Key Economic Indicators and Market Forces Explained

Posted on Jan 20, 2025 in Accounting and Finance

Shifters of Aggregate Supply

The aggregate supply is a model that shows what determines the total supply for the economy and how total demand and total supply interact at the macroeconomic level.

Factors that shift aggregate supply include:

Capacity and number of producers
Economic expectations for producers
Cost of factors of production
Technology and R&D

Shifters of Aggregate Demand

The aggregate demand is a model that shows what determines total supply or total demand for the economy and how total demand and total supply interact at the macroeconomic level.

Factors that shift aggregate demand include:

Population size
Economic expectations for consumers
Disposable income
Monetary policy and interest rates

Contractionary Policy

Contractionary policies impact the shifters of aggregate demand or aggregate supply and make the output of an economy slow down for a certain level of prices. Restrictive policies are applied when economies are overheating or growing too fast.

Measures include:

Increasing interest rates
Increasing bank reserve requirements
Decreasing government spending
Increasing taxes to reduce disposable income

Setbacks:

Deflation
Excessive indebtedness

Expansionary Policy

Expansionary policies impact the shifters of aggregate demand or aggregate supply and make the output of an economy grow for a certain level of prices.

Measures include:

Decreasing interest rates
R&D incentives
Tariffs on imports
Incentives to exports

Setbacks:

Budget deficit
Inflation

Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is the monetary value of all finished goods and services made within a country during a specific period.

GDP: Supply Approach

GDP is the aggregate value added by each of the three sectors of the economy:

Services
Industry
Agriculture

GDP: Demand Approach

GDP is the aggregate expense made to purchase the goods and services of the economy.

GDP = C + G + I + (X – M)

C: Household consumption
G: Government purchases (consumption and investment)
I: Gross private investment
(X – M): Net exports
- X: Exports
- M: Imports

GDP: Income Approach

GDP is the aggregate income earned by employees, proprietors, and companies in the country.

BT: Indirect business taxes
W: Wages (labor income)
GOS: Gross operating surplus
D: Depreciation
NOS: Net operating surplus
R: Rental income
i: Interest income
BP: Business profits

GDP Limitations

GDP omits depreciation of physical capital stock and resources (unless accounted for). Depreciation is the loss in value of physical capital due to usage, destruction, etc.
Controversial: A natural disaster will wipe out part of the physical capital of a country (buildings, roads, trees, etc.), but this will not reduce GDP. Companies have to take this into account by amortization.
Expenditure on rebuilding will be included. Natural disasters thus tend to increase GDP.
But, depending on the disaster, if it affects productive infrastructures, it may trigger a decrease in the GDP.
Home-made: GDP excludes home production of cleaning, cooking, and childcare done in the household. The value of home production in Spain was estimated at 43% of GDP in 2010!
Underground economy: GDP does not capture transactions conducted in the underground economy. However, in Europe, drug dealing and prostitution have recently been included.
Externalities: GDP does not count negative externalities such as pollution, noise, and crime.
Leisure: GDP does not record leisure. We might increase GDP by working more, but this will also reduce our time for leisure. Reduction in leisure time is not deducted from GDP.

Gross National Income (GNI)

GNI is the monetary value of all the income earned by nationals of an economy in the country and abroad in a particular year.

Components:

Flow: Non-static temporary dimension
Finished goods and services: Value added of the three sectors of the economy
Global: Produced by residents in the country and abroad
Time: One year
Monetary value: The country’s currency
GNI_mp = GDP_mp + NFFI

Inflation

Inflation is the sustained increase in the general price level of goods and services in an economy over a period of time that reduces the purchasing power per unit of currency.

Problems:

It causes uncertainty and falling investment.
Inflation increases costs and reduces competitiveness, which can lead to falling demand.
Firms may anticipate that interest rates will have to rise to deal with inflation, and this undermines business confidence.

Inflation is measured by the Consumer Price Index (CPI), an index that measures changes in the price level of the typical market basket of consumer goods and services purchased by a representative average family in a country over a certain time period.

The Labor Market

Active population: Part of the potential workforce, either working or actively looking for a job. Note: If you are not registered in the public job search offices, you will be considered inactive.
Inactive population: Part of the potential workforce, not working or actively looking for a job. If you are looking for a job but are not registered, you are officially inactive.
Employed population: Persons who are part of the active population and are currently working.
Unemployed population: Persons who are part of the active population, are willing to work, and cannot find a job.
Unemployment rate: Measure of unemployment that considers the percentage of the total current labor force or active population who are unemployed or willing to work and not finding a job.

Unemployment Rate = (Unemployed / Labor Force) * 100

Activity rate: Measure of employment that considers the percentage of the total population of a country that is part of the labor force, is of legal working age, and has a job or is looking for a job.

