• Secular changes
– women
• Cyclical changes
– secondary earners
• Seasonal changes
– teenagers
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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
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The Employment Situation
August 2001
Employed
millions
134.393
% of LF
95.1%
% of adult pop
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
100.0%
212.135
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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U.S. Unemployment, 1890-1998
Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.
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Unemployment
% of civilian labor force
Jan. 1987 - Aug. 2001
10
8
6
4
2
0
1987
1989
1991
1993
1995
1997
1999
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
2001
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Deficiencies with Overall
Unemployment Rate
• Masks Differences Across Demographic
Groups
• Qualifications of Job Seeker
• Discouraged Workers
• Does Not Measure Duration
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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
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U.S. Consumer Prices, 1800-1998
Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.
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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
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CPI Inflation in the US, 1801-1999
30
25
20
percent per year
15
10
5
0
-51800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
-10
-15
-20
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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CPI Inflation (12-month)
16
14
percent per year
12
10
8
6
4
2
0
1960
1965
1970
1975
1980
1985
1990
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
1995
2000
23
Deficiencies of Price Level and
Inflation Measures
•
•
•
•
Substitution Bias
New Product Bias
Quality Change Bias
Outlet Bias
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Example of Biases in the CPI
Basket = 1 Coke + 1 Pepsi + 2 cans of paint
January February
Price of Coke
($/Coke)
Price of Pepsi
($/Pepsi)
Price of paint
($/can)
Price of
basket ($)
“Cost of
living” ($)
March
1
1
1
1
2
1
4
4
8
10
11
18
10
10
10
New, improved paint introduced in March
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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
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II.A.1 Product Approach to
Measuring GDP
1999
Private Industries
Agriculture, Forestry, and Fishing
Mining
Construction
Manufacturing
Transportation and Public Utilities
Wholesale Trade
Retail Trade
Finance, Insurance, Real Estate
Services
Statistical Discrepancy
Government
Federal
State and Local
Gross Domestic Product (GDP)
$billions % of GDP
8140.8
87.5
125.4
1.3
111.8
1.2
416.4
4.5
1500.8
16.1
779.6
8.4
643.3
6.9
856.4
9.2
1792.1
19.3
1986.9
21.4
-71.9
-0.8
1158.4
12.5
375.4
4.0
783.0
8.4
9299.2
100.0
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II.A.2 Income Approach to
Measuring GDP
• Income
•
•
•
•
•
Wages
Proprietors' income
Rents
Interest
Profits
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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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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II.A.3 Expenditure Approach to
Measuring GDP
•
•
•
•
Private Consumption
Private Investment
Government Purchases
Net Exports
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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U.S. GDP
Expenditure Approach
2001-II
Personal Consumption Expend.
Gross Priv. Domestic Investment
Government Purchases
Net Exports
GDP
$billions
7047.4
1667.6
1837.1
-350.4
10201.6
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
% of GDP
69.1
16.3
18.0
-3.4
100.0
31
Components of Real GDP, 1987-I to 2001-II
8000
GDP
6000
C
4000
I
NX
2000
G
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
2001-I
2000-I
1999-I
1998-I
1997-I
1996-I
1995-I
1994-I
1993-I
1992-I
1991-I
1990-I
1989-I
-2000
1988-I
0
1987-I
billion of 1996 dollars
10000
32
U.S. Consumption Expenditures
2001-II
Durable Goods
Nondurable Goods
Services
Personal Consumption Expend.
$billions
844.9
2062.9
4139.6
7047.4
% of Consumption
12.0
29.3
58.7
100.0
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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4000
3500
3000
2500
2000
1500
1000
500
0
Durables
Nondurables
2001-I
2000-I
1999-I
1997-I
1998-I
1996-I
1994-I
1995-I
1993-I
1992-I
1990-I
1991-I
1989-I
1988-I
Services
1987-I
billions of 1996 dollars
Components of Consumption, 1987-I to 2001-II
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U.S. Private Investment
2001-II
Fixed Investment
Nonresidential
Structures
Equipment and Software
Residential
Change in Business Inventories
Gross Priv. Domestic Investment
$billions
1704.3
1259.0
336.7
922.3
445.3
-36.7
1667.6
% of Investment
102.2
75.5
20.2
55.3
26.7
-2.2
100.0
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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Components of Investment, 1987-I to 2001-II
Structures
1000
800
600
Equipment and
software
400
Residential
200
0
-200
1987-I
1988-I
1989-I
1990-I
1991-I
1992-I
1993-I
1994-I
1995-I
1996-I
1997-I
1998-I
1999-I
2000-I
2001-I
billions of 1996 dollars
1200
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
Change in private
inventories
36
U.S. Government Purchases
2001-II
Federal
National Defense
Nondefense
State and Local
Total Government Purchases
$billions % of Govt. Purchases
609.7
33.2
396.1
21.6
213.6
11.6
1227.4
66.8
1837.1
100.0
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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1200
1000
800
600
400
200
0
Federal-National
defense
Federal Nondefense
State and local
1987-I
1988-I
1989-I
1990-I
1991-I
1992-I
1993-I
