Unit 8 – Basic Economic Concepts

government use of spending and taxation to influence economic activity
- balanced when tax revenue equals expenditures
- President presents budget to Congress who approves and sends back to President for signature/veto

Budget surplus - more tax revenue than expenditures

Budget deficit - more expenditures than tax revenue

central bank's actions that affect quantity of money and credit in an economy
- determined by Board of Governors of the Fed (Federal Reserve Board)
- Expansionary (accommodative/easy) when central bank increases quantity of money and credit
- Contractionary (restrictive/tight_ when central bank decreases quantity of money and credit

Keynesian economics - recognizes importance of government intervention
- suggested lower levels of taxation and more government spending
- named after John Maynard Keynes who published The General Theory of Employment, Interest, and Money

Classical and supply-side economics - believes lower taxes and less government regulation benefits consumers through greater supply of goods and services at lower costs
- supply creates demand by providing jobs + wages
- supply and deman

Monetarist theory - believes that quantity of money (money supply) determines overall price levels and economic activity
- too much money leads to inflations
- too few dollars chasing too many goods leads to deflation

Federal Reserve Board:
Changes in reserve requirements - raising the amount of funds commercial banks must leave on deposit with the FED will lower the amount of money available to lend out and raise interest rates and vice versa

Changes in discount rate - rate the Fed charges member banks when lending them money
- higher rates lower borrowing, reducing money supply with lower rates

Open-market operations - when the Fed buys and sells US Treasury securities in the open market under the direction of the Federal Open Market Committee (FOMC)
- purchasing Treasuries increases money supply
- FOMC purchases Treasuries from commercial banks causing the banks the have greater reserves
** MOST actively used Fed tool

Other
Federal funds rate - rate that MEMBER BANKS of the Federal Reserve System charge each other for overnight loans of $1m or more
- consider barometer of direction of short-term interest rates
- listed in daily newspapers and most volatile

Prime rate - preferential interest rate that large US money center commercial banks charge their most creditworthy corporate borrowers
- each bank sets its own prime rate
- large banks generally setting rate that other banks follow
- banks lower prime rates when Fed eases money supply
- banks raise rates when Fed contracts money supply

measure all the nation's import/export transactions with those of other countries for the year
- contains all payments/liabilities to foreigners (debits) and payments/obligations (credits) received from foreigners

comparing the country's exports to its imports

Trade deficit - more imports than exports
- excessive trade deficit can lead to devaluation of country's currency because country is converting/selling its currency to obtain foreign currency to pay for increasing imports

Trade surplus - more exports than imports
- excessive trade surplus can lead to strengthening of country's currency

Top down analysis - broad at the top and narrow at the bottom
- analysis starts with broadest measure of overall economy and narrows it down to select companies that best fit the objectives

Bottom up analysis - start at the bottom with a specific company and work upwards through the industry and then the economy

Business cycles - reflect fluctuations in economic activity by measuring variables such as unemployment and GDP. The 4 cycles are:
1. Expansion: also known as recovery, increasing business activity
- increasing inflation, production, stock market, property values, GDP
- decreasing unemployment, inventory
2. Peak: when economy cannot expand further
- decrease to GDP GROWTH rate, unemployment and hiring, growth of consumer spending and business investment
- increase to inflation
3. Contraction: business activity declines from peak
- increase in bankruptcies, defaults, inventories, unemployment
- decrease in hours worked, spending and demand, home construction, stock markets, inflation, GDP growth rate
4. Trough: business activity stops declining and levels off
- negative to positive GDP growth rate
- high unemployment
- possible increase in spending and housing
- moderate/decreasing inflation rate

Gross Domestic Product (GDP) - market value of all final goods and services produced within a country in a given period
- based on a constant dollar in the US

Recession - short-term contractions (2+ qtrs.)

Depression - long-term contraction (6+ qtrs.)

