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TARHEEL

CONSULTANCY
SERVICES
Bangalore India
THE
MACROECONOMICS
OF FINANCIAL
MARKETS
MACROECONOMICS ?
 What is macroeconomics?
 It is the study of the economy as a whole and the
variables that control it
 It refers to the study of government policy meant
to control and stabilize the economy
 It refers to the study of fiscal and monetary
policy
ECONOMIC GROWTH
 What is economic growth?
 Itis a measure of the expansion of the economy
over time
 How is economic growth measured?
 Over exactly the same period in the immediate
past
 Such as a calendar year or quarter
 Who is concerned with growth
 Wage and income earners
 Producers
 Macro-economic planners
FINANCIAL MARKETS &
MACROECONOMICS
 GDP is a measure of the level of economic
activity
 GDP and its components are measured in real
terms
 Thequantity of goods and services is measured
using the base year prices

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MACROECONOMICS (CONT…)
 Intermediate transactions are not counted in
GDP
 Take a PC manufacturer who acquires
components to make the product and
employs labour for the same
 The cost of the components will not be included
 The salary paid to production workers will not be
included
 Because the price of the PC includes these costs

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MACROECONOMICS
 What drives the GDP?
 Thelevel of activity in an economy at a point in
time is determined by the aggregate demand
 Spending on goods and services
 The higher the aggregate demand
 The more the induced production
 And the higher the GDP

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AGGREGATE DEMAND
 The aggregate demand can be divided into
the following sectors
 Consumption
 Residential investment
 CAPEX on the part of firms
 Government Spending
 Inventories
 Foreign Trade

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CONSUMPTION
 It refers to the spending by the household
sector on items which are consumed
 In
the US it accounts for over 60% of aggregate
demand
 It can be divided into
 Durables
 An expected life of at least 3 years
 These are extremely cyclically sensitive
 Non durables
 Their consumption is not very cyclical
 Services
 They account for over 50% of consumption in the US
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CONSUMPTION (CONT…)
 Households spend out of their income
 The percentage of after-tax income that is
consumed by a household depends on
 Thestate of the labor market
 Home prices
 If property prices of owned property is high there is
less of an incentive to save
 The state of the stock market
 The percentage of the post-tax income not
consumed by the household sector is
 The SAVINGS Rate

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RESIDENTIAL INVESTMENT
 Refers to the spending of individuals on
property acquisition
 Itis sensitive to interest rates
 People are less likely to borrow when interest
rates are high
 Expected state of the labor market
 Only newly built homes are included in the
GDP
 Saleof existing properties adds nothing to
economic activity

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CAPEX
 Businesses spend a lot on plant and
equipment
 Motor vehicles
 And computers
 Are big components of CAPEX in the US

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CAPEX (CONT…)
 Business CAPEX is a much smaller portion of
aggregate demand as compared to
consumption and housing
 But it has a disproportionate impact on changes
in GDP
 It usually bears large responsibility for business
cycle fluctuations

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CAPEX (CONT…)
 It is the key driver of an economy’s future
growth
 For
it determines the economy’s future ability to
produce
 Other growth drivers are
 Spending on education and training
 Like SKILL India
 Government spending on infrastructure

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GOVERNMENT SPENDING
 Government spending is a key economic
driver
 Butdue to political pressures to present
relatively balanced annual budgets it has been
shrinking in terms of relative importance
 Often it is undertaken to support aggregate
demand
 Dueto declines in demand related to
consumption and CAPEX
 For instance the onset of a recession will
typically stimulate government spending

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GOVERNMENT SPENDING
(CONT…)
 A distinction is required between spending
on goods and services and transfer payments
 Transfer payments are like social security or
welfare payments
 They are not a part of aggregate demand
 They simply transfer spending power (by way of
taxes) from one individual to another

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INVENTORIES
 Inventories have an impact on GDP only when
there is a change
 An increase in inventories will raise the GDP
 The addition to inventories reflects an economic
output
 A decrease in inventories will lead to a decline
 It reflects spending from other sectors that did
not lead to production but to a decline in stocks

