IEQ University: Module 1: Macroeconomics

GDP

total value of all final goods and services produced within a country during a specific period

• most common measure of economic activity and economic growth

Nominal GDP

Nominal GDP measures the value of goods and services using current prices

• It includes the effects of inflation.

Real GDP

Real GDP measures economic output after adjusting for inflation

• making it a better measure of actual economic growth.

Why is Real GDP more useful than Nominal GDP?

Real GDP removes the effects of inflation and shows whether the economy is actually producing more goods and services.

When GDP growth is reported, what should investors ask?

Investors should ask whether growth came from increased production (Real GDP growth) or from higher prices (inflation)

• Real growth is generally more favorable for long-term economic and corporate earnings growth.

Components of GDP

Consumption, Investment, Government Spending, and Net Exports

Why consumption drives GDP

Consumer spending accounts for about two-thirds of the U.S. economy. Increased consumer spending boosts business revenue, profits, employment, and economic growth.

Why do investors watch consumer spending

Consumer spending drives corporate revenues and earnings

• Strong spending usually supports economic growth and stock market performance.

How do professional investors think about GDP?

Professional investors focus on what drives changes in GDP:

• Is consumer spending rising or falling?

• Are businesses investing more or less?

• Is government spending increasing or decreasing?

• Are exports strengthening or weakening?

These changes help predict economic growth, corporate earnings, interest rates, and market performance.

Why do investors care about GDP growth?

Higher GDP growth generally leads to:

• Higher corporate earnings

• More hiring

• Stronger consumer spending

• Better stock market performance

Slower GDP growth may signal weaker earnings and increased recession risk.

Inflation

Inflation is the general increase in prices over time, which reduces the purchasing power of money.

Consumer Price Index (CPI)

The government's most common measure of inflation.

It tracks the price changes of a basket of goods and services.

Examples:

• Food

• Housing

• Gasoline

• Healthcare

• Transportation

Why Investors Watch CPI

CPI is one of the main ways the Fed measures inflation.

A high CPI reading may cause:

• Higher interest rates

• Lower bond prices

• Stock market volatility

What Causes Inflation: 4 major causes

Demand-Pull Inflation

Cost-Push Inflation

Supply Shocks

Lax Monetary Policy

What Causes Inflation: Demand-pull inflation

Demand-pull inflation occurs when demand for goods and services grows faster than supply, causing prices to rise.

What Causes Inflation: Cost-push inflation

Production becomes more expensive.

Businesses pass those costs to customers.

Prices rise.

Cost-push inflation occurs when rising production costs cause businesses to increase prices to maintain profitability.

Investor Thinking

• This type of inflation is dangerous because:

  Companies face higher expenses.

  Profits may shrink.

  Consumers pay more.

  Everyone suffers.

What Causes Inflation: Supply shocks

A sudden disruption in the production or availability of goods and services that reduces supply and pushes prices higher.

ex: pandemic, wars, natural disasters, energy crisis

What Causes Inflation: Lax Monetary Policy

Lax monetary policy occurs when a central bank keeps interest rates low or increases the money supply, encouraging borrowing and spending, which can contribute to inflation.

idea

The central bank keeps policy too loose.

Interest rates stay too low.

Money becomes easy to borrow.

Spending rises.

Demand rises.

Inflation rises.

Why do investors pay attention to lax monetary policy?

Lax monetary policy lowers borrowing costs and increases liquidity in the economy. This can boost consumer spending, business investment, corporate earnings, and asset prices, often benefiting stocks and other risk assets.

How can lax monetary policy affect the stock market?

Lower interest rates make borrowing cheaper, encourage spending and investment, and can increase corporate profits. Investors may also move money from low-yield bonds into stocks, supporting higher stock prices.

What is the relationship between lax monetary policy and inflation?

Lax monetary policy can increase demand by encouraging borrowing and spending. If demand grows faster than supply, inflation may rise.

Why can markets initially like lax monetary policy but later worry about it?

Markets often welcome lower rates because they support growth and asset prices. However, if policy remains too loose for too long, inflation can rise, forcing the Fed to raise rates later, which may hurt markets.

Interest Rates

An interest rate is the cost of borrowing money or the return earned from lending money

Interest Rate formula - determines the interest rate a borrower pays

Interest Rate = Base Rate + Credit Spread

• The base rate reflects general market rates, while the credit spread compensates lenders for taking additional risk.

Interest Rates: Base Rate

A base rate is the underlying benchmark interest rate before accounting for borrower-specific risk.