Growth industries - industries growing faster than economy because of technological changes, new products, or changing consumer tastes (ex: tech, bioengineering)
- usually retain all earnings to finance business expansion so usually little to no dividends

Defensive industries - industries least affected by normal business cycle
- generally produce non-durable consumer goods (food, pharmaceuticals, tobacco, energy)
- investors come here during sector rotations such as peak to contraction

Inflation: increase in prices measured by index such as CPI
- caused by excessive demand (demand exceeds supply) and monetary expansion (rapid increase in money stock in excess of growth rate)
- mild inflation can encourage economic growth
- high inflation reduces dollar's buying power
- inflation inertia: inflation doesn't immediately react to changes in economic conditions, it lags behind
- increase in real income: percentage increase in income higher than rate of inflation

Deflation: decline in prices, rare, and usually during severe recessions
- caused when supply is higher than demand for goods and services

total value of all final goods and services produced within US borders during the year, regardless of who generates it. It includes:
- personal consumption (largest by far)
- government spending
- gross private investment
- foreign investment
- value of NET exports

most common employment indicators are:
1. weekly initial claims for unemployment compensation
2. average workweek in manufacturing

- most economists believe 4% unemployment reflects full employment where wage pressures do not create undue inflation

measure of general retail price level
- compare current cost of buying basket of goods with previous year
- published monthly by Bureau of Labor Statistics (BLS)
- most common measurement of inflation

Core CPI - index for all items, NOT including food and energy due to their short-term volatility
- term created by the media, NOT the BLS

Leading indicators - economic activities that tend to turn DOWN before recession or turn UP before expansion. Used to predict economic activity 4-6 months ahead and include:
- money supply
- building permits (housing starts)
- average weekly initial claims for unemployment insurance
- average weekly hours, manufacturing
- manufacturer new orders for consumer goods
- manufacturer orders for nondefense capital goods
- index of supplier deliveries (vendor performance)
- interest rate spread between 10-yr Treasury bond and federal funds rate
- stock prices
- index of consumer expectations

Coincident (current) indicators - measurements that change with the business cycle and include:
- nonagricultural employment
- personal income - social security/veteran benefits/welfare
- industrial production
- manufacturing and trade sales in constant dollars

Lagging indicators - measurements changing 4-6 months after economic change that help confirm new trends and differentiate between short-term and long-term trends. They include:
- average duration of unemployment
- ratio of consumer installment credit to personal income
- ratio of manufacturing and trade inventories to sales
- average prime rate
- change in CPI for services
- total amount of commercial + industrial loans outstanding
- change in index of labor cost per unit of output (manufacturing)

Interest rate - cost of borrowing money

Nominal interest rate - actual rate of interest a borrower pays
- if inflation is expected, interest rates would likely increase > new loans and bonds will carry a nominal rate higher than the current ones available > older, lower interest rate bond prices decline

Yield curve - sloping line on a graph of short-/long-term interest rates
- reflection of investor expectations on inflation
- long-term curves are usually higher due to:
1. time value of money
2. reduced buying power due to inflation
3. increased risk of default over long periods
4. loss of liquidity with long-term investments

- positive yield curves are normal

- negative (inverted) yield curves are unusual and can be a sign of high current demand for money relative to supply or sharp increase in short-term rates
+ short-term interest rates are more sensitive to Fed policy
+ negative yield curves can mean interest rates rates have rapidly risen and soon retreat

Flat yield curves have the same yield throughout all maturities

Yield spread (credit spread) - difference in yields between debt
- Treasuries and corporate bond yields are commonly used
- tends to widen when economic conditions go bad, narrow when they get better
- can be used between issues of the same issuer (2-year Treasury vs 10-year Treasury)

Widening yield spread between corporate and government bonds predict recession
- investors chose safety of government bonds over higher corporate yields

Narrowing yield spread between corporate and government bonds predict expansion
- investors willing to take risks

** when making a yield curve, the most common method is to use bonds of a single issuer over varying maturities