Chapter 24: Economics and Suitability

Disinflation

A reduction in the rate of inflation

Contraction

As prices rise, demand slackens, which causes economic activity to decrease. As business activity contracts, employers lay off workers, unemployment increases, and demand slackens. This causes the rate at which prices are rising to decline. Situation where prices are actually falling in real terms is called deflation.

Monetary Policy

Attempts to control the supply of money and credit in the economy, which effects interest rates. Primary focus is to control inflation. Federal Reserve System implements monetary policy in the US

Reserve Requirements

Banks are required to keep a portion of their deposits on reserve with the FRB, because by adjusting amount banks can keep with FRB, the fed can tighten or ease the money supply. If reserve requirements are lowered, banks are able to extend more credit, thus the money supply will increase. The amount of funds a bank has above the reserve requirement is called excess reserves. The multiplier effect is the rate at which banks can create new money by relenting deposits and, in turn, creating new deposits. This is one of the least used tools of monetary policy.

How Money is Created

Banks can only create money if they are able to attract deposits and subsequently make loans. Intermediation refers to the ability of financial intermediaries(such as banks) to attract deposits, and in turn, extend credit. Disintermediation is the process by which investors withdraw funds from banks and seek higher yielding investments elsewhere. The higher mutual fund yield may affect the bank's ability to attack and keep deposits.

Commodities Exposure May Hedge Inflation Risk

Certain commodities such as gold and silver have performed well during inflationary periods.

Trough

Bottom of the economy's decline. Lower prices will stimulate demand and the economy moves into a renewed period of expansion called a recovery. At times, economic decline can be pronounced. A recession occurs when Real GDP declines for two successive quarters (six months). A depression occurs when Real GDP declines for a more prolonged period.

Expansion

Business activity is growing, production and demand are increasing, and employment is expanding. Businesses and consumers normally borrow money to expand, causing interest rates to rise.

Margin Requirement

By increasing the margin requirements, the FRB reduces the amount of brokers and banks may lend, causing the money supply to tighten. Changing margin requirement is the least effective method the FRB has to control credit because it affects only stock market transactions.

Open Market Operations: Repurchase Agreements

Contract entered into by the federal reserve to purchase US government securities from dealers at a fixed price, with provisions for their resale back to the dealer at the same price plus a negotiated rate of interest. When the fed effects a repo, it is lending money and therefore increases bank reserves. A reverse repo (matched Sale) occurs when the FRB sells securities to dealers with the intention of buying the securities back at a future date. This has short term effect of absorbing funds from the money supply.

Peak

Demand for goods overtakes supply and prices rise, creating inflation. Businesses are able to charge more for their products, causing prices to rise, thereby reducing the purchasing power of the consumer.

Easy or Tight Money

Easy money- increases the money supply, lowers rates, and should eventually stimulate the economy. Tight money- reduces money supply, raises rates, and should dampen economic activity.

Equity Exposure May Hedge Inflation Risk

Equity securities or other related products have provided the best protection against inflation.

The Business Cycle:

Expansion (Recovery), Peak, Contraction (Decline), and Trough

Money Supply

FRB attempts to control the money supply and credit to maintain a stable, growing economy with the aim of combating inflation. Shifts in economic conditions will influence the Fed's focus on the money supply figures.

Moral Suasion (jawboning)

Fed exerts its influence through the public media or through the examiners sent to member banks. Its efforts to control the money supply by these means are limited by the extent to which they can elicit cooperation from these institutions.

The Effect of Business Cycle on Securities Markets: Interest Rate Changes

The level and direction of interest rates will influence numerous investments and may indicate inflationary trends. The prime rate is the interest that a commercial bank charges its best customers. The usual order of these rates from lowest to highest is: fed funds, discount, call, and prime.

Open Market Operations: Buying Securities

If Fed buys securities, it pays for securities with funds that are ultimately deposited in commercial banks, which causes deposits at banks to increase and thereby add to the funds available for loans. The result is an increase in reserves. Money becomes more available and interest rates tend to move downward (easy money policy).

Foreign Exchange Risk and Investing

If a US investor believed the dollar was about to weaken, he would increase exposure to foreign denominated investments. If thought dollar was going to strengthen, he would increase exposure to investments domiciled int he US. Does not mean investor is protected against currency risk.

Foreign Exchange and Trade

If interest rates int he US are higher than interest rates overseas, foreign investors wishing to earn a higher rate may want to invest in the US. In order to invest in the US, foreign investors must first convert their funds into dollars. As demand for dollars increases, the prices of dollars will increase. Typically, higher US interest rates compared to foreign yields may lead to a stronger dollar. If the US dollar is strong, US consumers can purchase more foreign goods since they are less expensive, increasing exports. However, foreign consumers will be unable to purchase the relatively more expensive US goods, causing exports from the US to decrease, possibly leading to a trade deficit (to correct US dollar must fall)

Yield Curves

In periods of easy money when interest rates are declining, yields on shorter securities will be less than those on longer maturities. Yield curves will tend to slope upward from the shorter to the longer maturities. In periods when FRB tightens aggressively, the yield curve may invert. This means that shorter-term interest rates will be higher than longer-term rates.

Fixed Income Investors Fear Inflation

Interest rates rise causing the market price of their holdings to fall while the purchasing power of their interest payments also decreases.

Deflation

Persistant and appreciable decline in the general level of prices. If the supply of goods and services was greater than the demand for those items.