Interest Rates: Credit Spread

A credit spread is the additional interest rate charged above a benchmark rate to compensate lenders for borrower risk.

Why Investors Care About Credit Spreads

Credit spreads tell investors how scared markets are.

Small Spreads

Investors feel confident.

Economy usually healthy.

---

Large Spreads

Investors worry about defaults.

Economy may be weakening.

What do widening credit spreads often signal?

Widening credit spreads often signal increasing concern about economic weakness, borrower defaults, or financial stress.

Interest Rates: Secured Overnight Financing Rate (SOFR)

a benchmark interest rate based on overnight lending backed by U.S. Treasury securities and is widely used throughout financial markets.

Why is SOFR important

SOFR serves as a benchmark for trillions of dollars of loans, bonds, and financial contracts and influences borrowing costs throughout the economy.

Interest Rates: London Interbank Offered Rate (LIBOR)

LIBOR was a benchmark interest rate used for global lending and borrowing. It has largely been replaced by SOFR.

Interest Rates: Fed Funds Rate

When the Fed wants to slow inflation:

Raises Fed Funds Rate.

When the Fed wants to stimulate growth:

Lowers Fed Funds Rate.

The Fed Funds Rate is the interest rate targeted by the Federal Reserve for overnight lending between banks and is the primary tool used to influence economic activity and inflation.

Why do investors closely watch the Fed Funds Rate?

Changes in the Fed Funds Rate influence borrowing costs, economic growth, inflation, corporate earnings, bond yields, and stock valuations.

Interest Rates: Prime Rate

The Prime Rate is the interest rate commercial banks charge their most creditworthy customers and is heavily influenced by the Fed Funds Rate.

Fed Funds Rate rises

↓

Prime Rate usually rises

↓

Consumer borrowing costs rise

How does the Federal Reserve influence the economy through interest rates?

When the Fed raises rates, borrowing becomes more expensive, spending and investment slow, economic growth weakens, and inflation tends to fall. When the Fed lowers rates, borrowing becomes cheaper, spending and investment increase, growth accelerates, and inflation may rise.

Fed Raises Rates

↓

Fed Funds Rate rises

↓

SOFR rises

↓

Prime Rate rises

↓

Loans become more expensive

↓

Consumers spend less

↓

Businesses invest less

↓

Economic growth slows

↓

Inflation falls

Why do investors care about interest rates?

Interest rates affect borrowing costs, consumer spending, business investment, corporate earnings, bond prices, stock valuations, real estate values, and economic growth. Changes in interest rates influence nearly every financial asset.

Inflation → Fed → Interest Rates → Economy → Corporate Earnings → Markets

Monteray Policy

The Federal Reserve (Fed) controls monetary policy through interest rates and money supply.

Uses:

• Interest rates

• Money supply

• QE

• Forward guidance

Monetary Policy Goals

Stimulate economic growth

Expansionary Monetary Policy

Expansionary monetary policy occurs when the Federal Reserve lowers interest rates and increases money supply to stimulate economic growth, spending, investment, and employment.

Expansionary Monetary Policy Pros

• Supports growth

• Encourages borrowing

• Encourages hiring

• Reduces unemployment

Expansionary Monetary Policy Cons

• Inflation may rise

• Asset bubbles may form

• Too much borrowing can create future problems

When is Expansionary Monetary Policy typically used?

When economic growth is weak, unemployment is rising, or recession risks are increasing.

What is the biggest risk of Expansionary Monetary Policy?

Expansionary monetary policy can increase inflation if borrowing and spending grow faster than the economy's ability to produce goods and services.

Contractionary Monetary Policy

Contractionary monetary policy occurs when the Federal Reserve raises interest rates and reduces money supply to slow inflation and reduce economic activity

Contractionary Monetary Policy Pros

• Controls inflation

• Prevents overheating

• Stabilizes prices

Contractionary Monetary Policy Cons

• Slower growth

• Higher unemployment

• Greater recession risk

When is Contractionary Monetary Policy typically used?

When inflation is too high or the economy is growing too quickly and risks overheating.

Fiscal Policy

The federal government (Congress and the President) controls fiscal policy through taxation and government spending.

Uses:

• Government spending

• Taxes

Expansionary Fiscal Policy

Expansionary fiscal policy occurs when the government increases spending or lowers taxes to stimulate economic growth and employment.

Expansionary Fiscal Policy Pros

• Supports growth

• Creates jobs

• Helps during recessions

Expansionary Fiscal Policy Cons

• Larger deficits

• More government debt

• Potential inflation

What is the biggest downside of Expansionary Fiscal Policy?

