El Derecho a la Defensa

Introduction

3.0

Economics: gross domestic product

4.1.1

Measuring gross domestic product

4.1.2

GDP and GNP

4.1.3

Nominal and real GDP

3.1

Economic fluctuations: unemployment and inflation

4.2.1

Business cycles

4.2.2

Business cycle indicators

4.2.3

Unemployment

4.2.4

Inflation

3.2

Fiscal policy

4.3.1

Fiscal policies

3.3

Money and the banking system

4.4.1

Definitions of money supply

4.4.2

Interest rates

4.4.3

Monetary policy

3.4

Foreign exchange and the global economy

4.5.1

Foreign exchange market

4.5.2

Exchange rate regimes

4.5.3

Determinants of currency value

4.5.4

Balance of payments

Review questions

Learning objectives

The syllabus for this examination is broken down into a series of learning objectives and is included in the Syllabus Learning Map at the back of this workbook. Each time a learning objective is covered, it appears in a text box preceding the text.

INTRODUCTION

Due to the importance of economic analysis, this chapter is exclusively devoted to providing an overview of the macro economy and government policy. The international aspects are also detailed in the context of the foreign exchange market and a country's balance of payment accounts.

The ultimate objective of fundamental analysis is to estimate the earnings and dividend prospects of the firm. The macroeconomic environment affects all firms, although some are affected to a larger extent than others. Security analysts must monitor those macroeconomic variables that best describe the state of the economy and understand how these variables are influenced by government actions. The government uses two broad methods of intervention to manage the economy. These are Fiscal Policy (the use of government expenditure and taxes) and Monetary Policy (adjustment of money supply). Issues relating to each of these policies are discussed in this chapter. The objectives of the nation's economic policy are to protect the purchasing power of the nation's currency (manage inflation), encourage conditions favorable to sustainable economic growth, maintain low unemployment rates, and foster a reasonable balance in transactions with other nations over the long run. This chapter provides an overview of these economic ideas and issues.

4.1 ECONOMICS: GROSS DOMESTIC PRODUCT

4.1.1 MEASURING GROSS DOMESTIC PRODUCT

Learning Objective 4.1.1 – Understand Gross Domestic Product (GDP), how it is measured and its significance

A nation's standard of living is a measure of its economic performance. Measuring economic performance enables us to monitor changes in a nation's economic activity and to compare its level of activity with that of other nations. These measures allow policymakers to 'check the pulse' of an economy. Economists rely on four important measures of economic activity: gross domestic product, inflation, interest rates, and unemployment. Periodic release of information relating to these variables can affect stock and security prices.

Gross Domestic Product (GDP) is a broad measure of a nation's economic output. GDP measures the current value of all final goods and services produced for sale in an economy in a year. Ideally, GDP will increase at a steady pace from year to year, indicating constant expansion in the quality and quantity of goods and services available to the population. Countries such as the United States, Japan, and United Kingdom measure their GDP in trillions of dollars. Smaller countries such as Switzerland and Luxembourg have much smaller total GDP, but still have a high standard of living.

There are three different but equivalent approaches to measuring GDP:

1 - The total spending on goods and services by different groups - households, businesses, government and foreigners.

2 - The total of production in different industries - agriculture, mining, manufacturing...etc. 3 - The total of income earned by different groups in the form of wages, profits...etc.

The most widely used among the three is the spending approach. To measure GDP through spending, simply add up total spending on goods and services produced in a nation during a given period.

Gross Domestic Product = Consumption + Fixed Investment

+ Inventory Investment + Government Purchases + Exports -Imports. Increases in GDP imply an expanding economy, and presumably one in which firms can profitably operate, reflected by higher security prices.

4.1.2 GDP AND GNP

Learning Objective 4.1.2 – Know the differences between Gross Domestic Product and Gross National Product

Gross National Product (GNP) is a related measure of economic activity and differs from GDP by including foreign income earned by citizens and excluding income earned by foreigners in the domestic economy. Although GNP differs from GDP, the impact of overseas investment income is not sufficiently significant to prevent both measures telling a similar story regarding the health of the economy.

4.1.3 NOMINAL AND REAL GDP

Learning Objective 4.1.3 – Know the differences between nominal GDP and real GDP

In measuring GDP over time, it could be the case that the growth in GDP is occurring because the economy is producing a larger output of goods and services and/or that goods and services are being sold at higher prices. The latter could simply be due to inflation. As a result, if inflation were significant, it would be desirable to remove the impact of inflation and look at GDP changes based purely on the output of goods and services. Economists call this real GDP, which is GDP excluding the impact of inflation, based on money with the same purchasing power.

The GDP measure that incorporates both the production of goods and services and the impact of higher prices (inflation) is often referred to as the nominal GDP.

4.2 ECONOMIC FLUCTUATIONS: UNEMPLOYMENT AND INFLATION

4.2.1 BUSINESS CYCLES

Learning Objective 4.2.1 – Understand what is meant by the 'Business Cycle', its effects and various stages:

 Effect on cyclical companies

 Effect on defensive companies

 Prosperity, recession, depression and recovery

All economies go through recurrent phases of expansion and contraction with varying degrees of severity and for differing lengths of time. Such periodic booms and busts are referred to as business cycles. The fortunes of the majority of firms tend to follow these cycles of the waxing and waning of economic activity - such companies are referred to as cyclical companies. However, there are some companies, termed defensive companies that are immune to or barely sensitive to the business cycle. Examples of defensive industries are food producers, pharmaceuticals and utilities.

The business cycle can be described by its four distinct stages: prosperity, recession, depression, and recovery. An expansionary phase is characterized by recovery followed by prosperity whereas in a contractionary phase the economy goes through a recession, which may prolong to a depression. A recession is said to occur when gross domestic product (GDP) declines for two consecutive quarters. A depression is an extremely long and severe recession in which GDP falls and unemployment rises dramatically. A slowdown need not result in a depression if a recovery gets under way before the economy tumbles too far down. These periods of expansion and contraction can vary from several months to several years.

4.2.2 BUSINESS CYCLE INDICATORS

Learning Objective 4.2.2 – Know the main leading, coincident and lagging indicators that assist economists to identify the state of the Business Cycle

The task of the analyst is to forecast the stage of the business cycle and make recommendations of the type of securities to invest in. In the recovery stage it would be advisable to invest in cyclical stocks, whereas in the recession stage it would be prudent to invest in defensive stocks.

Since these business cycles seem to be recurrent, economists look at key variables in the economy that may help in predicting the cycle. These variables are termed economic indicators and are divided into categories. Leading indicators are those that precede the cycle while coincident or lagging indicators move jointly with or lag the cycle. From experience and hindsight the following list of indicators has been identified and is widely used (especially in the U.S).