Chapter 5 Economics and Investment Analysis Macroeconomic Theory Central Banks Microeconomic Theory Statistics Financial Mathematics Fundamental and Technical Analysis Yields and Ratios Valuation This syllabus area will provide approximately 21 of the 100 examination questions1. Macroeconomic Theory Economic activity: Production, Distribution, and Consumption of Goods and Services. Economies is the study of Economic activity. Resources/Factors of production: land, labor and capital and entrepreneurship/organization (this 4 one, entrepreneurship has been added by the recent economic theory called Neoclassical The study of economics can be divided into two broad categori Microeconomics & Macroeconomics. Microeconomics Macroeconomics ‘Sinaller picture view of the economy. Bigger picture view of the economy Study of decisions made by: ‘Study of decisions made by: 41) Individuals and 2) Firms 41) Individuals, 2) Firms, 3 (Government In a particular market Of the whole economy like National Income, Employment and Inflation Households Firms Comprises the owners of the factors of | Entities which result from the combination of the three production and their input into economic | primary resources (land, labour and capital) and their processes through thelr labour, the use of | integration by enterprise or organization. land and the resources which are ultimately part of a commonwealth and the application of capital, 441 National Income Circular Flow of Economy How money flows through the economy. Economy consists of two principal actors, also called agents on economy. 1) Individuals/households/consumers and 2) firms. Economic output cycle Flow of households supplying the factors and the demand for their utilization from firms. Firms produce engaging factors from households who consume production. ee ss Fume produce im goods and services aoc } aoe wousenowes Income and/or expenditure cycle Flow of money through the system in which consumers or households purchase goods and services. (their expenditure) from the firms. The firms then use this income or revenue to purchase labor, land and capital from the households, Page 2 of 65The Income and expenditure cycle Goods and services from households \ x J of production to housen 1.1.1 National Income Economic activity or a country's economic health/National Income may be measured in different ways. + Gross domestic product GDP + Gross National Product-GNP + Balance of Payments-BOP Gross domestic product GDP In simplified economy/simple model Individuals or consumers and Firms. My, an economy comprises of: Circular flow of income - Money flows from producers to workers as wages and flows back to producers as payment for products. In short, an economy is an endless circular flow of money. ‘Simplified Model of the Economy _ ET — / : \ 3 a oe ee \ y / /!National Income of a simplified/simple model economy: Can be measured in one of three ways: + Individuals’ the total income- paid by firms to individuals. + Individuals’ total expenditure on firms’ output-what individuals consume. + The value of total All should yield the same figure. The most common method of calculating GDP is the expenditure method, This simple economy is just a simple Agrarian barter-based sociely, whose economy is based on producing and maintaining crops land. However, as economies develop from simple agrarian barter-based societies through to manufacturing- based and finally services-based, or post-industrial economies with developed monetary and financial Page 3 of 65the measuring the economic activity/National Income becomes a bil complex because of the following factors. + Individuals save some of their income for future consumption . Business investments in both new and replacement capital + Government spending and taxation decisions + Firms' imports and exports to overseas economies. ‘These above are classified as: Teakages Expenditures/injections Removing money from economy Tnireducing money info The economy ‘Taxes, Imports, Savings Govt spending, Exports, investments Reduce the overall flow of income Tnarease the overall fiow income Circular Flow of Income Taxes Imports savings Government Exports. Investment ‘Spending 1.2 Gross Domestic Product and Gross National Product National income of an open economy is measured in two ways. GP (1.2.1) GNP(L22) J calendar year. [they produce, lBroadest financial measurement [Takes into account net income from foreign investments. Iknown as economic grovAh in between calendar years, Inches property income lncludes production by forelgn companies Net property incor lExcludes production by domestic companies abroad Ionp= IGOP being gross is because itis calculated before depreciation| 5, llowance in the capital stock ofthe economy. = wages, profits, intrest and dividends, [Consumption + Investment + Govt Spending + Export country Consumption — represents personal expenditure of households’ goods and services. Investment - represents expenditure by businesses and individuals for capital investment. Government spending — government spending on goods and public sector jobs. Page 4 of 65 IMost commonly used measure of economic activity |For te economies that are heavily dependent on foreign earnings. IMarket value of a final output of gis made within a country during|market value of goods and services made by a