1994-I
1995-I
1996-I
1997-I
1998-I
1999-I
2000-I
2001-I
billions of 1996 dollars
Components of Government Purchases
1987-I to 2001-II
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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U.S. Net Exports
2001-II
Exports
Goods
Services
Imports
Goods
Services
Net Exports
$billions
1079.3
754.3
325.0
1429.7
1197.3
232.4
-350.4
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
% of Exports
100.0
69.9
30.1
132.5
110.9
21.5
-32.5
39
Trade in Goods and Services, 1987-I to 2001-II
500
Exports: Goods
0
-500
1987-I
1988-I
1989-I
1990-I
1991-I
1992-I
1993-I
1994-I
1995-I
1996-I
1997-I
1998-I
1999-I
2000-I
2001-I
billions of 1996 dollars
1000
Exports: Services
Imports: Goods
Imports: Services
-1000
-1500
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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Saving Identity
• National Saving = Income - Consumption
- Government Purchases
• Income = Consumption + Investment +
Government Purchases + Current Account
• National Saving = Investment + Current
Account
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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Graphical View of
Saving Identity
Current account
Government
Purchases
Government
Purchases
Consumption
Consumption
GDP
GDP
Investment
National
Saving
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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Saving in the United States
2001-II
Gross Private Saving
Personal
Business
Gross Government Saving
Federal saving
State and local saving
$billions % of GDP
1314.4
12.9
81.5
0.8
1232.9
12.1
432.1
288.8
143.4
4.2
2.8
1.4
Total National Saving
1746.5
17.1
Investment
Private
Federal
State and local
Current Account Balance
Investment + Current Account Balance
2013.7
1667.6
99.9
246.2
-416.0
1597.7
19.7
16.3
1.0
2.4
-4.1
15.7
Statistical Discrepancy
-148.7
-1.5
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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Government Saving in the U.S.
2001-II
Gross Government Saving
Federal saving
Receipts
Current expenditures
Current surplus
Consumption of fixed capital
State and local saving
Receipts
Current expenditures
Current surplus
Consumption of fixed capital
$billions
432.2
288.8
2092.7
1903.4
189.3
99.5
143.4
1294.2
1272.7
21.5
121.9
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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Saving Identity in the U.S.
Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
46
Saving Identity, 1987-I to 2001-II
25
20
Private Saving
10
Government Saving
Current Account
5
Investment
2001-I
2000-I
1999-I
1998-I
1997-I
1996-I
1995-I
1994-I
1993-I
1992-I
1991-I
1990-I
1989-I
-5
1988-I
0
1987-I
percent of GDP
15
-10
Investment includes government and private investment
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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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
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Current Account
• Trade Balance = Exports minus Imports
• Current Account Balance
• Trade balance plus
• Net factor income from abroad
• Remittances and unilateral transfers
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
50
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
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51
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
52
Net Exports
• Exports
• Effect of exchange rate
• Effect of foreign income
• Imports
• Effect of exchange rate
• Effect of domestic income
• Tariffs
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
53
The J curve
Imports
Net Exports = Exports Exchange rate
• Exchange rate falls
• Exports increase
• Imports/exchange rate increases initially
• Real value of imports increases initially
• Net exports fall initially
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
54
© 1998, Addison Wesley Longman, Inc.
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
55
The J Curve: An Example
Real Exchange Rate, e
(VCRs/car)
Exports, X
(cars)
Imports, IM
(VCRs)
Real Imports, IM/e
(cars)
Real Net Exports, X - IM/e
(cars)
Initial Short Long
Situation Run Run
10
8
8
60
65
75
800
720
640
80
90
80
-20
-25
-5
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
56
2
140
1
120
0
100
-1
80
-2
60
-3
40
e
NX/GDP
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
-5
1976
0
1974
-4
1972
20
NX as percent of GDP
160
1970
Real exchange rate index
Real Exchange Rate & NX (Quarterly)
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
57
III. Financial Markets and
Economic Activity
A. Broad Asset Categories
B. Rates of Return and Asset Pricing
C. Asset Demands
D. Asset Supplies
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58
III.A. Broad Asset Categories
• Money
• Bonds
• Equity
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
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Money
• Medium of Exchange
• Store of Value
• Unit of Account
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001
60
Bonds
• Claims to Predetermined Schedule of
Payments
• Term Structure of Interest Rates
• Risk Premia Vary with Issuer and with
Seniority of Debt
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61
Equity
• Claim on Physical Capital
• Rate of Return
• Dividend
• Capital gains or losses
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62
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"
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63
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
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64
Bond and Capital Demand
• Increasing in Own Rate of Return
• Decreasing in Other Interest Rates
• Assets are substitutes
• Increasing in Wealth
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65
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
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66