It can increase government deficits, debt levels, and inflationary pressures.

Contractionary Fiscal Policy

Contractionary fiscal policy occurs when the government reduces spending or raises taxes to slow economic activity and reduce inflationary pressures.

Contractionary Fiscal Policy Pros

• Can reduce inflation

• Can reduce deficits

Contractionary Fiscal Policy Cons

• Slower growth

• Lower spending

• Potential unemployment increases

What is the primary goal of Contractionary Fiscal Policy?

To reduce inflationary pressures and improve fiscal sustainability by slowing economic activity.

What is the difference between Monetary Policy and Fiscal Policy?

Monetary Policy is controlled by the Federal Reserve and uses interest rates and money supply to influence the economy.

Fiscal Policy is controlled by the government and uses taxation and government spending to influence the economy.

Why do investors care about Monetary Policy more than Fiscal Policy on a day-to-day basis?

Monetary policy directly affects interest rates, borrowing costs, asset valuations, bond yields, and financial markets. As a result, Fed decisions often have immediate effects on market prices.

Economic Cycle

1. Expansion

2. Peak

3. Contraction

4. Trough

Economic Cycle: Expansion

Expansion is a period of economic growth marked by rising GDP, employment, consumer spending, business investment, and corporate earnings.

Usually:

• GDP rising

• Employment rising

• Consumer spending rising

• Business investment rising

• Corporate earnings rising

Which assets often perform well during Expansion?

Stocks, growth companies, small-cap stocks, and real estate often perform well because economic growth supports corporate earnings and investment.

Economic Cycle:

Economic Cycle: Peak

Peak is the point where economic growth reaches its highest level before beginning to slow. Inflation pressures are often elevated.'

Often:

• Inflation rises

• Labor markets tighten

• Fed becomes concerned

Economic Cycle: Contraction

Contraction is a period of slowing economic activity marked by weaker GDP growth, rising unemployment, declining spending, and lower corporate earnings.

Usually:

• GDP slows or declines

• Unemployment rises

• Consumer spending weakens

• Corporate earnings fall

Which assets often struggle during Contraction?

• Stocks

• Cyclical businesses

• Risky assets

Which assets often hold up better during Contraction?

High-quality bonds, defensive sectors, and cash often perform relatively better as investors seek safety.

Economic Cycle: Trough

Trough is the lowest point of the economic cycle where economic activity stops deteriorating and begins preparing for recovery.

Why do stock markets often recover before the economy?

Markets are forward-looking and price expected future improvements before economic data actually improves.

Economic Indicators

• Leading

• Coincident

• Lagging

Economic Indicators: Leading

Leading indicators provide signals about the future direction of the economy before broader economic activity changes.

They help predict where the economy is going.

examples

• yield curve

• stock market

• housing starts

• consumer confidence

Yield Curve

It compares interest rates on government bonds with different maturities.

Example:

• 3-month Treasury

• 2-year Treasury

• 10-year Treasury

• 30-year Treasury

The yield curve shows interest rates across bonds with different maturities and is used to assess economic expectations.

Normal Yield Curve

Long-term rates higher than short-term rates.

This usually means:

Investors expect normal economic growth.

Inverted Yield Curve

An inverted yield curve occurs when short-term interest rates exceed long-term interest rates and has historically been a strong recession indicator.

Short-term rates higher than long-term rates.

This usually means:

Investors believe growth will slow and the Fed may need to cut rates later.

Why do investors closely monitor the yield curve?

The yield curve reflects market expectations about future growth, inflation, and interest rates and has historically provided valuable recession signals.

stock market as a leading indicator

Stock prices reflect investor expectations about future corporate earnings and economic conditions, often moving before economic data improves or deteriorates.

housing starts

The number of new homes being started by builders.

why builders matter and why it is leading

Building a house requires:

• Lumber

• Concrete

• Electricians

• Plumbers

• Appliances

• Furniture

• Labor

Housing impacts many parts of the economy.

Builders are making decisions today based on what they think demand will be in the future.

If housing starts rise:

Builders are saying: We think people will want homes in the coming months

Housing starts reflect builder expectations about future housing demand and economic conditions. Changes often occur before broader economic activity changes.

Consumer confidence (what it is and what it says)

Consumer confidence measures how optimistic consumers feel about the future. Because consumer spending drives much of the economy, confidence often predicts future spending behavior.

