TARHEEL CONSULTANCY

SERVICESBangalore India

THE MACROECONOM

ICS OF FIXED INCOME

MARKETS

FIXED INCOME MARKETS & MACROECONOMICS GDP is a measure of the level of

economic activity GDP and is components are measured in

real terms The quantity of goods and services is

measured using the base year prices

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MACROECONOMICS (CONT…) Intermediate transactions are not

counted in GDP Take a PC manufacturer who acquires

components to make the product and employs labour for the sameThe cost of the components will not be

includedThe salary paid to production workers will

not be includedBecause the price of the PC includes these

costs

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MACROECONOMICS What drives the GDP?

The level of activity in an economy at a point in time is determined by the aggregate demand Spending on goods and services

The higher the aggregate demand The more the induced production And the higher the GDP

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AGGREGATE DEMAND The aggregate demand can be divided

into the following sectors ConsumptionResidential investmentCAPEX on the part of firms Government Spending InventoriesForeign Trade

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CONSUMPTION It refers to the spending by the household

sector on items which are consumed In the US it accounts for over 60% of aggregate

demand It can be divided into

Durables An expected life of at least 3 years These are extremely cyclically sensitive

Non durables Their consumption is not very cyclical

Services They account for over 50% of consumption in the

US04/28/2023 7

CONSUMPTION (CONT…) Households spend out of their income The percentage of after-tax income that

is consumed by a household depends on The state of the labor market Home prices

If property prices of owned property is high there is less of an incentive to save

The state of the stock market The percentage of the post-tax income

not consumed by the household sector isThe SAVINGS Rate

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RESIDENTIAL INVESTMENT Refers to the spending of individuals on

property acquisition It is sensitive to interest ratesExpected state of the labor market

Only newly built homes are included in the GDPSale of existing properties add nothing to

economic activity

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CAPEX Businesses spend a lot on plant and

equipment Motor vehiclesAnd computers Are big components of CAPEX in the US

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CAPEX (CONT…) Business CAPEX is a much smaller

portion of aggregate demand as compared to consumption and housing But it has a disproportionate impact on

changes in GDP It usually bears large responsibility for

business cycle fluctuations

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CAPEX (CONT…) It is the key driver of an economy’s

future growth For it determines the economy’s future

ability to produce Other growth drivers are

Spending on education and training Government spending on infrastructure

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GOVERNMENT SPENDING Government spending is a key economic

driverBut due to political pressures to present

relatively balanced annual budgets it has been shrinking in terms of relative importance

Often it is undertaken to support aggregate demandDue to declines in demand related to

consumption and CAPEX For instance the onset of a recession will

typically stimulate government spending

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GOVERNMENT SPENDING (CONT…) A distinction is required between

spending on goods and services and transfer paymentsTransfer payments are like social security or

welfare payments They are not a part of aggregate demand They simply transfer spending power (by

way of taxes) from one individual to another

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INVENTORIES Inventories have an impact on GDP only

when there is a change An increase in inventories will raise the

GDPThe addition to inventories reflects an

economic outputA decrease in inventories will lead to a

decline It reflects spending from other sectors that

did not lead to production but to a decline in stocks

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INVENTORIES (CONT…) Inventory accumulation foretells a future

decline in productionAlthough it is positive for current economic

output Inventory usage is positive for future

GDP growthAlthough it is negative for current economic

output

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INVENTORIES (CONT…) In the case of accumulation

Was it a result of overstocking to meet sales which never materialized

Or was it due to strong consumer spending Overstocking will indicate a decline in

future output Strong consumer spending does not With the increasing importance of the

service sector as a component of GDP Inventories are no longer perceived in

developed countries as an item of significance

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FOREIGN TRADE When aggregate demand exceeds the

economy’s output Imports will exceed exports

If aggregate demand is less than economic output Imports will be lower than exports

Net exports stimulate economic activity They depend on the relative price and quality of

domestic goods and services vis a vis foreign products

The level of currency exchange rates The country’s aggregate demand relative to that

of its trading partners 04/28/2023 18

THE ROLE OF PROFITS Firms will produce goods and services

only if the activity is profitable If so employment will increase as will CAPEX

Sometimes the cost structure may lead to a loss if business activity is undertaken If so more demand will not translate to

greater production There will be no increase in employment or

CAPEXGDP will not grow

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THE OUTPUT GAP AND INFLATION What an economy can produce – as

opposed to what it actually produces – is termed as Potential GDP It represents the level of output that the

economy will tend towards in the long run Potential GDP depends on

The labor forces – its experience, education, and training

Stock of physical capitalAvailable natural resources Technology and innovation

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OUTPUT GAP (CONT…) The difference between potential and

actual GDP is the Output Gap or GDP Gap

The mandate of the government and central bank is to narrow the gapThe wider the gap the greater will be the

level of unemployment Labor is not being fully utilized

One way to reduce the gap is by increasing government spending

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OUTPUT GAP (CONT…) There is a flip side

The narrower the output gap the greater will be the inflationary pressure

The central bank needs to take cognizance of what impact its policies will have on pricesThis could preclude it from taking actions to

narrow the GDP gap

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INFLATION As real GDP grows more labor is

required This will tighten labor markets forcing an

increase in wages They will lead to a higher price for goods

and services since producers will pass on their costs

Also the increase in supply may not immediately keep pace with the growing demandThe result is inflation