Activity Rate = (Active Population / Potential Population) * 100

Open and Closed Economies

Open Economy

An open economy interacts with other economies in the world. GDP ≠ GNI

The economy relies on international trade and is willing to trade and compete with other countries to buy and sell goods and services.
The economy relies on international markets and is willing to hold, purchase, and sell capital and financial assets in foreign markets.
There are no restrictions on citizens to move to other countries.

Closed Economy

A closed economy has no relation with the rest of the world and is confined to itself. GDP = GNI

There are no imports or exports, and the economy is self-sufficient to produce everything citizens need.
The economy doesn’t allow foreign investment in capital and financial markets.
Citizens are not allowed to freely move to other countries and must report their location.

The Balance of Payments

The balance of payments is a statement that summarizes the country’s record of all economic transactions between the residents of the country and the residents of the rest of the world for a specified time period.

Components:

Current Account:
- Goods
- Services
- Primary income
- Secondary income
Capital Account
Financial Account:
- Direct investment
- Portfolio investments
- Other investments
- Reserve assets
Errors and Omissions

Current Account Balance

The current account covers income-related transactions.

Goods: Trade balance of goods: Exports (+) and imports (-) of goods (FOB value; no freight & insurance)
Services: Trade balance of services: Exports (+) and imports (-) of services, including freight & insurance, tourism & travel, transport, communications, financial services, recreation & culture, royalties, and other services
Primary income (net foreign factor income): Income transactions corresponding to the use of factors of production (labor and capital) owned by residents abroad (+) and non-residents in the country (-) => interests, dividends, or compensations to employees
Secondary income (net current transfer payments): Non-productive and non-financial income transactions, including transfers from non-residents to residents (+), gifts and donations from abroad (+), transfers from residents to non-residents (-), and gifts and donations to foreign countries (-) => charities or private remittances

Exchange Rates

The exchange rate is the value of a nation’s currency in terms of another currency, determined by supply and demand according to the interaction of the different agents that buy and sell that currency in the foreign exchange markets.

Nominal Exchange Rate

The nominal exchange rate is the number of units of the local currency that can be purchased with one unit of foreign currency. Nominal exchange rates are given by foreign exchange markets (e.g., GBP 1 = EUR).

Real Exchange Rate

The real exchange rate is the number of units of a domestic good or service that can be purchased with one unit of a foreign good or service.

Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is a theory for measuring prices at different locations that states that, if there were no transaction costs nor barriers for a certain good or service, the price for it should be the same at every location, in local currency.

PPP exchange rate = domestic price / foreign price

Growth, Monetary Mass, and Inflation

Growth

When the economy grows, the currency should appreciate. If the economy grows by 2%, the currency should appreciate. We are referring to an increase in real GDP.

Monetary Mass

When the monetary mass increases, the currency should depreciate. If the monetary mass is increased by 2%, the currency should depreciate by 2%.

These two effects neutralize one another, and the strongest one shall decide the evolution of the currency.

If growth is greater, the currency increases its value (Real GDP).
If monetary mass growth is greater, the currency decreases its value (Monetary aggregates).

Inflation’s Effect on Exchange Rates

In the long run, when a country increases its monetary mass over the growth of the economy, it shall generate inflation. So, if we look at the evolution of inflation in the long run, the country with lower inflation shall appreciate its exchange rate over the one with higher inflation. In the short run, things may work otherwise. It depends on whether the increase in the monetary mass is due to an increase in economic activity or the consequence of an expansionary monetary policy in which the government is printing money that is not generating growth.

Floating Exchange Rate

A floating exchange rate is when the par value of a domestic currency is set by supply and demand for that currency in the foreign exchange market.

Types

Free float: The exchange rate depends on market forces and reacts to impacts on supply and demand with no intervention from the central bank.
Managed float: The central bank intervenes to influence the exchange rate with monetary policies to keep a target rate in stages of extremely volatile floats.

Advantages:

Independent monetary policy
Lower demand for foreign currency reserves
Less speculation

Disadvantages:

Volatility in foreign exchange rates
Instability in times of crisis

Fixed Exchange Rate

A fixed exchange rate is a regime applied by a government or central bank that ties the country’s official currency exchange rate to another country’s currency or the price of gold. The purpose of a fixed exchange rate system is to keep a currency’s value within a narrow band.

Disadvantages:

Limited independence, flexibility, and autonomy
High demand for foreign currency reserves
Speculation and attacks that demand high interest rates
Limited competitiveness in the foreign trade markets

Tariffs

A tariff is a tax on imported goods and services between sovereign states that increases the price, making them more expensive to consumers. A specific tariff is levied as a fixed fee; an ad valorem tariff is based on the item’s value. A protective tariff is used to raise the price of an imported good to protect a domestic market against competition from foreign markets.

