TARHEEL

CONSULTANCY
SERVICES
Bangalore India

THE
MACROECONOMICS
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 same
The

cost of the components will not be included

The salary paid to production workers will not be
included
Because 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
Consumption
Residential

investment
CAPEX on the part of firms
Government Spending
Inventories
Foreign 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 US

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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 is
The

SAVINGS Rate
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RESIDENTIAL INVESTMENT

Refers to the spending of individuals on

property acquisition
It

is sensitive to interest rates

Expected state of the labor market

Only newly built homes are included in the

GDP
Sale

of existing properties add nothing to

economic activity

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CAPEX

Businesses spend a lot on plant and

equipment
Motor

vehicles
And 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 economys future

growth
For

it determines the economys 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

driver
But

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

demand
Due

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 payments
Transfer

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 GDP
The

addition to inventories reflects an economic

output
A 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 production
Although

it is positive for current economic

output

Inventory usage is positive for future GDP

growth
Although

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 economys

output
Imports

If aggregate demand is less than economic

output
Imports

will exceed exports

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 countrys aggregate demand relative to that of
its trading partners
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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
CAPEX
GDP 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 capital
Available 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 gap
The

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
prices
This

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
demand
The

result is inflation

Thus the narrower the GDP gap the higher

the rate of inflation
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INFLATION (CONT)

Inflation could influence peoples

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 in
And is very difficult to control in practice

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INFLATION (CONT)

External factors could produce one-off

changes in the price level
For

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 wages
During

a recession, wages may actually decline

Wage gains will lead price increases which

will manifest itself as higher inflation
Thus

low unemployment is associated with high

inflation

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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

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FISCAL DEFICITS

Budgets have fiscal deficits when

Government expenditure exceed income
Obviously

the Government needs more funds

For this the Government will borrow

Sources of funds for the GOI

Borrow

within India
Or from other countries
Or supranational organizations like IMF

The money borrowed by a countrys

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 rates
Stimulate 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 countrys

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 feasible
Nor is it easy to switch to alternative sources of
energy
Thus higher oil prices mean greater imports
This will lead to a greater trade deficit
There 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 petrol

Or 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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