Series 65 Unit 6 Basic economic concepts

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48 Terms

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business cycles

periods of economic expansion have been followed by periods of contraction in a pattern

reflect fluctuations in economic activity as measured by the level of activity in such variables as the rate of unemployment and the GDP

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business cycles go through four stages:

expansion

peak

contraction

trough

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gross domestic product (GDP)

the market value of all final goods and services produced within a country in a given period of time

to account for inflation, GDP in the United States is based on a constant dollar

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expansion or recovery

economic expansion: increasing business activity in sales, manufacturing, and wages

peak: GDP increases rapidly, businesses reach productive capacity, and the economy cannot expand further

contraction: business activity declines from its peak.

- recession: mild, short-term contraction.

- depression: longer, more severe contraction

trough: business activity stops declining and levels off

recession definition: decline in GDP for two or more consecutive quarters

depression definition: decline in GDP for six consecutive quarters

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expansions are characterized by increasing consumer demand for goods and services, possibly leading to an:

increasing rate of inflation

increasing industrial production, generally leading to

- a decreasing unemployment rate as hiring accelerates

- falling inventories

- rising stock markets

- rising property values

- increasing GDP

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peaks are characterized by:

a decrease to the GDP growth rate

a decrease to the unemployment rate, but a slowdown in hiring

a slower rate of growth in consumer spending and business investment

an increase to the inflation rate

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contractions/recessions in the business cycle tend to be characterized by:

rising numbers of bankruptcies and bond defaults

decreasing working hours and increasing unemployment rate

decreasing consumer spending, home construction, and business investment

falling stock markets

a decrease to the inflation rate

rising inventories (a sign of slackening consumer demand)

a negative growth rate for the GDP

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troughs tend to be characterized by:

a change from negative to positive GDP growth rate

a high unemployment rate and increasing use of overtime and temporary workers

a possible increase in spending on consumer durable goods and housing

a moderate or decreasing inflation rate

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Practice Question

If the Consumer Price Index (CPI) is down but consumer demand is up, the economy is likely in which stage of the business cycle?

A. Trough to expansion

B. Peak to contraction

C. Recovery to trough

D. Contraction to trough

Answer: A. As prices trend downward and consumer demand increases, the economy is recovering from a trough (the bottom) to expansion, choice A. As demand continues to increase, assuming supply remains constant, upward pressure will be put on prices through the expansion to the peak.

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cyclical industries

highly sensitive to business cycles and inflation trends

most cyclical industries produce durable goods, such as heavy machinery and automobiles, as well as raw materials, such as steel

during recessions, the demand for durable goods declines as manufacturers postpone investments in new capital goods and consumers postpone purchases of automobiles

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countercyclical industries

tend to turn down as the economy heats up and to rise when the economy turns down

gold mining has historically been a countercyclical industry

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growth industries

most industries pass through four phases during their existence: introduction, growth, maturity, and decline

an industry is considered in its growth phase if the industry is growing faster than the economy as a whole because of technological changes, new products, or changing consumer tastes

social media and bioengineering are examples of current growth industries

because many growth companies retain nearly all of their earnings to finance their business expansion, growth stocks usually pay little or no dividends

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defensive industries

least affected by normal business cycles

companies in defensive industries produce nondurable consumer goods like food, pharmaceuticals, tobacco, and energy

public consumption of these goods remains steady throughout the business cycle

during recessions and bear markets, defensive stocks decline less than other stocks

during expansions and bull markets, defensive stocks may advance less

investments in defensive industries involve less risk and lower returns

sector rotation involves moving into defensive stocks when a contraction is expected

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Practice Question

An investor fears a coming recession. She would probably invest in

A. biotech

B. steel producers

C. drug companies

D. home builders

Answer: C. In a recessionary period, business activity slows, so one should take a defensive position. Drug companies (pharmaceuticals) tend to have steady earnings, even in bad economic times. After all, those taking needed prescription drugs will not stop. Even OTC drugs like headache remedies and antacids will continue to be sold (some say even more in a downturn). People generally don't buy a new home when things slow down, nor do they buy new cars (much of the steel produced goes into the manufacturing of autos). Biotech companies will find that funding for experimental treatments dries up.

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Practice Question

When the business cycle is in the recovery stage, what type of industry tends to perform the best?

A. Countercyclical

B. Cyclical

C. Defensive

D. Growth

Answer: B. In general cyclical industries, those that follow the cycle tend to be the best performers during expansion (recovery). Countercyclical industries would tend to go in the opposite direction, and defensive industries are billed as such because they tend to be stable regardless of where we are in the business cycle. Most economists would agree that growth industries react later as the recovery gets closer to the peak.