International Markets and Perfect Competition

In an open economy that is perfectly competitive, the average price in the market is below the equilibrium price because imports are sold for a lower price, and consumers buy imports. Imports are sold at a lower price because if foreign products are not price competitive, they wouldn’t enter the local market.

Tariffs on Imports: A Good Idea?

The revenue from tariffs (in the case of imports) is kept by the government and doesn’t benefit the supplier or consumer.

Characteristics of Money

Money is the basic monetary unit (currency) circulating within a monetary system that is designated by a government to serve as the basis of its currency system into which things in the country are convertible and comparable.

Functions of money:

Medium of exchange (payment) for transactions and repayments
Unit of account for pricing and settlement
Store of value for keeping convertible value into other assets
Standard of deferred payment that allows to give value to future transactions

Bitcoin can be considered money, but it belongs to bank money. It is a deposit, which means the total value of records of funds held in deposit accounts in commercial banks that are subject to regulation concerning withdrawal and maturity conditions.

Money Multiplier

The money multiplier indicates how the amount of money supplied in an economy changes when the amount of money in circulation (coins and notes) changes.

The supply of money results from the following formula:

S_m = MB * m

MB: Monetary base
m: Money multiplier

The supply of money is the product of the monetary base and the money multiplier.

MB: Notes and coins in circulation (in the hands of the public) + notes and coins in bank vaults + notes and coins in the Central Bank vault
m: Number of times that commercial banks can multiply the monetary base in an economy

Monetary Aggregates

The supply of money consists of standard money and bank money, currency in circulation, and deposits. Monetary supply can be monitored using certain elements called monetary aggregates that measure the amount of money circulating in an economy to predict economic growth.

According to the ECB, monetary aggregates are:

M1: Currency in circulation + overnight deposits
M2: M1 + time deposits + saving deposits
M3: M2 + repurchase agreements + money market deposits + securities with a maturity of up to two years

Technical and Fundamental Analysis

Fundamental Analysis: Analysis of traded values based on financial statements in order to conduct a company stock valuation and predict price evolution, business performance, and risk and find out the intrinsic value of a share.
Technical Analysis: Based on the historic behavior of the value.

Rating Agencies

Rating agencies provide a rating with the credit risk and solvency quality of a company.

Moody’s
Standard and Poor’s
Fitch

Money Demand

D_m = Y * L(r)

Y: Nominal income in the economy (NGDP income)
L(r): Liquidity preference
r: Nominal interest rate in the economy

When interest rates are high, the demand for money is low, and people prefer to invest in financial instruments. When interest rates are low, the demand for money is high, and people prefer to use money for transactions.

The amount of money demanded is negatively proportional to the interest rate in the economy: the higher the interest, the lower the demand for money.

The quantity demanded changes with income: the higher the income, the higher the amount of the transactions and the higher the demand for money; the lower the income, the lower the amount of the transactions and the lower the demand for money.

Money Supply

The supply of money is decided by the central bank and doesn’t depend on the interest rate but on the economic cycle and the monetary policy. The supply of money is perfectly inelastic, as the amount of money in the economy doesn’t change with the interest rate. The interest rate is monitored by central banks to allow economic growth.

Money Demand Shifters

Changes in prices: If prices change, people would need more or less money for transactions.
- Increasing → D_M → i↑
- Decreasing → D_M ← → i↓ (Y, nominal income)
Income: Income affects the amount and volume of transactions that people can accept.
- Increasing → D_M → i↑
- Decreasing → D_M ← → i↓ (Y, nominal income)
Technology in the banking system: Use of credit cards and similar items that can replace money.
- Increasing → D_M → i↑
- Decreasing → D_M ← i↓ (Liquidity preference)

Expansionary Monetary Policy

Expansionary monetary policy involves increasing the monetary base, carried out by the central bank, purchasing treasury bonds, or reducing discount rates for commercial banks with the aim of increasing deposits. It also reduces the reserve coefficient, so commercial banks increase the monetary aggregates and reduce market interest rates so that consumers demand more money.

Effects:

The interest rate in the economy goes down.
The cost of borrowing money is lower.
The spending power of people and businesses increases.
Household consumption and private investment increase.
Aggregate demand increases.
Production and labor increase, so aggregate supply increases to meet demand.
Prices increase if aggregate supply reaches full capacity and doesn’t meet demand.

Contractionary Monetary Policy

Contractionary monetary policy involves decreasing the monetary base, carried out by the central bank, selling treasury bonds, or increasing discount rates for commercial banks with the aim of decreasing deposits. It also increases the reserve coefficient, so commercial banks reduce the monetary aggregates and increase market interest rates so that consumers demand less money.