Economic Terms

• Gross Domestic Product (GDP)
  • Measurement of the output of goods and services produced within the US (disregards origin of producer – this is GNP)
    • Key measure of aggregate economic activity
• Consumer Price Index (CPI)
  • Measures the changes in prices of fixed # of goods purchased by a typical consumer
    • Key measure of inflation
• Inflation
  • “Too much money chasing too few goods”
    • Leads to a rise in prices of goods and services
    • High inflation usually accompanies high interest rates
• Deflation
  • A general decline in prices, often caused by a reduction in the supply of money or credit
  • Interest rates trend downward 
• Disinflation
  • Reduction in the rate of inflation
    • 6% → 2% disinflation (we’re still in inflation)

The Business Cycle

• Expansion
  • Economy is growing
• Peak
• Contraction/Recession
  • Negative GDP growth 
  • Recession is 2 consecutive quarters of a contracting economy 
• Trough

• Inflation may begin to occur between Expansion and Peak, with the FRB then responding with a “Tight Monetary” policy
• The Federal Reserve Board pursues an “Easy Money” policy to stop the contraction (between Peak & Recession)

Economic Indicators

• Leading
  • Building permits, private housing units
  • Manufacturer’s new orders, consumer goods, non-defense capital goods
  • S&P 500 Index
  • Initial claims for unemployment insurance
  • Interest rate spreads, 10-year T-bonds less federal funds
• Coincident(move w/ business cycle)
  • The Index of Industrial Production
  • Employees on nonagricultural payrolls
  • Personal income less transfer payments
• Lagging
  • Change in the Consumer Price Index for services
  • Average prime rate charged by banks
  • Average duration of unemployment 

Matching

• Consumer price index
  • Key measure of inflation
• FRB employs a tight money policy
  • As the peak is approached in the business cycle
• FRB employs an easy money policy
  • During periods of contraction
• Leading indicator
  • S&P 500 index
• Coincident Indicator
  • Personal income
• Lagging Indicator
  • Prime rate of interest 

Measuring Interest Rates

• Prime Rate
  • The rate charged by commercial banks to their best corporate clients 
• Discount Rate
  • The rate charged by the Fed when a member bank borrows from it
    • The Fed sets this 
• Federal Funds Rate
  • The rate charged on an overnight loan of reserves between member banks
• Call Money Rate
  • The rate charged by commercial banks on collateralized loans to broker-dealers (margin)

Classifications of Stock

• Cyclical
  • Performance tends to run parallel to changes in the economy
    • Includes machine tool companies, construction firms, transportation and automotive
    • These tend to do well during the expansion phase of the business cycle
• Defensive
  • Have smaller reactions to changes in the economy
    • Examples include utility, tobacco, alcohol, cosmetic, pharmaceutical, and food companies
    • These tend to do better during contraction
• Growth
  • Companies whose sales and earnings are growing at a faster rate than the economy
    • They reinvest most of their earnings and pay little or no dividends
    • Tend to be riskier than other stocks, but offer greater potential for appreciation
• Value
  • Stocks that trade at lower prices relative to the issuing company’s fundamentals
    • The risk is that investors may ignore these companies
    • Investors who buy value stocks are considered contrarians 

Market Capitalization of Stocks

• Value of all the shares outstanding in the company

Monetary and Fiscal Policy

Tools of the Feds

• The following “tools” are listed from the least to the most used
• Regulation T
  • Extension of credit by broker-dealers (50%)
• Discount Rate
  • The only rate that’s directly controlled by the Fed
• Reserve Requirement
  • Amount of money that a bank must maintain based on a percentage of deposits 
• Federal Open Market Committee (FOMC)
  • Trades US Treasuries through “primary government dealers”

Actions of the FOMC

• To increase money supply and ease credit, the FOMC will
  • BUY Securities and Engage in Repos (easing)
    • This will cause deposits and reserves to: increase
• To decrease money supply and tighten credit, the FOMC will
  • SELL Securities and Engage in Reverse Repos (tighten)
    • This will cause deposits and reserves to: decrease
• The goal of these actions is to influence the Fed Funds Rate

International Economic Factors

• Interest Rates
  • An inverse relationship exists between the US dollar and foreign currencies
  • Rising interest rates in US will normally be accompanied by a strengthening of the dollar in relation to other currencies
• Balance of Trade
  • System of recording all of a country’s economic transactions with the rest of the world over a specific period
    • Favorable balance of trade:
      • A decline in the dollar (relative to other currencies)
      • When the US exports more than it imports
    • Unfavorable balance of trade
      • An increase in the dollar (relative to other currencies)
      • When the US imports more than it exports 

Foreign Exchange

• Companies that receive revenue and incur costs in foreign currencies will have exchange-rate risk

Fill in the Blank

• The Federal Reserve Board changes and provides lending through the discount rate
• Regulation-T Is the rate used by the Federal Reserve Board to control the extension of credit by broker-dealers
• The FOMC will increase the money supply when it should buys securities which should increase deposits and reserves
• The Reserve Requirement dictates the amount that member banks must keep on deposit
• Rising Interest rates in the US generally leads to a strong dollar
• The balance of trade tends to become more favorable with a weak dollar relative to foreign currencies

The Balance Sheet

• Goodwill is cost in excess of the fair value of the assets – liabilities of the company being bought
• Paid-In Capital (excess above par value that company raised when they issued stock)

The Income Statement