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INVENTORIES (CONT…)
 Inventory accumulation foretells a future
decline in production
 Although it is positive for current economic
output
 Inventory usage is positive for future GDP
growth
 Although it is negative for current economic
output

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INVENTORIES (CONT…)
 In the case of accumulation
 Was it a result of overstocking to meet sales
which never materialized
 Or was it due to strong consumer spending
 Overstocking will indicate a decline in future
output
 Strong consumer spending does not
 With the increasing importance of the
service sector as a component of GDP
 Inventoriesare no longer perceived in developed
countries as an item of significance

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FOREIGN TRADE
 When aggregate demand exceeds the economy’s
output
 Imports will exceed exports
 If aggregate demand is less than economic output
 Imports will be lower than exports
 Net exports stimulate economic activity
 They depend on the relative price and quality of
domestic goods and services vis a vis foreign products
 The level of currency exchange rates
 The country’s aggregate demand relative to that of its
trading partners

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THE ROLE OF PROFITS
 Firms will produce goods and services only if
the activity is profitable
 If so employment will increase as will CAPEX
 Sometimes the cost structure may lead to a
loss if business activity is undertaken
 Ifso more demand will not translate to greater
production
 There will be no increase in employment or
CAPEX
 GDP will not grow

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MEASURING GDP
 GDP measures the monetary value of final
goods and services produced in a country
 It counts all the output generated within the
borders of a nation
 It refers to the output of capital and labour
of all residents of a country
 It consists of goods and services produced for
sale in the market and some non-market
items
 Defence related production
 Education services provided by the government
GDP VERSUS GNP
 GNP counts all the output generated by the
citizens of a country regardless of where the
output is generated
 So if a German company has a factory in the
US the output will be
A part of US GDP
 As well as German GNP
MEASURING GDP (CONT…)
 Not all productive activity is included in the
GDP
 Unpaid work performed by homemakers or
volunteers is not included
 Black-market activities are not included
 These are difficult to accurately measure
 Example: If a baker produces a loaf of bread
 Itwould be counted as a part of GDP if sold to a
customer
 But not if it is consumed by his family
GDP (CONT…)
 GDP does not factor in the wear and tear of
machinery, buildings and other items of
capital stock
 If the depreciation of such assets is
subtracted from the GDP we get the NDP
 Net domestic product
GDP (CONT…)
 It is important to prevent double counting to the
extent possible
 That is count the market value of goods and
services only once
 Exclude the following
 Cost of intermediate goods and services
 Market products meant not for consumption but
intended for further processing
 Transfer payments
 Financial transactions like buying and selling of
securities
 Welfare payments
 Cost of resold or second hand items
GDP (CONT…)
 GDP needs to be deflated to account for
inflation
 Else a perceived growth could be entirely
due to a increase in price levels
 Even real GDP gives an inaccurate picture
because it excludes self-provided household
services
MEASURING GDP
 There are three approaches to GDP
measurement
 The production approach
 The expenditure approach
 The income approach
THE PRODUCTION APPROACH
 It measures the value added at each stage of
production
 Valueadded is equal to total sales minus the
value of intermediate inputs
 Example if a baker bakes a loaf of bread
 Thevalue added would be the price of bread
minus the cost of flour and other inputs
THE EXPENDITURE APPROACH
 It adds up the value of purchases made by
final users
 Consumption of food, durables, and medical
services by households
 Investments in plant and machinery by
companies
 Purchases of goods and services by the
government and foreign nationals
THE INCOME APPROACH
 This approach sums up the income generated
by production
 Compensation received by workers
 The operating surplus of companies
REAL GDP
 GDP is calculated using current or nominal
prices
 Thus we cannot compare two periods without
making an adjustment for inflation
 To determine the real GDP the nominal GDP
must be adjusted to take price changes into
account
 Has GDP increased because more has been produced
 Or is it because prices have increased
 The Price or GDP deflator converts nominal
GDP to real GDP
IMPORTANCE OF GDP
 It gives information about the size of an
economy
 And its performance
 The growth rate of real GDP is often used as
an indicator of economic health
 An
increase is a sign that the economy is doing
well
 If real GDP is increasing
 Employment is likely to rise
 And people’s disposable incomes will increase
COMPARING TWO COUNTRIES
 A country’s GDP is measured in its domestic
currency
 Consequently when we compare the GDPs of
two countries we need to make an
adjustment
 The usual method is to convert the GDP of
each country into US dollars and then
compare
 The conversion may be done
 Using
market exchange rates or purchasing
power parity exchange rates
COMPARING (CONT…)
 The PPP exchange rate is the rate at which
the currency of one country would have to
be converted to another to purchase the
same basket of goods and services
 In Emerging Markets there is a large gap
between market and PPP exchange rates
 For most EMs the ratio of market and PPP
USD exchange rates is between 2 and 4
EXAMPLE
 Assume India’s GDP is 2,400,000,000,000 INR
 If the market exchange rate is 60 USD-INR,
the equivalent in USD is 40,000,000,000
 However if a basket of goods and services
costing $1 in the US were to cost only Rs 25
in India, the equivalent in USD is
96,000,000,000
GDP (CONT…)
 GDP however cannot reveal everything
 It is not a measure of the overall standard of
living of a country
 GDP does not factor in important issues that
may have an impact on people
 For example output may grow at the cost of the
environment
 It may result in the depletion of non-renewable
natural resources
 Also the overall standard of living depends on
the disparity in incomes of citizens
GDP (CONT…)
 Consequently an economy may have a high
GDP
 But there may be severe economic inequalities
 If so the overall quality of life may be poor
 To account for such factors the UN computes
a Human Development Index
 Itlooks at per capita GDP
 Life expectancy of citizens
 Average literacy levels
 School enrolment
THE OUTPUT GAP AND
INFLATION
 What an economy can produce – as opposed
to what it actually produces – is termed as
Potential GDP
 Itrepresents the level of output that the
economy will tend towards in the long run
 Potential GDP depends on
 The labor force – its experience, education, and
training
 Stock of physical capital
 Available natural resources
 Technology and innovation