country, wherever leo #0 + 14G+ x—m) + Production by county owned factor of producton hel abroad, |. Production by foregn owned factors of producton in teExports — Imports Whether GDP is higher or GNP higher, depends upon the economy. Like GNP of US is higher than GDP because mass production by US companies happens abroad. Final output What purchased by the end user. Intermediate output of one process becomes input of another process, so to avoid double counting, the concept of Value added is considered Market value: the value of output at current prices inclusive of indirect taxes, such as VAT National Income Accounts (NIAs} A bookkeeping system that a government uses to measure the amount of the country’s economic activity in a given time period. Economic activity is measured either in terms of income or expenditure or output and is stated in terms of GDP or GNP. GDP is reported in ats. 1) the percentage change within the most recent quarter of reference and 2) the current quarter's relationship to the same period a year ago. Capita stock- the plant, equipment and other assets used in production within an economy. GDP is a lagging indicator, why? Because it takes time to compile and is often subject to changes when more up-to-date information becomes available. As a result, some observers may wish to pay more attention to the general trend as opposed to absolute figures. 1.2.3 Uses and Limitations of GDP Measures Uses of GDP GOP per capita & GDP Growth are used as barometers of national prosperity/Standard of Living GDP again can be measured in of Nominal GDP Real GDP 'Value of @/s produced in a county at current markel]Vaiue of gs produced in a country at constant Price, base year Ptice/nominal terms prcelreal price [Nominal GDP at infated price Effects of infation are taken out Ino ination, then nominal and real GDP wil be same Reflects changes in real production, not due to price change. If Nominel GDP > Real GDP, it means ther is inflation If there is no change in production, no change in real GDP it Nominal GDP < Real GDP, itmeans there is deflation. Economic growth is alvays expressed in eal terms. |GDP Defator estabishes the relationship between Nominal an] lReal GDP. So, basically the difference between nominal and real GDP is all about inflation. Nominal GDP Vs Real GDP - example Year: Yr2019 Yr2018 Production-Mt 400 700 Rate 55 (inflation)-10% 50 Value—say 5,500 5,000 Nominal GDP @ current year price 5,500 (100 X 55) Real GDP @ base year price 5,000 (100 X50) Page 5 of 65| copper 600 at he County Capita Formula = Population of Vat County | aaa abaas ‘The GDP deflator, what * GDP Deflator establishes the relationship between Nominal and Real GDP. % Indicates how much is the inflation % ¢ The difference between Nominal and Real GDP is that of inflation, we say deflator, ‘ Means, Real GDP + Inflation on Real GDP = Nominal GDP + Inflation, say 4% means, the Nominal GDP is 4% more than Real GDP GDP Deflator_ _NominalGOP , 199 Formula RealGbP_* Real GDP = Nominal GDP / Deflator, Nominal GDP = GDP Deflator X Real GDP_ Example: Nominal GDP is $100,000, and real GDP is $45,000 GDP deflator will be 222 ($100,000/$45,000 * 100 = 222.22). Itindicates how much % Nominal GDP is over and above the Real GDP. So, the current year price is 222% more than the base year price. Limitations of GDP: Economic growth may benefit a narrow section of society rather than society as a whole depending On the composition of and distribution of GDP. GDP only captures those aspects of economic activity that can be measured. Value of leisure activities not accounted for in GDP Certain activities in a shadow economy also go unrecorded because of tax evasion. GDP data is complex to collect and time consuming. GDP figures are constantly revised upwards or downwards owing to the time lag in collecting data. GDP Growth Rate-Example: GDP of 2018 15 trillion USD, In 2019, iis 15.5 Tn USD, Real GDP growth Growt! 1=3.33% (15.5-15/15X100) 1.3 The Economic Cycle (Business cycle) Trend Growth Rate Trend rate of growth defines an economy's potential output level or full employment level of output. Same as potential growth rate Average sustainable non-inflationary increase in GDP growth over time, caused by an increase in a country’s productive capacity, potential output. Growth in the long run means sust: growth rate or trend rate of growth, comes from many sources. the growth and produotivity of the labor force domestic savings capital attracted from overseas. replacement of obsolescent capital equipment. infrastructure If the economy grows at it trend growth rate: There will be no output gaps. Page 6 of 65‘Trend growth is reported as Either being above 50 = growing, or Below 50, meaning contraction. ‘There is a strong interrelationship between economics and investment. ‘The performance of various sectors of the economy is heavily influenced by economic factors such as unemployment, inflation, interest and exchange rates et. When do we say the Ec i n? A significant decline in real GDP. When growth rate slows because output contracts If economic growth rate tums negative for at least 2 consecutive calendar quarters, The economy enters into a deflationary period. Results in spare capacity and unemployment. ‘Output GAP = Potential/Capacity oufput VS Actual Output Potential Capacity Output ‘Actual