Definitions of the Money Supply

M1= Currency in circulation + demand deposits + other checkable deposits M2=M1 = Money market deposit accounts + savings and relatively small time deposits + balances at money funds + overnight repurchase agreements at banks M3=M2= Large time deposits + term repurchase agreements at banks and savings and loans + eurodollars (no longer published by the FRB)

Consumer Price Index

Measures the prices of a fixed basket of goods bought by a typical consumer. If CPI rises, it means the economy is experiencing inflation.

Measuring National Output: Gross National Product (GNP)

Measures the total value of all goods and services produced by a national economy. For the US this measure includes goods and services produced overseas by a US company

The Effect of the Business Cycle on Securities Markets: Cyclical Stocks

Move with the business cycle. If economy is prospering, so are these companies. If economy falters, so does cyclical stocks. Examples include basic industries, construction firms, transportation, automotive, energy, homebuilders, and manufacturers of durable goods.

Stagflation

Prolonged period of a high rate of inflation at the same time as a high rate of unemployment. Does not happen often since high unemployment usually leads to a period of low inflation or even deflation and the possibility of a recession. A period of low unemployment usually leads to rising prices and increased inflation.

Inflation

Occurs when the demand for goods and services in the market increases at a faster rate than the supply of these items

Federal Open Market Committee (FOMC)

Oversees the FRB's buying and selling of US government securities in the secondary markets. Open markets is the most effective and frequently used tool of monetary control used by the FRB, as well as the most flexible and easiest to reverse. Open markets involve the purchase and sale of US government securities, primarily Treasury bills. FRB also trades government notes and bonds, which are executed through primary government dealers, banks, and brokerage firms appointed by the FRB.

Supply side economics

Places an emphasis on reducing taxes and the size of government to stimulate the economy. Reducing the size of government allows for lower taxes. By reducing taxes, individuals and corporations have more money to invest.

Leading Economic Indicators

Precede the upward and downward movements of the business cycle. May used to predict the near-term activity of the economy. 10 components of the monthly released index are: -Average workweek for production workers in manufacturing -Average weekly initial claims for state unemployment insurance -New orders for consumer goods and materials -Vendor performance(companies receiving slower deliveries from suppliers) -Contracts and orders for plant and equipment -New building permits for private housing units -The prices for the S&P 500 Index common stocks -The Money Supply (M2) -The change in credit outstanding for business and consumer borrowing -Interest rate spreads, 10 year Treasury bonds less federal funds -Index of Consumer expectations

Keynesian Economics

States that government intervention in the economy is necessary for sustained economic growth and stability. Further states that the government should use fiscal policies to combat the effects of inflation and deflation, as well as to influence economic activity.

Real Interest Rate

Rate of interest an investor expects to receive after allowing for the decline in his purchasing power. Calculated as (Nominal Return - Inflation Rate)

The Effect of the Business Cycle on Securities Markets: Defensive Stocks

React less to changes in the business cycle than cyclical stocks. These would include utilities, tobacco, alcohol, cosmetics, pharmaceutical, and food companies. These companies are last to be affected negatively as the economy moves through difficult periods since people need basic serves to exist.

Lagging Economic Indicators

Represents items that change after the economy has moved through the various stages of the business cycle. Index of lagging indicators should confirm the economic condition portrayed by previous leading and coincident indexes. Indicators include: -Average duration of unemployment -Relationship of inventories to sales, manufacturing, and trade -Labor cost per unit of output for manufactured goods -The average prime rate charged by banks -Commercial and industrial loans outstanding -Relationship of consumer installment credit to personal income -Consumer price index for services.

Major Tools of the FRB

Setting Reserve Requirements Setting the discount rate Implementing open market operations Setting margin requirements Using moral suasion

Federal Funds

Short-term loans of excess reserves banks lend to each other. The rate of interest charged is called the federal funds rate, which is determined by supply and demand.

Open Market Operations: Selling Securities

Should the Fed wish to reduce the money supply, it will sell securities to banks and securities dealers. Banks and dealers will pay for these securities by withdrawing money from their demand accounts. Withdrawal of money from the banks will decrease the amount of money available for loans, which has a tightening effect on the money supply, causing interest rates to rise.

Fiscal Policy

The government's use of taxation and expenditure programs to maintain a stable, growing economy. If economy is in a recession or trough, the government can increase its spending to stimulate demand. It can cut taxes, which will increase the disposable income of consumers and stimulate demand. IF there is too much demand, the government can cut its spending or increase taxes. Set by the president and congress, so some decisions may be based on political rater than purely economic motives. Primary focus is on economic growth and high employment.

Measuring National Output: Gross Domestic Product (GDP)

The most important measure of output and spending in the US. This is the output of goods and services produced by labor and property located int eh US without regard to the origin of the producer. Real GDP: GDP adjusted for inflation using constant dollars. Rising GDP signifies economic growth and potential inflation.

Discount Window

The rate charged for loans is called the discount rate by the FRB. When members of the Fed borrow using discount window, new money is injected into the system. By decreasing discount rate, FRB encourages borrowing which expands money supply. A change in the discount rate is usually taken as a very strong sign that monetary policy has shifted. Discount rate is only rate directly set by the FRB.

Coincident Economic Indicators

Usually mirror the movements of the business cycle. Include four components: -Employees on nonagricultural payrolls -Personal income less transfer payments (transfer payments represent aid for individuals in the form of Medicare, Social Security, and veteran's benefits, to list a few). -The Index of Industrial Production -Manufacturing and trade sales