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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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 2
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 3
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 4
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 5
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 6
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 7
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 8
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 9
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 10
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 11
Problems inConstruction of GDP Data
• Identification of Final Goods• Quality Changes• Underground Economy• Seasonality
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 12
Deficiencies in Concept of GDP
• Ignores Use of Exhaustible Resources• Ignores Deterioration of Environment• Does Not Value Leisure• Government Services Valued at Cost• Aggregation
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 13
I.C. Employment Statistics
• Labor Force• Demographic changes• Participation rates
• Secular changes– women
• Cyclical changes– secondary earners
• Seasonal changes– teenagers
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 14
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 Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 15
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%
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 16
U.S. Unemployment, 1890-1998
Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 17
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 18
Deficiencies with Overall Unemployment Rate
• Masks Differences Across Demographic Groups
• Qualifications of Job Seeker• Discouraged Workers• Does Not Measure Duration
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 19
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 20
U.S. Consumer Prices, 1800-1998
Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 21
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 22
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 23
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 24
Deficiencies of Price Level and Inflation Measures
• Substitution Bias• New Product Bias• Quality Change Bias• Outlet Bias
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 25
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 26
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 27
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 28
II.A.2 Income Approach to Measuring GDP
• Income• Wages• Proprietors' income• Rents• Interest• Profits
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 29
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 30
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 31
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 32
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 33
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 34
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 35
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 36
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 37
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 38
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 39
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 40
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 41
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 42
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 43
Graphical View of Saving Identity
Consumption
Current account
GovernmentPurchases
InvestmentNationalSaving
Consumption
GD
P
GD
P
GovernmentPurchases
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 44
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 45
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 46
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 47
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 48
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 49
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 50
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 51
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 52
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 53
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 54
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 55
© 1998, Addison Wesley Longman, Inc.
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 56
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 57
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 58
III. Financial Markets and Economic Activity
A. Broad Asset CategoriesB. Rates of Return and Asset PricingC. Asset DemandsD. Asset Supplies
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 59
III.A. Broad Asset Categories
• Money• Bonds• Equity
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 60
Money
• Medium of Exchange• Store of Value • Unit of Account
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 61
Bonds
• Claims to Predetermined Schedule of Payments
• Term Structure of Interest Rates• Risk Premia Vary with Issuer and with
Seniority of Debt
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 62
Equity
• Claim on Physical Capital• Rate of Return
• Dividend• Capital gains or losses
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 63
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"
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 64
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
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 65
Bond and Capital Demand
• Increasing in Own Rate of Return • Decreasing in Other Interest Rates
• Assets are substitutes
• Increasing in Wealth
The Role of Financial Markets in the Economy, Andrew Abel, October 1, 2001 66
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