Output economic condton with 100% employment across al sector, steady| fey ate ‘Aso called ful employment level at tts escurces are productively employed [Maxum sustainable output ofthe economy - ‘utp, i, the sustainable level of output an eccromy can produce when|ReaHime measurement of al ouput at any rte or any given tne, [ssn state of business ofthe economy Positive Output GAP output > Potential Output joe demand, more market pic, inflation [More employment, rise in price, sales and earrings grow Negative Output GAP ouput < Poertial Output demand, low market price, deflation decine in sales and earings growth ate is slowing down ‘urring below capacity. wage growth an an overall correction ofthe money supply is below 50. Economic cycle =the movement of the economy from peak to trough and trough to peak. The state of the economy goes through six stages. Recovery, Acceleration, Boom, Overheating, Deceleration and Recession. Factors such as GDP, interest rates, total employment, and consumer spending can help determine the current stage of the economic cycle. Page 7 of 65Expansion/Acceleration Demand grows, more production, low interest rates (accommodative monetary policy) for easy borrowings, more employment, more expansion/capex, profits begin to rise and so the stock prices, GDP also begin to rise, and the economy gets its ‘boom’ under way. Peak/Boom The highest point of the economy, before the recession begins. ‘The economy reaches a maximum rate of growth, As consumer demand rises, there's a point at which businesses may no longer be able to ramp up (increase) production and supply to match the increasing demand. The two main signs of an overheating economy are: Rising rates of inflation and an unemployment rate that is below the normal rale for an economy. Overheating Overheating is the peak of boom of an economy that is expanding at an unsustainable rate. The economy is picking up speed leading to increased inflation. It occurs when its productive capacity is unable to keep pace with growing aggregate demand. Itis generally characterized by an above-trend rate of economic growth, where growth is occurring at an unsustainable rate. Boom periods are often characterized by overheating in the economy. Causes of an overheating economy range from external economic shocks to asset bubbles. This stage is unsustainable, and the deceleration starts. Deceleration/Contrac ‘The Boom cannot sustain forever and hence the business may begin to see a topping-off in profit despite charging high prices because of high manufacturing costs. This stage is called deceleration. Corporate profits and consumer spending begin to fall. Overall, economic activity slows, stocks enter a bear market, and a recession typically follows. Trough/Recession and severe contraction (depression) Recession can be mild or severe (depression) Significant decline in national output, typically lasting a minimum of six months. The lowest point of output in a recession, before a recovery begins. Recession lasts from peak to trough, and an economic upswing runs from trough to peak. ‘The economy hits its trough, bottoms out. All stimulating measures are taken and then a new cycle, recovery starts. Recovery Policies enacted during the contraction phase begin to bear fruit. Businesses that retrenched during the contraction begin to ramp up again. ‘Stock values tend to rise as investors see greater potential returns in stocks than bonds. Production ramps up to meet rising consumer demand, business expands, more employment, more income, and increase in GDP. The lenath of a cyck tween: Between successive economic peaks or between successive economic troughs. Usually, it takes over a period. Duration of each stage is difficult to quantify. The duration and characteristics of economic cycles can vary widely as they are influenced by various factors 1) fiscal and monetary policies 2) technological advancements 3) geopolitical events 4) shifts in consumer 8) investor confidence 7) accommodative monetary policy (low interest rate), 8) Page 8 of 65fiscal stimulus measures (tax cuts) There is a strong relationship between economics and investment; and the performance of various sectors of the economy is heavily influenced by economic factors like - Shifts in interest rates can impact on the attractiveness of assets such as bonds - Fluctuations in consumer spending patterns directly affect industries such as retail, hospitality and leisure; and - Changes in commodity prices (driven by economic growth or contraction) can significantly impact on companies engaged in resource extraction and production. ‘Summary Global approach to investing Reducing exposures to those economies slowing down and preferring those economies that are growing. There is often a .etween the economy and investment markets. There is a strong interrelationship between economics and investment. Asset markets sometimes pick up before actual recovery owing to sentiment and forward forecasting. Hence, that is why markets are referred to as based on expectations. If those expectations are not met or they change, investment markets react. 