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OUTPUT GAP (CONT…)
 The difference between potential and actual
GDP is the Output Gap or GDP Gap
 The mandate of the government and central
bank is to narrow the gap
 The wider the gap the greater will be the level
of unemployment
 Labor is not being fully utilized
 One way to reduce the gap is by increasing
government spending

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OUTPUT GAP (CONT…)
 There is a flip side
 The narrower the output gap the greater will be
the inflationary pressure
 The central bank needs to take cognizance
of what impact its policies will have on
prices
 This
could preclude it from taking actions to
narrow the GDP gap

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OUTPUT GAP (CONT…)
 During a recession the output of an economy
will contract
 In a boom period output will increase
 These cyclical ups and downs is termed as the
Business Cycle
 The issue for a policymaker is how close the
current output is to the economy’s long-term
potential output
 Thus the issue is not just whether GDP is up or
down
 Butwhether it is above or below the potential for
the economy
INFLATION
 As real GDP grows more labor is required
 This will tighten labor markets forcing an
increase in wages
 They will lead to a higher price for goods and
services since producers will pass on their costs
 Also the increase in supply may not
immediately keep pace with the growing
demand
 The result is inflation
 Thus the narrower the GDP gap the higher
the rate of inflation

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INFLATION (CONT…)
 Inflation could influence people’s
expectations
 If so it becomes self-fulfilling
 Labor wages and commodity prices will be based
on expected inflation
 High inflation will lead to higher expected
inflation which will lead to higher actual
inflation
 This cycle will go in
 And is very difficult to control in practice

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INFLATION (CONT…)
 External factors could produce one-off
changes in the price level
 Forinstance if crude oil prices were to rise there
could be an impact on the prices of goods and
services produced in an economy

