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