1.4.1 The Balance of Payments and International Trade Learning Objective Understand the composition of the balance of payments. Factors behind and benefits of international trade and capital flows: current account; imports; exports; Effect of low opportunity cost producers 1.4.2Balance of Payments-BOP and a Country's Economy ‘Summary of all the international transactions in FX, between a country and rest of the world Inflows and outflows of FX of an economy. It impacts a country’s economy. Allinternational FX transactions are grouped under: Current account transactions (short-term) and Capital account transactions (long-term). Page 9 of 65tomas Pr ie Poser? a Cur} The Current Account Balance: CAB Exports of goods (visible) and services (invisible) - Import of goods and services +Dividends from overseas assets/investments brought in - Income on investments taken out + Remittances from nationals working abroad. - Remittanc from fc n nals are taken out. Current Ac Balance Current Account is used to keep records of the current account transactions above. CAB should be Zero, theoretically. A surplus in CAB means inflow of FX > outflow, good, economy is a net creditor to the rest of the world, The currency becomes strong, more imports, less exports. Imports > Exports = trade deficit, Exports> Imports = trade surplus The visible trade balance: The difference between export and import of goods. The invisible trade balance: The difference between export and import of services. ‘The capital account, records international capital transactions as follows: Capital transactions relate to investments in business, real estate, bonds and stocks. Transactions relating to ownership of fixed assets Purchase and sale of domestic and foreign investment assets ‘Those capital ac transaotions can be divided into categories: 1. Foreign Direct Investment (FDI)- where an overseas firm acquires a new plant or an existing business. 2. Portfolio investment - trading in stocks and bonds, and 3. Other investments - which include transactions in currency and bank deposits. or else deficit or surplus Page 10 of 65en Account For the balance of ‘The current account must equal the capital account rent i resulting from a count ‘a net importer of overseas goods and services and this deficit must be met by a net inflow of capital from overseas, taking account of lany measurement errors and any central bank intervention in the {oreign currency market. ‘The subject of the balance of payments is intrinsically linked to. international trade, exchange rates and international competitiveness. Exchange Rates The rate at which one country's currency can be traded for another country's currency. The price of one currency in terms of another, impacts the BOP. Currency Appreciation Currency Depreciation TEUR from 4.00 AED, now to AED 3.90 TEUR from 4.00 AED, now to AED 4.15 Nominal Value rises Nominal Value falls Exchange rate rises/goes up Exchange rate falls/goes down AED aitractive ‘AED not attractive ‘AED became strong ‘AED became weak Imports will increase, less expensive Imports will decrease, more expensive Infiations falls Inflation rises Exporis reduces, exporis less competitive Exporis increases, exporis more competitive Demand for local product falls Demand for local product increases Cost of production tess Cost of production more Balance of payments surplus Balance of payments deficit Result of higher interest rate, more FDI Result of reduced interest rate Economic outlook better Economic outlook weak Demand for focal currency rises Demand for local currency falls Es fecting exchange rai Demand and supply in the forex market. Economic outlook Inflation Interest rat Hf more, currency is attractive, exchange rate/value of currency will rise. Low interest rates spurs consumer spending which results in economic growth and excessive consumer spending may lead to inflation Change in competitiveness — if a country’s exports become more attractive and competitive, this will cause the value of the exchange rate to rise. Balance of payments Speculation-speculative activity in the FX markets can cause exchange rates to rise_or fall Relative strength of other currencies. Purchasing Power Parity (PPP) The nominal exchange rate between two countries that reflects the difference in their respective rates Page 11 of 65of inflation. PPP says that the that the exchange rate between one currency and another is in equilibrium. When their domestic purchasing powers at that rate are equivalent. ‘The purchasing power of both currencies is equivalent. The quantity supplied by a currency is equal to the quantity demanded of a currency. A basket of goods should cost the same in each country once the exchange rate is taken into account. But that's not true in the real world. Exchange rates are determined using either a fixed exchange rate system or a floating exchange rate system, A fixed exchange / pegged exchange rate. - Two currencies will always be exchanged at the same price. ~ Exchange rate is tied to another country's currency. - Tokeep a currency's value within a narrow band. - The government entirely or predominantly determines the rate. - Provide greater certainty for exporters and importers. - Helps lower inflation. +/Ina fixed exchange rate system, when the rate falls, we say the A floating exchange rate is a reaime where. = The rate is based on supply and demand relative to other currencies. = The currency is allowed to float freely in the market and find it's own level. = Ina floating exchange rate system, when the rate falls, we say the clitrency has depreciated. Currency devaluation Deliberate downward adjustment of the value of a country's currency against another currency. 