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INFLATION (CONT…)
 Why is inflation an issue of concern for policy
makers?
 Business decisions are based on expected profits
 Profits depend on costs of inputs and labor and
prices of outputs
 During inflationary periods the decision making
process gets corrupted
 Businesses postpone production and CAPEX related
decisions
 Interest rates rise due to greater inflation premiums
 People earning fixed incomes lose real earnings due
to inflation

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UNEMPLOYMENT
 A low unemployment rate reflects a tight
labor market
 This leads to higher wages
 A high unemployment rate results in a
smaller increase in wages
 During a recession, wages may actually decline
 Wage gains will lead to price increases which
will manifest itself as higher inflation
 Thus low unemployment is associated with high
inflation

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OUTPUT GAP AND
POLICYMAKING
 For many central banks maintaining full
employment is a policy goal
 Full employment corresponds to an output
gap of zero
 Central banks seek to keep inflation under
control and the output gap is a determinant
of inflationary pressure
 The output gap gauges when an economy is
underperforming or overheating
 Thus it has implications for monetary policy and
fiscal policy
OUTPUT GAP AND MONETARY
POLICY
 During a recession the gap will be negative
 The central bank may stimulate economic
growth by lowering interest rates
 This will boost demand
 And prevent inflation from falling below the
target set by the bank
 In a boom the gap is positive
 This generates upward pressure on inflation
 The bank may cool the economy by raising
interest rates
OUTPUT GAP AND FISCAL
POLICY
 To reduce the output gap fiscal policy tools
may be used
 If the gap is negative an expansionary policy
may be used
 Raise
aggregate demand by increasing
government spending or lowering taxes
 If there is a positive gap contractionary
policies may be used to reduce demand and
combat inflation
 Through lower government spending
 Or increasing tax rates
IMPLICATIONS FOR A GLOBAL
ECONOMY
 The economies of the world are getting
increasingly integrated
 Thus the global output gap may affect
domestic inflation
 For instance if there is strong demand for a
product US producers will increase export
prices
 However since all producers are likely to hike
their prices, the price charged for domestic
sales will also rise
THE BUSINESS CYCLE
 This refers to the volatility of economic
growth and the different periods that an
economy goes through
 There are various phases of the cycle
 Economic growth – real output increases
 Economic boom – fast economic growth which
tends to be inflationary and unsustainable
 Economic downturn – the growth rate falls and
the economy heads towards a recession
 Recession – period of negative economic growth
and decline in real output
CAUSES OF THE BUSINESS
CYCLE
 Changes in interest rates
 Ifrates are cut borrowing costs will decline
 This will lead to higher spending by consumers
 And greater investments by producers
 The result will be economic growth
 However if the central bank were to increase
interest rates to tame inflation
 This will reduce consumer spending and investment
 Leading to an economic downturn and recession
CAUSES (CONT…)
 Changes in Property Prices
 Ifproperty prices rise there is a wealth effect
 Leads to higher consumer spending
 Consumer and Business Confidence
 Market participants are easily influenced by
external events
 If there is a succession of bad news
 People will cut back on investments
 And a minor slowdown may magnify into a bigger
recession
CAUSES (CONT…)
 Similarly if there is a string of good news
 Consumers will borrow more and banks will lend
more
 This will lead to economic growth
 Changes in government spending
 This has a multiplier effect
 A cut in public spending would lead to lower
aggregate demand and a rise in unemployment
 Unemployed citizens will cut back on spending
 This will deepen the effects of recession
 Similarly an increase in government spending can
give a big boost to economic growth
CAUSES (CONT…)
 The level of investments
 This depends on the rate of change of economic growth
 If growth were to decline firms will cut back on
investments
 Investments are highly volatile and small changes in the
growth rate can significantly influence the level of
investments
 Inventory cycle
 It can be argued that people buy certain luxury goods
every 4-5 years
 In a booming economy people will spend on such goods,
which will lead to faster economic growth
 In a recession people will not buy such products and the
slowdown will be magnified.
INTEREST RATES
 Finance is all about transfer of resources
from Surplus Budget Units (SBUs) to Deficit
Budget Units (DBUs)
 Interest rates equilibrate the SBUs’
willingness to extend credit and the DBUs’
need for it
 Peoplewho save are paid interest to forego
current consumption and lend
 That is they are paid for waiting to spend
 By borrowers who cannot wait and whose current
needs exceed the available capital

