Lecture3

# Lecture3 - The Six Key Macroeconomic Variables Chapter 2 A...

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The Six Key Macroeconomic Variables Chapter 2

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A Quick Recap ! Business Cycles ! Six Key Macro Variables ! Inflation ! CPI Calculation ! Interest Rate ! term premium, risk premium ! Stock Market ! DJIA, S&P500 6/25/08 2 © 2008 Arnav Sheth. All rights reserved.
Business Cycles ! Fluctuations in production, employment, prices, stock markets and interest rates ! booms or expansions occur when production grows and unemployment falls ! recessions or depressions occur when production falls and unemployment rises 6/25/08 3 © 2008 Arnav Sheth. All rights reserved.

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Business Cycles Industrial Production Relative to Trend (Figure 1.3) 6/24/08 4 © 2008 Arnav Sheth. All rights reserved.
The Six Key Macroeconomic Variables 1. Real GDP 2. Unemployment 3. Inflation 4. Interest Rate 5. Stock Market 6. Exchange Rate 6/24/08 5 © 2008 Arnav Sheth. All rights reserved.

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Inflation ! Two measures: 1. CPI 2. GDP Deflator ! The CPI ! Is an expenditure -weighted index ! Has little meaning by itself ! Is measured using a fixed basket of goods 6/25/08 6 © 2008 Arnav Sheth. All rights reserved.
Consumer Price Index (An Example) ! e ! Choose a base year – say, 2006 ! Calculate respective weights of each good for base year 2006 (Our Base Year) 2007 Price Expense Weight Price Beer \$10 4 x 10 = \$40 40/55 = .73 \$8 Cigarettes \$5 3 x \$5 = \$15 15/55 = .27 \$7 Total 40 + 15 = \$55 .73 + .27 = 1 6/24/08 7 © 2008 Arnav Sheth. All rights reserved.

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Consumer Price Index (An Example) ! To calculate CPI for 2007, do the following: 1. Calculate the ratio of prices for focus year and base year 2. Multiply ratio with base-year expenditure weights 3. Add everything up ! Step 1 ! For beer: \$8/\$10 = .8 ! For cigarettes: \$7/\$5 = 1.4 ! Step 2 ! For beer: 0.8 x .73 = .584 ! For cigarettes: 1.4 x .27 = .378 ! Step 3 ! CPI 2007 = .584 + .378 = 0.962 6/24/08 8 © 2008 Arnav Sheth. All rights reserved.
Types of Indices ! Laspeyres Index ! Fixed expenditure weights ! Does not account for substitution bias ! People switch from expensive to cheaper goods ! Tends to overstate inflation ! CPI ! Paasche Index ! Variable expenditure weights ! Accounts for substitution ! but does not account for loss in value of cheaper goods ! Tends to understate inflation ! GDP Deflator 6/24/08 9 © 2008 Arnav Sheth. All rights reserved.

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The Six Key Macroeconomic Variables 1. Real GDP 2. Unemployment 3. Inflation 4. Interest Rate 5. Stock Market 6. Exchange Rate 6/24/08 10 © 2008 Arnav Sheth. All rights reserved.
The Interest Rate ! Main distinguishing characteristics between different rates: ! Risk ! the risk premium ! Duration ! the term premium ! Terms of repayment (coupons) ! Tax treatment ! Difference between nominal and real rates is inflation ! nominal – real = inflation 6/25/08 11 © 2008 Arnav Sheth. All rights reserved.

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The Six Key Macroeconomic Variables 1. Real GDP 2. Unemployment 3. Inflation 4. Interest Rate 5. Stock Market 6. Exchange Rate 6/24/08 12 © 2008 Arnav Sheth. All rights reserved.
Stocks vs. Bonds ! Buying a stock gives you ownership of a company !

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