1 USD for INR 85, made 90 deliberately To boost exports To shrink trade deficits To reduce sovereign debt burdens Imports become expensive. 1.4.4 International Trade International Trade is the exchange of goods and services between countries. It happens becau: © Sper ‘economies of scale in the production % Competition -more competitive prices and quality of products The Law of Comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners. Protectionism or Erection of trade barriers, tit-for-tat To protect certain industries, the government interferes in international trade and engages in protectionism. This brings {fat of titfortat, trade barriers and disputes rise. Hence, GATT ato (General Agreement on Tariffs and Trade) created WTO (World Trade Organization), which aims to reduce barriers to free trade, 1.4.5 International Competitiveness The right exchange rate is imperative where international trade constitutes a significant share of GDP. Exchange rate is the price of one currency in terms of another. The exchange rate affects the trade balance and have the following consequences: Page 12 of 65Effect of rise/fall in nominal value of currency rate freakiFall in nominal rate (1 GBP = AED 4.90 > 4.95) | Strongirise in nom rate (1 GBP = AED 4.90 > 4,80) Currency depreciated Currency appreciated increase trade surplus, reduce trade deficit Reduce trade surplus, worsen trade deficit More exports, exporis more competitive Less exports, exports less compeiitive overseas Less imporis, Import less competitive ‘More imports, imports more competitive More profit in local currency Tess profit in local currency Foreign goods costlier Foreign goods cheaper in domestic market Purchasing power decreases Purchasing power increases Production cost becomes more Exchange rates are of different types. ‘The Nominal Exchange Rate, Real Exchange Rate Nominal Exchange Rate-NER Nominal exchange rate, the price of one currency in terms of another. It's usually expressed as the domestic price of the foreign currency. So, if it costs a U.S. dollar holder $1.36 to buy one euro, from a euro holder's perspective the nominal rate is 0.735 NER of Germany EURO relative to USA $ USD / EURO = 1.36 /1 =1.36 NER of USA relative to Germany = EURO / USD = 1/ 1.36 = .735 The Real Exchange Rate-RER The real exchange rate (RER) between two currencies is the product of the nominal exchange rate (the dollar cost of a euro, for example) and the ratio of prices between the two countries. Refers to the relative price of qoods of two countries India and USA. Itis the rate at which the Indians can trade its own goods for those of the USA. This means that the rate at which the Indians can exchange foreign and domestic depends on two factors: (i) The price of the good in local currency; and (ii) The rate at which the two currencies are exchanged. A rising real exchange rate signifies Reduction in international competitiveness. Rising prices, inflation, hence loses international competitiveness So, if India's inflation is rising at a faster rate than in the US without a compensating weakening of the nominal exchange rate, India’s international competitiveness declines. ‘The precise effeut on the trade balance and the revenues of importing and exporting firms will of course also depend on factors such as: > The price elasticity of these internationally traded goods and services, Page 13 of 65> Any productivity improvements in those industries >The speed with which consumers substitute goods and services when faced with a change in price. urve Effect ‘When faced with changing prices due to depreciation or devaluation by the country of its currency (say, to improve EUR from 4.80 > 4.90), to deal with the BOP deficit, with the intention to boost exports and curb imports, there is a time lag in implementing the policies, change of consumption patterns etc. and also the imports and exports contracts are already signed. So, initially, the Import exceeds exports, hence widening the trade deficit further. After some time only, the real effects come where the exports will exceed the imports and hence there willbe @ reduction in the BOP deft So, when the (rads a 8 dr €, we say the therefore, t 4.5 Unemployment and Inflation Learning Objective How inflation/deflation and unemployment are determined, measured and their inter- relationship Concept of nominal and real returns Inflation-the increase in price over a period: Erodes purchasing power of money Hinders the ability of price mechanisms to clear the markets (reducing prices to be able to sell outstanding stock) Reduces spending power — eg, $1 of goods ten years ago is not worth $1 of goods today. Individuals are not rewarded for saving; savings reduce in spending power. Borrowers gain at the expense of a saver, when interest rate is fixed, depreciates the value of debt. The official level of inflation is worked out on a basket of goods by a government agency. However, that basket of goods is not relevant to everyone. Basket of goods such as the price of oil, petrol and food. Inflation affects people in different ways, because motorists may face a greater level of inflation (and indiroot tax) when petrol prices