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INTEREST RATES (CONT…)
 If the GDP gap is substantial and there is major
unemployment people tend to save more
 Firms see less profitability in expansion and
tend to borrow less
 Obviously interest rates will decline
 When the GDP gap is narrow households will
save less
 Businesses will borrow more aggressively
 Interest rates will rise
 Inflationary expectations will rise
 This will further push up interest rates

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INTEREST RATES (CONT…)
 Thus when the GDP gap is narrow interest
rates will tend to accelerate
 When the gap widens interest rates will
decelerate

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FISCAL DEFICITS
 Budgets have fiscal deficits when
Government expenditure exceeds income
 Obviously the Government needs more funds
 For this the Government will borrow
 Sources of funds for the GOI
 Borrow within India
 Or from other countries
 Or supranational organizations like the IMF
 The money borrowed by a country’s
government is called the Public Debt

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FISCAL DEFICITS (CONT…)
 To pay interest on the debt the Government
has three options
 Increase tax rates
 Stimulate economic growth so that tax revenues
automatically increase
 Print more money to pay back the debt – debt
monetization
 Debt monetization will trigger inflation
 Rising taxes may lead to declining economic
activity

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FISCAL DEFICITS (CONT…)
 Deficits as a percentage of GDP may
decrease during economic booms
 Increase in tax revenues
 Lower unemployment – leading to reduced
welfare payments
 How can a country counter a deficit?
 Stimulate economic growth
 Reduce government expenditure
 Increase taxes

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FISCAL DEFICITS (CONT…)
 Governments issue bonds to finance their
deficits
 Issue of Treasury securities
 T-bills, notes and bonds
 Countries like the US have a unique
advantage
 The USD is a global currency
 Thus the US can run larger deficits than other
countries

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FISCAL DEFICITS (CONT…)
 Every year the deficit adds to the country’s
sovereign debt
 As the debt grows it increases the deficit in
two ways
 Interest has to be paid on a larger base
 This increases spending without any
accompanying benefits
 Second high debt levels may make it difficult for
a government to borrow
 Borrowers will demand greater interest to
counter this risk

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FISCAL DEFICITS (CONT…)
 Rising debts can lead to a debt trap
 Countries need to issue more debt to repay
interest and principal on existing debt
 At some stage interest rates may skyrocket
 If the trend continues a country may default

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IMPACT OF OIL PRICES
 Demand for oil is relatively price-inelastic in
the short run
 Ifoil prices were to increase cutting back on
consumption immediately is not feasible
 Nor is it easy to switch to alternative sources of
energy
 Thus higher oil prices mean greater imports
 This will lead to a greater trade deficit
 There will be a decline in domestic demand
 This will push up the unemployment rate

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OIL (CONT…)
 The drop in GDP will reduce oil demand
 This will lead to lower oil consumption
 Rising oil prices will push up the prices of all
goods since
 They are transported using vehicles using petrol
 Or else in some cases they use oil as an input
 Due to a higher cost of living labour may
demand higher wages
 Businesses may respond by hiking prices
 There could be an inflationary spiral

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QUANTITATIVE EASING
 In response to the financial crisis of 2008,
central banks of developed countries loosened
monetary policy
 Quantitative Easing is such a mechanism
 Itrefers to the purchase of financial assets using
central bank money
 In response to the crisis the BOE cut interest
rates sharply
 By 4½%
 But this was perceived as insufficient
 So the BOE announced the acquisition of public
and private assets using central bank money
QE (CONT…)
 How does QE work?
 The central bank electronically creates new money and uses it to
purchase gilts from private investors such as pension funds and
insurance companies.
 These investors typically do not want to hold on to this money,
because it yields a low return.
 So they tend to use it to purchase other assets, such as corporate
bonds and shares.
 That lowers longer-term borrowing costs and encourages the
issuance of new equities and bonds and that should stimulate
spending. 
 The policy was designed to help businesses raise finance without
needing to borrow from banks. 
 And also to lower interest rates for all households and
businesses.   
 