If Confidence Is High

People are more likely to:

• Buy cars

• Take vacations

• Eat out

• Purchase homes

• Spend money

Future spending rises.

---

If Confidence Is Low

People become cautious.

They:

• Save more

• Spend less

• Delay purchases

Future spending falls.

Why do investors pay close attention to leading indicators?

Leading indicators help investors anticipate future economic conditions, corporate earnings, interest rates, and market performance.

What do the major leading indicators measure?

• Yield Curve → Investor expectations about the economy

• Stock Market → Investor expectations about future earnings

• Housing Starts → Builder expectations about future housing demand

• Consumer Confidence → Consumer expectations about future economic conditions and spending

Economic Indicators: Coincident

Coincident indicators reflect current economic conditions and tend to move alongside the economy.

Examples

• GDP

• Personal Income

• Industrial Production

Why is GDP considered a coincident indicator rather than a leading indicator?

GDP measures current economic activity and output that has already occurred. It describes the present state of the economy rather than predicting future conditions.

Coincident Indicator: Personal Income

The amount of income people are earning.

Examples:

• Salaries

• Wages

• Bonuses

• Investment income

Why is personal income considered a coincident indicator?

Personal income reflects current economic conditions because it measures the earnings people are receiving from ongoing economic activity.

What personal income tells us

How healthy are consumers right now?

Strong economy:

People get raises.

Income rises.

Spending rises.

GDP rises.

Weak economy:

Layoffs increase.

Income falls.

Spending weakens.

GDP slows.

Coincident Indicator: Industrial Production

Measures how much factories, mines, and utilities are producing.

Why is industrial production considered a coincident indicator?

Industrial production measures current manufacturing and production activity, providing a snapshot of ongoing economic conditions.

Example

Suppose consumers buy more cars.

Manufacturers increase production.

Industrial production rises.

It tells us:

Economic activity is currently strong.

Economic Indicators: Lagging

Lagging indicators confirm economic trends after they have already occurred.

Answer: Did what we thought would happen actually happen?

Confirmation tools

Examples

• Commercial Lending Activity

• Inventory-to-Sales Ratios

• Prime Rate

Lagging Indicators: Commercial Lending Activity

Loans being made by banks to businesses.

Why is commercial lending activity a lagging indicator?

Businesses often increase borrowing after economic conditions improve and expansion plans are already underway, making lending activity a confirmation of existing trends.

The loan comes AFTER the improvement begins.

Lagging Indicators: Inventory-to-Sales Ratios

A measure of:

Inventory ÷ Sales

How much inventory businesses have compared to what they're selling.

Rising Ratio

Inventory building up.

Potentially weaker demand.

Falling Ratio

Products selling quickly.

Potentially stronger demand.

Why is the inventory-to-sales ratio a lagging indicator?

Inventory levels adjust after changes in consumer demand occur, making the ratio a confirmation of economic trends that have already developed.

Lagging Indicators: Prime Rate

The rate banks charge their best customers.

Why is the Prime Rate considered a lagging indicator?

The Prime Rate typically changes after the Federal Reserve adjusts interest rates, making it a reaction to prior policy actions.

Federal Reserve: what it does/ main goals

1. Price Stability: keep inflation under control

2. Maximum Employment: keep unemployment low

How the Fed Drives the Economy

The Federal Reserve changes interest rates and money supply, which affect borrowing, spending, investment, economic growth, inflation, and financial markets.

Example

Inflation rises → Fed raises rates → Borrowing becomes expensive → Consumers spend less → Businesses invest less → Growth slows → Inflation eventually falls.

Reverse example

Inflation falls

↓

Fed cuts rates

↓

Borrowing becomes cheaper

↓

Spending increases

↓

Growth increases

↓

Employment improves

Quantitative Easing (QE)

an unconventional monetary policy where a central bank creates new digital money to buy assets, such as government bonds and mortgage-backed securities, from the financial marke

Why QE Exists

QE is used when interest rates are already very low and the Fed wants to provide additional economic stimulus.

to inject liquidity into the economy, lower long-term interest rates, and encourage lending and investment

What problem does QE solve

QE helps stimulate the economy when traditional rate cuts are no longer sufficient.

The economy is weak.

Rates are already extremely low.

The Fed wants to provide additional stimulus.

What Does QE Actually Do?

The Fed buys:

• Treasury Bonds

• Mortgage-Backed Securities

from financial institutions.

When the Fed buys these assets:

Banks receive cash.

Liquidity increases.

Financial conditions become easier.

Long-term interest rates often fall.