rise, while cyclists may benefit from a fall in metal prices, lowering the price of bikes. The inflation also affects people in different ways — this Is due to various factors such as spending habits, investment choices, and levels of debt and savings. Nominal Return Vs Real Returns ial Return = what you get Nominal Rate does not consider inflation. Real Return = What you get after the inflation effect The real rate is adjusted for inflation. Real Return considers time value of money and inflation. Nominal Rate can be ZERO but cannot be Negative, but Real Return can be negative sometimes. So, Real Return = Nominal Rate ~ Inflation rate Damage occurs when the inflation rate exceeds the nominal interest rate — when the real interest rate is negative. When the real interest rate is negative: It creates uncertainty, This leads to firms deferring investment decisions and consumers deferring spending decisions. Time is spent guarding against inflation rather than being devoted to more productive means. Exported goods and services have become less competitive internationally. Page 14 of 65If inflation can be fully anticipated by society, then its costs can be minimized Example: You've purchased 100 shares that cost $15 each After exactly one year, the share price of each stock is $22. Nominal Return = the gain % you have got, 7/15X100 = 46.67% (Profit of 7 over investment of 15) But, if inflation rate is 10%, then, Real return = 46.67 % - 10% = 36.67% When talking about returns, especially with clients, it is important to be able to show the projected expected returns of their investments in absolute returns (nominal) and relative returns (real ~ taking account of inflation). One of the biggest fears for investors over the long term is that their savings/ returns will get eroded by inflation. Therefore, when developing a long-term saving plan (eg, retirement), financial advisers must factor in an inflation rate over the saving period. Therefore, clients should get an idea of how much they need to save to get an expected final value in both absolute and real terms. Hence, advisors must always assume a rate of inflation, thereby lowering expected real returns. 1.5.2 Types and Measures of Inflation ‘Types of Inflation Cost-push inflation -when cost increases, the producers increase the sales price. Consumers will, in turn, demand higher wages from firms, causing a wage price spiral to develop. This was the case in 2022, when global supply chain disruptions and the energy price spikes (caused by geopolitical tensions, particularly the Russia/Ukraine conflict) led to significant increases in production costs; these costs were subsequently passed onto consumers in the form of higher prices for goods and services. Demand-pull inflation —Price increase when demand is more than the supply. A recent example was observed in 2021-22, when many economies experienced a surge in consumer demand as they emerged from COVID-19 lockdowns. Stimulus payments (ie, government payments to taxpayers designed to boost their spending power and spur economic activity), pent-up savings and low interest rates fueled significant consumer spending; however, supply chains were still recovering from pandemic disruptions, leading to a mismatch between high demand and limited supply. This imbalance resulted in higher prices across various sectors. Inflation- can be measured in several ways: ‘As we know, inflation is the rate of changes in prices, measured over a year: Mostly changes in retail prices and changes in producer prices. Retail Pri Changes in retail prices are measured using a consumer price index (CPI). CPI tracks changes in the retail prices of basket of consumer goods/services purchased by households. CPI: Consumer Price Index Cost of basket today Cost of basket in base year CPI of the base year is always taken as 100. PI 100 Countries may have their own inflation measures tailored to their specific economic circumstances ‘and policy objectives-for example: RPI-The Retail Price Index in U.K Page 15 of 65GPI-U-Consumer Price Index for all Urban Consumers in the US Producer Prices Changes in the selling prices of goods/services are measured using a producer price index (PPI). PPI tracks changes in sales prices from the perspective of the seller. is sometimes known as factory gate inflation and. 1.5.3 Deflation, Disinflation and Stagflation Deflation: 2000 aoe Observe, the decrease in inflation is not same are price fall. Inflation Disinfiation Deflation Reflation (Opposite | Stagflation of disinflation) Rise in price | Fallin inflation Fall below last year | But, when prices are | High inflation Last year From 15, itis falling | price, below 10, say 9. | too low, the state | Growth slows price 10 This | down, but still The — opposite of | introduces down. year price 15 | above last year inflation, Purchasing | deliberate inflation, | Inflation is price of 10. power increases to. stimulate the | combined with economy by | aslow-to- Can result from: increasing money | negative -Excess capacity supply, lowering | econo -Excess production interest rates, | growth, -Negative demand reducing taxes, until | resulting in the prices are back | rising Results in: tothe normal price. | unemployment op in stock market | Reflation _steps | and possibly 2-Slow in economy taken to diminish | recession 3- Unemployment the effect of 4-Drop in wages deflation. 