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QE (CONT…)
 The BOE originally purchased medium to long
dated gilts
 These securities amounted to 30% of the gilts
held by the private sector and 14% of annual
nominal GDP
 The British Government also authorised the
BOE to purchase commercial paper and
corporate bonds
QE (CONT…)
 How do asset purchases affect spending an
inflation?
 Purchases of financial assets by the BOE will initially
increase money holdings; push up asset prices; and
stimulate expenditure by lowering borrowing costs
 QE pushes up the price of assets and leads to money
in the hands of sellers
 Money is usually not a substitute for securities
 So sellers will rebalance their portfolios by buying
other assets
 This will raise the prices of assets till investors are
willing to hold the overall supplies of assets and
money
QE (CONT…)
 Higher asset prices mean lower yields
 And lower borrowing costs for firms and
households
 This will stimulate spending
 Spending is also stimulated by the fact the
higher prices mean more wealth for holders
 The BOE purchases were targeted at long-term
assets held by non-bank institutions
 Such as insurance companies and pension funds
 This would encourage these institutions to invest in
riskier assets such as corporate bonds and equities
QE (CONT…)
 Before QE began gilts were primarily held by
non-bank institutions and overseas investors
 Overseas investors may be inclined to invest
in foreign securities
 Thus they may convert the sale proceeds back to
their domestic currencies
 The supply of sterling would cause it to
depreciate relative to the USD and the Euro
 In the UK Gilt yields came down by 100 bp
QE (CONT…)
 If QE were to taper off, interest rates in the
US will rise
 There will be a reversal of FII into India
 There will be a fall in Indian equity prices
due to less demand from FIIs
 Less demand for the rupee will lead to
depreciation of the rupee
 Companies with unhedged Forex exposure
could suffer

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QE (CONT…)
 Slow down of capital inflows could hurt
investments
 This will lead to a lower than expected
growth in GDP
 A weakening rupee would mean rising
exports
 This will lead to inflationary pressure