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interest rate

cost of borrowing money determined by supply and demand for loanable funds, borrower's credit quality, and loan duration

cost influenced by current and expected inflation

bonds issued by companies have fixed interest rates or coupon payments

bond prices in the secondary market fluctuate with interest rates

when interest rates increase, bond prices decrease; when interest rates decrease, bond prices increase

inverse relationship between interest rates and bond prices

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nominal rate of interest

the actual rate of interest a borrower pays on the borrowed money

if inflation is expected, it is likely that interest rates are going to increase

that means that new loans, e.g., bonds, will carry a nominal rate higher than the bonds currently available

as a result, as interest rates rise, market forces will lead the price of those older, lower interest rate bonds to decline

that is because an investor's rate of return needs to be equivalent to current market conditions

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yield curve

an important tool in gauging investor sentiment toward future interest rates

the difference between short and long-term interest rates normally reflects an upward sloping line

when it is an upward sloping curve, it is a positive, or normal, yield curve

the yield curve is also a reflection of investor expectations about inflation

if investors expect high inflation rates, they will require higher rates of return to compensate for the reduction in purchasing power over time

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long-term interest rates are normally higher than short-term rates for a number of reasons

lenders must be compensated for the:

time value of money

reduced buying power of money resulting from inflation

increased risk of default over long periods

loss of liquidity associated with long-term investments

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yield spread (credit spread)

greater risk leads to higher bond yield

analysts compare yields on bonds with same maturity but different quality to gauge market sentiment

yield spread is the difference between yields on Treasuries and corporate bonds

yield spread widens when economic conditions worsen and narrows when they improve

yield spread can also be used between issues of the same issuer

popular measurement is the yield spread between 2-year and 10-year Treasury notes

yield spread narrows when investors are optimistic and widens when pessimistic

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Practice Question

A bond analyst is plotting a yield curve and notices that short-term maturities have higher yields than intermediate and long-term maturities. This is an example of

A. an inverted yield curve

B. a positive yield curve

C. a normal yield curve

D. an algorithmic yield curve

Answer: A. An inverted, or negative, yield curve is one that results when debt with short-term maturities has higher yields than those with maturities that are longer. A positive, or normal, yield curve results when the yields increase as maturities do.

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fiscal policy

refers to a government's use of spending and taxation to influence economic activity

the budget is said to be balanced when tax revenues equal government expenditures

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budget surplus

when government tax revenues exceed expenditures

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budget deficit

when government expenditures exceed tax revenues

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monetary policy

the central bank's actions that affect the quantity of money and credit in an economy in order to influence economic activity

monetary policy is said to be expansionary (or accommodative or easy) when the central bank increases the quantity of money and credit in an economy

conversely, when the central bank is reducing the quantity of money and credit in an economy, the monetary policy is said to be contractionary (or restrictive or tight)

monetary policy is under the control of the Federal Reserve Board (the Fed)

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Keynesian economics

Keynesian economists recognize the importance of government intervention

he laid out how and why recessions happen and what must be done to recover from them

his strategy for recovery from a recession was for government to run deficits to stimulate demand and employment

in other words, he suggested lower levels of taxation and more government spending

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classical and supply-side economics

the belief that lower taxes and less government regulation benefits consumers through a greater supply of goods and services at lower costs

holds that supply creates demand by providing jobs and wages

the prices of goods of which there is excess supply will fall, and the prices of goods in demand will rise

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monetarist theory

the quantity of money, or money supply, determines overall price levels and economic activity

too many dollars chasing too few goods leads to inflation, and too few dollars chasing too many goods leads to deflation

one of the principal roles of the Federal Reserve Board is monitoring the money supply and making adjustments when necessary

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tools of the Federal Reserve Board

changes in reserve requirements

changes in the discount rate

open market conditions

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federal funds rate

the rate banks that are members of the Federal Reserve System charge each other for overnight loans of $1 million or more

the rate is considered a barometer of the direction of short-term interest rates

the federal funds rate is listed in daily newspapers and is the most volatile rate; it can fluctuate drastically under certain market conditions

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prime rate

most preferential interest rate on corporate loans at large U.S. money center commercial banks

each bank sets its own prime rate, with larger banks generally setting the rate that other banks follow

banks lower their prime rates when the Fed eases the money supply and raise rates when the Fed contracts the money supply

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Practice Question

Which of the following statements regarding significant interest rates in the U.S. economy is not true?

A. The federal funds rate is the rate the Federal Reserve charges for overnight loans to member commercial banks.

B. The prime rate is the interest rate that large U.S. money center commercial banks charge their most creditworthy corporate borrowers.