5-Reduced spending 6-Reluctance to borrow These all called 1.5.4 Unemployment sons why unemployment exists. Structural unemployment ~certain skills in particular sectors of the economy become redundant, Frictional unemployment — Unemployed because of disabilities. Keynesian unemployment — unemployment as a result of a drop in aggregate demand, Classical unemployment - when wages are priced too high. Seasonal unemployment — unemployment for certain parts of the year. Page 16 of 65Natural/Voluntary unemployment: job is there, job market in equilibrium, but one sits at home voluntarily. The labor market is in equilibrium: The balanced situation where the supply of potential employees is equal to the demand. Neither a labor excess nor a labor deficit Pay scales tend to remain constant as a result All persons who are looking for work at the going wage can find a job. 1.6 Fiscal and Monetary Policy Learning Objective Understand the role, basis and framework within which monetary and fiscal policies operate: government ‘spending; government borrowing; private sector investment; private sector spending; taxation; interest rates; inflation; currency revaluation/exchange rates/purchasing power parity; quantitative easing Stabilization Policies (to stabilise money su EMS is more IEMSis less rise-inflation Tall-deflation to contract MS to expand MS to withdraw money from system | _ to pump money in to system Policies applied Contractionery policies Expansionary policies IPolices brought by-CG & CB |c6-Fiscal policies-tools increase decrease decrease increase -Bonds/Borrowing borrow (sale bonds) redeem bonds |cB-Monetary policies-tools increase interest rate (stringent | decrease interest rate (soften the l1-interest Rate-quantitati litative ares, Rate Teancketec nye loan creteria) eligibility criteria) less lending more lending more deposits less deposits 2-cRR increases decreases |3-OMO (Open market operations}-to influence short-term interest rate CB sells short-term treasuries | CB buys short-term treasuries |4-quantitative easing(when short-term teyadia slalubsian sleriut lint rate almost ZERO) not for contractionary = . could bring inflation -AIRP (Negative interest rate policy) not for contractionary i Se a = NIRP-lowers banks profit |6-MMT (Modern Monetary Theory) not for contractionary Printing of money Fiat currency (w/o gold reserve) causes inflation causes increased deficit Fiscal policy and monetary policy measures-siablizalion policies Governments use the combination of policies, attempting to: . Page 17 of 65To Controlling the level of economic activity To reduce the impact of short-term cyclical fluctuations in economic activity: Governments use both: Monetary policy -to control the supply and cost of money Fiscal policy (demand management) ~ to set their objectives on taxation, public spending and borrowing. 1.7 Fiscal Policy also called Demand management. Inusing fiscal policy, governments to influence: > aggregate demand and the level of economic activity > the pattem of resource allocation > the distribution of income. Fiscal policy, or demand management, tak forms: 1.A discretionary, or proactive, approach to either boost or restrain demand Boost demand means expansionary policy, restraining demand means contractionary ( restrictive or tight fiscal policy) 2A passive approach Policies whereby spending (on items such as social security or welfare payments) automatically increase and tax revenue decreases as the economic cycle moves into its recessionary phase. These are known as automatie or built-in stabilisers Government fiscal_policy can also be neutral, expansionary or contractionary in order to achieve its_macroeconomic aims as shown below: [Link] stance — Increasing government spending to stimulate economic activity. It increases the budget deficit. [Link] or restrictive fiscal policy — Government seeking to increase taxes or reduce government spending, to slow down an overheating economy. [Link] stance- Balancing between collecting taxes and public spending, Balanced budget. Practical problems a: with fiscal policy Time lags — the length of time that elapses between recognizing the need for action (based on economic data that is itself time-lagged), implementing the appropriate. Crowding out — an economic term referring to the increase in government spending that drives down or can eliminate private sector borrowing or spending if an expansionary fiscal policy is financed through borrowing. The crowding out effect means that govt spending reduces private spending. Higher future tax rates — pursuing an expansionary fiscal policy may result in a higher future tax burden being imposed on the economy. Another risk of fiscal policy is that, once expansionary legislative and tax changes have become law, they are politically difficult to reverse — it will be difficult to turn off the fiscal taps once they are turned on, leading to out- of-contro! inflation. Once inflation takes hold, history shows that if not checked, it can quickly run out of control and be very economically damaging. But moving from stimulus to austerity, especially at speed, is difficult due to the long-term nature of many fiscal commitments and public resistance. Further, consumers may not respond in the intended way to