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BOND MARKETS &
MACROECONOMICS
 Bond markets are affected by the following
factors
 The unemployment rate
 The inflation rate
 The budget deficit
 The foreign trade deficit
 Cyclical changes in the economy have
implications for the performance of bonds
BONDS (CONT…)
 Economic changes affect bonds in two ways
 The first is with respect to credit risk
 If the national economy is doing badly it affects
governments, federal, national, and local, as well as
corporations
 If the credit risk were to be perceived as having
increased, yields will increase and consequently
bond prices will decline
 Similarly if a foreign economy were to perform
poorly
 Bonds issued by entities in that country will be
impacted
BONDS (CONT…)
 Secondly a change in the interest rate
structure of a country will affect bonds
 Thus it is imperative that we understand the
factors that lead to shifts in the interest rate
structure
 The role of the federal government is to
sustain growth and control inflation
 Growth is measured by GDP
 Inflation is captured by various indices
 CPI; PPI; GDP Deflator
BONDS (CONT…)
 Any increase in inflation has a negative
impact on people earning fixed incomes
 In addition to managing GDP growth and the
level of inflation the government needs to
control the budget deficit and the current
account deficit
 The primary tools available to the
government are fiscal and monetary policies
FISCAL POLICY
 The term refers to the use of government
spending and/or taxation to influence the
demand for goods and services by
 Consumers
 Investors
 The government
EXPANSIONARY FISCAL POLICY
 If an economy is in recession the government
may cut tax rates
 This will put more money in the hands of
consumers who will spend a portion of it
 This increased economic spending is likely to
percolate down the economy increasing
aggregate demand
 It should be understood that one person’s
expenditure is another’s income
 Thusputting more money in the hands of
consumers has a multiplier effect
EXPANSIONARY (CONT…)
 An alternative policy is to increase
government spending
 This will directly stimulate aggregate
demand
 And it too will have a multiplier effect
CONTRACTIONARY FISCAL
POLICY
 If the economy is booming and there is
excess demand the government can increase
tax rates
 This will take away money from the hands of
the consumers and lead to a contraction in
demand and a lower rate of inflation
 The alternative is to reduce government
spending which will bring down aggregate
demand
ISSUES WITH FISCAL POLICY
 If the government is confronted with a
burgeoning budget deficit, fiscal policy may
not offer much of an option
 A deficit indicates a higher level of spending
 To stimulate an economy in recession the
government has to spend more and/or
reduce tax rates
 Both these actions will exacerbate the deficit
 Thus in such situations monetary policy
offers an alternative
MONETARY POLICY
 Monetary policy is implemented by
controlling money supply and short-term
interest rates
 Itis administered by the central bank
 Monetary policy attempts to control inflation and
remove its distortionary economic effects
 This is expected to lead to stable growth in the
medium to long term
POLICY TOOLS
 There are three monetary policy tools
available to a central bank such as the
Federal Reserve
 Reserve requirements
 Open market operations
 The discount rate
RESERVE REQUIREMENTS
 Changing the reserve requirements directly
influences the ability of banks to create
credit
 To stimulate recovery the central bank can
lower the reserve ratio
 This will increase the amount of loanable
funds which will circulate in the economy
 If the ratio were to be increased loanable
funds will be pulled out of the economy
which will lead to a reduction in the level of
economic activity.
OPEN MARKET OPERATIONS
 These involve purchases and sales of government
securities to inject or remove funds from the
banking system
 These transactions normally target a desired fed
funds rate
 Therate at which banks make overnight loans to one
another
 The fed funds rate is a short term rate
 By influencing it the Fed hopes to ultimately influence
long term rates and the level of economic activity
 This is the FED’s primary tool for implementing
monetary policy
OMO (CONT…)
 If the central bank wishes to slow down the
economy it will sell Treasury securities
 This will reduce the level of reserves in the
banking system
 The reduction in money supply will exert
upward pressure on the Fed Funds rate
 This will cause a slowdown in economic
activity
 Becauseboth consumers and businesses will face
higher borrowing costs
OMO (CONT…)
 If the central bank wishes to stimulate the
economy it will acquire Treasury securities
from dealers
 This will increase the amount of reserves in
the banking system
 The increase in money supply will lead to a
reduced Fed Funds rate and will stimulate
economic activity
 Asbusinesses and consumers react to lower
borrowing costs
THE DISCOUNT RATE
 This is the rate charged by the central bank
on loans to depository institutions
 By altering the discount rate the central
bank can influence monetary policy
 However borrowing from the central bank is
not a normal practice for most banks
 Thus changes in the discount rate are largely
symbolic
 Ifthe central bank wants to signal that it desires
lower interest rates it will reduce the discount
rate
BUDGET DEFICITS
 A budget deficit occurs when government
expenditure is higher than the revenue
received in the form of taxes and other
sources
 This shortfall has to be covered by public
borrowing