C. The discount rate is the rate the New York Federal Reserve Bank charges for short-term loans to member banks.

D. The most active tool used by the Fed is the buying and selling of Treasury securities by the FOMC.

Answer: A. The federal funds rate is the rate that member banks charge each other for overnight loans of $1 million or more; it is not the rate that the Federal Reserve charges member banks for overnight loans.

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balance of payments

measures all the nation's import and export transactions with those of other countries for the year

the balance of payments account contains all payments and liabilities to foreigners (debits) and all payments and obligations (credits) received from foreigners

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trade deficit

an excess of one country's imports over its exports and is reported as part of the balance of payments figures

over time, an excessive trade deficit can lead to the devaluation of a country's currency because the country will be converting, or selling, its currency to obtain foreign currency to pay for its increasing imports

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trade surplus

the opposite of a trade deficit, a trade surplus is an excess of one country's exports over its imports and is reported as part of the balance of payments figures

over time, an excessive trade surplus can lead to the strengthening of a country's currency

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top-down analysis

it would look like an inverted isosceles triangle: broad on top and narrow on the bottom

the analyst starts with the broadest measure of the overall economy and then successively narrows it down to finally select the company or companies that best fit the objectives

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bottom-up analysis

direct opposite of top down

start at the bottom (the point) of the triangle with the specific company and work our way up through the industry and then the economy

this analyst starts with the narrowest indicator and then steadily broadens the search

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inflation

a general increase in prices as measured by an index such as the consumer price index (CPI)

inflation is caused by excessive demand and monetary expansion

excessive demand occurs when aggregate demand exceeds the aggregate supply and prices rise

monetary expansion is a rapid increase in a nation's money stock in excess of the nation's growth rate

increased inflation drives interest rates higher and drives bond prices lower

decreases in the inflation rate have the opposite effect: bond yields decline and bond prices rise, as you will learn shortly

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deflation

a general decline in prices

deflation usually occurs during severe recessions when unemployment is on the rise

deflation is caused by conditions opposite those that cause inflation

basically, when the demand for goods and services is substantially below the supply of those goods or services, prices tend to drift downward (certainly not increase) to encourage an increased demand

one other possible cause of deflation is a severe shrinkage in the money supply

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Practice Question

The contraction phase of the business cycle is least likely accompanied by decreasing

A. consumer spending

B. economic output

C. inflation pressure

D. unemployment

Answer: D. An economic contraction is likely to feature increasing unemployment (i.e., decreasing employment), along with decreasing consumer spending, declining economic output, and decreasing inflation pressure.

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gross domestic product (GDP)

expresses the total value of all final goods and services produced within the United States during the year

GDP includes personal consumption (by far the largest component), government spending, gross private investment, foreign investment, and the total value of net exports

if imports exceed exports, that negatively affects GDP and that net amount is subtracted

the GDP measures a country's output produced within its borders regardless of who generated it

when the GDP is negative, it is generally a sign of deflation

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Practice Question

A U.S.-based firm assembles electronic equipment using parts imported from Singapore. Its income statement looks like this:

Sales $60 million

Wages $30 million

Parts $16 million

Expenses $46 million

Net Income $14 million

What is this firm's contribution to the U.S. GDP?

A. $14 million

B. $30 million

C. $44 million

D. $60 million

Answer: C. The question is how we measure this firm's contribution to U.S. output. At first glance, the answer would seem to be $60 million, the total value of its sales. However, $16 million of this was produced somewhere else, so it shouldn't be counted as part of the firm's—or the United States'—output. Thus, the correct answer is $44 million, the amount of value the firm has added to the imported parts.

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unemployment level

key indicator of a country's economic health and bears a relationship to inflation

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consumer price index (CPI)

a measure of the general retail price level

by comparing the current cost of buying a basket of goods with the cost of buying the same basket a year ago, we can get an indication of changes in the cost of living

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the leading economic indicators include the following:

money supply

building permits (housing starts)

average weekly initial claims for unemployment insurance

average weekly working hours, manufacturing

manufacturers' new orders for consumer goods

manufacturers' new orders for nondefense capital goods

index of supplier deliveries—vendor performance

interest rate spread between 10-year Treasury bonds and the

federal funds rate

stock prices (e.g., S&P 500)

index of consumer expectations

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widely used coincident indicators include the following:

nonagricultural employment

personal income minus social security, veteran benefits, and welfare payments

industrial production

manufacturing and trade sales in constant dollars

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lagging indicators include the following:

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 the CPI for services

total amount of commercial and industrial loans outstanding

change in the index of labor cost per unit of output (manufacturing)

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Practice Question

Core inflation is best described as an inflation rate

A. for producers' raw materials

B. the central bank views as acceptable

C. that excludes certain volatile goods prices

D. that represents a market basket of consumer items

Answer: C. Core inflation is measured using a price index that excludes food and energy prices.