fiscal stimulus (eg, they may save rather than spend a tax cul). It is therefore easy to understand why monetary policy is generally viewed as the fifStTiN® OF GBFEASE in stabilizing the economy during a downturn. Direct taxe: Levied on income or wealth, eg, income tax. Page 18 of 65Linked to ability Indirect taxes: Ad valorem tax, Value-added tax (VAT), Sales tax on the price of a good or service, Tax on the sale of property Indirect taxes are levied on transactions irrespective of the circumstances of the buyer or seller Not linked to ability Specific Indirect tax Levied as a fixed amount per unit, eg, taxes on petrol. Regressive tax: The proportion of tax decreases as income, wealth or expenditure rises. Opposite of Progressive Tax Progressive ta The proportion of tax increases as income, wealth or expenditure rises. Proportional tax: The proportion of tax is the same regardless of income, wealth or expenditure. Progressive Tax (Proportional Tax Tax Rate Regressive Tax Income 1.8 Monetary Policy Monetary policy Central bank activities that are directed toward Influencing the quantity/supply of money and credit in an economy, Achieving some balance between inflation and output stabilization. Achieving growth objectives S) changes in the money supply can Because in the short run (anything from affect the actual production of goods and services. ‘The measures the central bank applies to are described later. Practical problems associated with monetary policy: * Defining money supply’ * Time lags * Velocity of circulation of money Page 19 of 65Interest Rates-Central bank sets in consideration of: « The expression of views of the traders and institutions: + Exchange rate + Bond rates + Prices for short-term money market instruments ‘* Outlook for GDP growth * Employment + Inflation Do Markets or Central Banks Set Interest Rates? Central bank, of course based on what market participants predict about. Policy Vs Monetary Policy Monetary Policy Change in interest rates / money supply. Set by a Central bank ‘Target inflation Side effect on exchange rate and housing market Mostly Independent from the political process Fiscal Policy Fiscal policy refers to the government's decisions about taxation and spending. Both monetary and fiscal policies are used to regulate economic activity over time. They can be used to accelerate growth when an economy starts to slow or to moderate growth and activity when an economy starts to overheat. In addition, fiscal policy can be used to redistribute income and wealth. 1.8.1 The Money Supply Know the nature, determination and measurement of the money supply and the factors that_affect it: reserve requirements; discount rate; government bond issues. Me and moné suf What is Money? Anything that is generally acceptable as a means of settling a debt and is an acceptable medium of exchange. Act as a store of value for future consumption. Provide a unit of account against which the price of goods and services can be compared. Cryptocurrencies, therefore, are not money because they are not widely accepted To be acceptable, money must also be: Recognizable, Divisible, Portable and Durable Money Supply The amount of money that exists in the economy at any point in time. Ifthe money supply is arowina fa that output and income are growing, th Page 20 of 65This could result in an increase in prices and a fall in individual standards of living. locity of, The number of times money changes hands, What (the Latin word for ‘it shall be’) Currency? Alegal tender, not backed by a physical commodity, not linked to physical reserves. Currency that has no intrinsic value, solely based on the faith and credit of the country. The government may print too much currency as it is not obliged to hold commodity reserves. This may cause hyperinflation. Hyperinflation is very high and typically accelerates inflation. A fiat currency (also called ‘iat money’ or ‘physical money’) has no intrinsic value and has no backing from a physical asset in a vault; rather, their value is derived from the backing by the government which declares it to be ‘egal tender’ (ie, tis accepted as having value because the government says it has, and people trust the government enough to accept i) Subelassifications of Money / Measures of Money Narrow money — this represents the m: is Notes and coins in circulation + Overnight deposits Broad money ~ this is the broader measure of the money supply and consists of Narrow money + Bank deposits + Money market instruments. Examples of Money Supply Measures in different countries In United States-M1 & M2 Two measures of money supply are M1(Narrow) and M2(Broad) ‘M4, the narrowest measure, covers most liquid forms of money: Currency + Demand deposits + Other deposits against which cheques can be written. M2, the broadest measure M1 plus + Savings accounts Plus + Time deposits of less than $100,000 and + Balances in retail money market mutual funds. ‘n Eurozone-M1, M2 & M3 The ECB definitions of euro-area monetary aggregates are M1(Narrow), M2(Intermediate and M3(Broad) M1 (narrow money) Currency in circulation and + Overnight depos M2 (intermediate money) Mi + Deposits with agreed maturities of up to two years plus + Deposits redeemable at notice of up to three months M3 (broad money) M2. + Repo agreements + Money market funds and Page 21 of 65