 The sum of all budget deficits over time is
the National Debt
 Itis the total of all funds borrowed and owed to
the investing public
BUDGET DEFICITS (CONT…)
 There is no limit in principle as to how much
the country can borrow for the federal
government can print money as and when
required
 However excessive spending, which
consequently leads to printing of money, can
have severe inflationary effects
 There are three negative facets of budget
deficits
 The Crowding-Out Effect
 Reliance on External Debt
 Displacement of Capital
CROWDING OUT EFFECT
 One manifestation of this is increased
competition for a given pool of funds
 When the federal government steps in to
borrow from the public it is effectively
competing with companies
 This could lead to rising interest rates which
could cause projects to become unviable
 Thus federal government borrowing crowds
out private investment
CROWING OUT EFFECT (CONT…)
 The crowding out effect also shows up as
tighter monetary policy
 Budget deficits effectively leads to an
increase in aggregate demand and economic
growth
 The central bank may judge this as
inflationary and hike interest rates
 The higher cost of capital will discourage
consumer spending and corporate borrowing
 And result in a slowdown in the economy
RELIANCE ON EXTERNAL DEBT
 External debt is created when a nation
borrows from people who are not its own
citizens
 When this debt is repaid there will be dollars
in the hands of foreigners
 If
these investors choose to sell the dollars it
would result in the dollar getting devalued
 If foreign bondholders choose to sell their
holdings prices will fall and interest rates
will rise
DISPLACEMENT OF CAPITAL
 As government deficits mount investors will
be left holding large quantities of
government bonds
 This means that corporations can raise less by
way of debt and equity
 This could lead to a decline in economic growth
and quality of life
CURRENT ACCOUNT DEFICIT
 CAD is the amount by which national
investment exceeds national savings
 It can be divided into three parts
 Balance of trade
 Income
 Transfers
BALANCE OF TRADE
 This the difference between imports and
exports of goods and services
 If imports are more than exports there is a
trade deficit else there is a trade surplus
INCOME ACCOUNT
 This records income received from foreigners
versus payments made to foreigners
 The major component of income is the
interest payment on debt held by foreigners
as well as interest earned on foreign assets
held by the country’s citizens
TRANSFERS
 This records transfer payments to and from a
country
 One of the major components for the US is
the aid that it gives to various countries
around the globe
CONTROLLING CAD
 The major impact of a rising CAD is on the
exchange rate
 A high deficit would mean that imports
exceed exports which would lead to large
balances of the USD in foreign hands
 If this were to be liquidated the dollar will
depreciate
 One way to address a trade imbalance is by
devaluing the domestic currency
 Thiswill lead to a reduction in imports and an
increase in exports
INFLATION
 Inflation is usually categorized into two
causal groups
 Demand Pull Inflation
 Cost Push Inflation
DEMAND PULL INFLATION
 This occurs when aggregate demand rises
more rapidly than what firms producing
goods and services can supply
 Thus too much demand is chasing too little
supply
 Because of the relative scarcity prices will be
pushed upwards
 In such a situation wages and salaries will also
increase
 This is because to meet the growing demand
producers will be compelled to recruit
 This will further exacerbate inflationary pressure
DEMAND PULL (CONT…)
 An event such as war can trigger off a bout
of inflation
 High government spending on defence
related products will push up aggregate
demand
 If supply cannot keep pace, the consequence
will be inflation
COST PUSH INFLATION
 Inflation can rear its head at a time when
demand is low and unemployment is high
 This is termed as cost push inflation
 This has little to do with demand
 In involves an increase in the cost of the factors
or production
 Both raw materials and wages
 Producersin such situations will pass on the
increased costs to the consumers
COST PUSH INFLATION
 In the 70s and early 80s countries like the US
experienced Stagflation
 Highunemployment
 And High inflation
 This can be explained using the theory of
cost push inflation
 During this period there was a steep increase in
the price of crude oil which pushed up the prices
of all products
INFLATION (CONT…)
 Market power inflation is a type of cost push
inflation
 It is also known as profit-push inflation
 It refers to the ability of monopolist
producers to set prices at a high level and
force consumers to absorb them
 Wage-price spiral inflation refers to
situations where unions cause an increase in
worker wages which causes a hike in prices
and in inflation
INFLATION (CONT…)
 Expectation inflation is caused by an
inflationary psychosis
 It refers to a crippling fear of inflation that
forces consumers and producers to take
actions that lead to higher prices
 Full employment inflation is caused when
demand is strong and all available resources
are fully engaged
 Cateringto this demand will lead to greater
costs and prices
FULL EMPLOYMENT INFLATION
 Causes
 Producers are forced to use inferior resources
and less competent labour
 Producers are forced to pay over-time
 Factories are over-utilized leading to a higher
rate of machine depreciation
 Workers are over-stretched leading to lower
productivity
 Producers need to pay more to retain efficient
workers

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