Thus the narrower the GDP gap the higher the rate of inflation 04/28/2023 23

INFLATION (CONT…) Inflation could influence people’s

expectations If so it becomes self-fulfilling

Labor wages and commodity prices will be based on expected inflation

High inflation will lead to higher expected inflation which will lead to higher actual inflation

This cycle will go inAnd is very difficult to control in practice

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INFLATION (CONT…) External factors could produce one-off

changes in the price levelFor instance if crude oil prices were to rise

there could be an impact on the prices of goods and services produced in an economy

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INFLATION (CONT…) Why is inflation an issue of concern for policy

makers?Business decisions are based on expected profits Profits depend on costs of inputs and labor and

prices of outputs During inflationary periods the decision making

process gets corrupted Businesses postpone production and CAPEX

related decisions Interest rates rise due to greater inflation

premiums People earning fixed incomes lose real earnings

due to inflation

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UNEMPLOYMENT A low unemployment rate reflects a

tight labor market This leads to higher wages A high unemployment rate results in a

smaller increase in wagesDuring a recession, wages may actually

decline Wage gains will lead price increases

which will manifest itself as higher inflationThus low unemployment is associated with

high inflation 04/28/2023 27

INTEREST RATES Interest rates equilibrate the SBUs’

willingness to extend credit and the DBUs’ need for it People who save are paid interest to forego

current consumption and lend That is they are paid for waiting to spend By borrowers who cannot wait and whose

current needs exceed the available capital

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INTEREST RATES (CONT…) If the GDP gap is substantial and there is

major unemployment people tend to save more

Firms see less profitability in expansion and tend to borrow less Obviously interest rates will decline

When the GDP gap is narrow households will save less

Businesses will borrow more aggressively Interest rates will rise Inflationary expectations will rise This will further push up interest rates

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INTEREST RATES (CONT…) Thus when the GDP gap is narrow

interest rates will tend to accelerate When the gap widens interest rates will

decelerate

FISCAL DEFICITS Budgets have fiscal deficits when

Government expenditure exceed incomeObviously the Government needs more

fundsFor this the Government will borrow

Sources of funds for the GOI Borrow within India Or from other countriesOr supranational organizations like IMF

The money borrowed by a country’s government is called the Public Debt

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FISCAL DEFICITS (CONT…) To pay interest on the debt the

Government has three options Increase tax ratesStimulate economic growth so that tax

revenues automatically increase Print more money to pay back the debt –

debt monetization Debt monetization will trigger inflation Rising taxes may lead to declining

economic activity

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FISCAL DEFICITS (CONT…) Deficits as a percentage of GDP may

decrease during economic booms Increase in tax revenues Lower unemployment – leading to reduced

welfare payments How can a country counter a deficit?

Stimulate economic growth Reduce government expenditure Increase taxes

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FISCAL DEFICITS (CONT…) Governments issue bonds to finance

their deficits Issue of Treasury securities T-bills, notes and bonds

Countries like the US have a unique advantage The USD is a global currency Thus the US can run larger deficits than

other countries

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FISCAL DEFICITS (CONT…) Every year the deficit adds to the

country’s sovereign debt As the debt grows it increases the deficit

in two ways Interest has to be paid on a larger base This increases spending without any

accompanying benefits Second high debt levels may make it

difficult for a government to borrow Borrowers will demand greater interest to

counter this risk

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FISCAL DEFICITS (CONT…) Rising debts can lead to a debt trap

Countries need to issue more debt to repay interest and principal on existing debt

At some stage interest rates may skyrocket If the trend continues a country may default

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IMPACT OF OIL PRICES Demand for oil is relatively price-

inelastic in the short run If oil prices were to increase cutting back on

consumption immediately is not feasibleNor is it easy to switch to alternative

sources of energy Thus higher oil prices mean greater imports This will lead to a greater trade deficitThere will be a decline in domestic demand This will push up the unemployment rate

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OIL (CONT…) The drop in GDP will reduce oil demand This will lead to lower oil consumption Rising oil prices will push up the prices

of all goods since They are transported using vehicles using

petrolOr else in some cases they use oil as an

input Due to a higher cost of living labour may

demand higher wages Businesses may respond by hiking

prices There could be an inflationary spiral

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OIL (CONT…) The central bank will witness a widening

gap between actual GDP and potential GDP In response due to concern with higher

unemployment it may increase the money supply

This will lower interest rates, stimulate the economy and narrow the GDP gap

However if the central bank is more perturbed about spiralling inflation It will reduce money supply This will increase the GDP gap but is likely

to lower expected inflation and therefore actual inflation

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QUANTITATIVE EASING How does QE work? The central bank electronically creates new money and

uses it to purchase gilts from private investors such as pension funds and insurance companies.

These investors typically do not want to hold on to this money, because it yields a low return.

So they tend to use it to purchase other assets, such as corporate bonds and shares.

That lowers longer-term borrowing costs and encourages the issuance of new equities and bonds and that should stimulate spending. 

The policy was designed to help businesses raise finance without needing to borrow from banks. 

And also to lower interest rates for all households and businesses.   

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QE (CONT…) If QE were to paper off, interest rates in

the US will rise There will be a reversal of FII into India There will be a fall in Indian equity

prices due to less demand from FIIs Less demand for the rupee will lead to

depreciation of the rupee Companies with unhedged forex

exposure could suffer

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QE (CONT…) Slow down of capital inflows could hurt

investments This will lead to a lower than expected

growth in GDP A weakening rupee would mean rising

exports This will lead to inflationary pressure

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