MScBA – Business Economics
Individual assignment
Lauk Beumer – u134811
Surging world growth makes a mockery of Brexit panic
November 2018
Prof.dr. B. Harrison
Word count: 2,386
1. How is economic growth measured and why is it important?
Economic growth is the increase rate of Gross Domestic Product (GDP) in an economy over a period of time. Usually measured quarterly and annually. Four components of expenditure are combined in GDP: consumption, investment, government spending, and net exports. The following equation is used to measure GDP (Mankiw & Taylor, 2017).
GDP=C+I+G+NX
In this equation, consumption (C) consists of all private expenditures in the economy such as food, rent, autos, and clothing. Investment (I) is the number of goods that will have a contribution to future output including buildings, and machinery. Government spending (G) is the sum of all expenses of the government on services and final goods. Salaries of government workers and purchasing weapons for the army are examples of government spending. Net exports (NX) is the difference between export and import in a certain country.
To compare GDP over a period of time economist look at GDP in two different ways: real increase and nominal increase. Nominal GDP measures current prices while real GDP is adjusted before inflation. They can be measured with the following equation:
(GDP t – GDP t-1)
GDP t-1 – 1
The difference between the price level of nominal GDP and real GDP can be calculated by the GDP deflator:
Nominal GDP
Real GDP
Economic growth for a nation means a rise in national income, national output, and total expenditure. But why is growth so important for a nation? As seen in the calculations of the GDP there are four major components. These four components are related to each other. As an example, when there is no economic growth and new machinery is needed (I) this will lead to less consumption (C). Less consumption (C) means fewer taxes and this will influence the amount of money the government can spend (G). Less government spending (G) means cutting back the imports (NX), and so on. On the other side, when there is an economic growth, there is an opportunity to invest in new machinery without consequences for the other components. A growing economy will lead to more consumption (C) thus more taxes. Now, government spending can increase, and government borrowings can be cut down. Economic growth will give the society the opportunity to spend money on one of the four components without cutting back on another component.
Figure 1. Virtuous Circle of Economic Growth
Source: economicshelp.org
2. Give a detailed explanation of the paragraphs underlined in the above article.
| The US Federal Reserve’s retreat from four rate rises this year has had a catalytic effect, reviving the fortunes of emerging markets and once again lifting the Sword of Damocles hanging over the heads of those who have borrowed $11 trillion in dollars outside US jurisdiction. The Fed is in effect acting as the central bank for the whole world, giving a shot in the arm to an international financial system that is has never been so tightly-linked to the dollar or to US borrowing costs – at least since the end of the Gold Standard. |
The four rate rises in 2016 refer to the lifted interest rates of the central banking system of the United States. The increase of the interest influences the loans of banks. For banks in the United States, it is more expensive to borrow money than before.
The main goal of the Fed (US Federal Reserve) is to maximum sustainable employment, stable prices, and moderate long-term interest rates (The Federal Reserve, 2018). By lifting the interest rate the Fed influences the moderate long-term interest rates. In this case, the economy of the US was growing too strong, so there was no price stability anymore.
Emerging markets are nations that are investing in a capacity that is more productive. Those countries including China, Indonesia, and India are moving away from their traditional economies (Amadeo, 2018).
Figure 2. US Federal Reserve's interest rate
Monthly federal funds effective rate
Source: Federal Reserve
These countries had a benefit by borrowing money at a low-interest rate between 2008 and 2015, but now they have a huge debt and it will be more difficult to service them. Another impact of the higher interest is the fall of foreign investments. The higher interest rate could draw back investors to the US and they will retrieve their money from the emerging markets (Kuepper, 2018). In 2018, the Fed also raised the interest rates, and this had an influence on the national currencies of some important emerging market currencies as shown in Figure 3.
Figure 3. Emerging market currencies on the slide
Source: Bloomberg
There are multiple central banks in the world, but the Fed it is seen as the most powerful one. And besides all other central banks, the Fed has two global responsibilities. Firstly, the dollar is the currency of choice for lending and borrowing money. Secondly, monetary conditions worldwide are affected by the policies of the Fed. Because of these two reasons the Fed is able to act as the central bank of the world. The value of the dollar matters more because of the domestic financial conditions and the effect on inflation (Valasco, 2016).
Figure 4. Total assets of major Central banks in US Dollars
Source: National Inflation Association
3. What is meant by the term “Fiscal stimulus” and what is the purpose behind launching this?
Fiscal stimulus is related to ‘economic growth’ as discussed in question 1. The term ‘fiscal stimulus’ means that the government decides to stimulate the economy to create an economic growth. They can accomplish this by lowering taxes or increase government spending, to name a couple. As an example, the government can lower taxes to stimulate higher consumption (C) and investment (I). So, the government decides to stimulate the economy financially to get a more positive outcome in the virtuous circle of economic growth (Figure 1).
The government will decide to stimulate the economy when there is an economic decline, like a recession. As an example, after the recession of 2007 Central Banks decided to reduce the interest rate to offset the increase in private sector risk (Taylor, 2010). Another reason for the government to give a boost is to prevent an economic slowdown. The purpose of launching a fiscal stimulus is to reverse or prevent a recession and invigorate the economy by boosting employment and spending (Momoh, 2017)
By frontloading is meant that plans are made so that a large proportion of the activities occur in an early stage (Thefreedictionary, 2018). Frontloading is done by a government if they are obsessed by immediate results. By front loading a fiscal stimulus the government wants quick results of their stimulus. In this case, the government is not waiting an entire year to stimulate the market but spends a lot of money at the beginning of the period, so the results are visible immediately. For emerging market countries such as China, frontloading is possible if the Fed moves to normalize its monetary policy (AsianDevelopmentBank, 2017). By normalizing its monetary policy, the Fed increases the rates of interest on the short term and shrinks the size of the balance sheet (Feldstein, 2018).
4. How is a recession defined and what are the consequences of recession?
There are multiple definitions of ‘recession’, and all of them are about a decline in economic activities among a certain period. As a technical indicator, a recession can be indicated as a negative economic growth in two consecutive quarters (Staff, 2018)
A recession is part of the business cycle. The business cycle describes the rises and fall of real GDP over time as shown in Figure 5. There are multiple recessions in this figure. Every time the line decreases below the 0.0% line for more than one quarter there is a recession. As shown in arrow 1, a decrease of Real GDP does not mean that a decrease of Real GDP will cause a recession. Arrow 2 is an example of a negative economic growth for more than two quarters; a recession.
Figure 5. Real GDP: quarterly growth
Source: St Louis Federal Reserve
The consequences of a recession depending on the size and time of the decrease in Real GDP. As an example, the financial crisis in 2007 was a global recession which had a huge impact on many different aspects such as loss of jobs (Figure 6), lack of funds available for borrowings, families, and companies that could not pay their bills, and fall of real estate value. And all these financial consequences had an influence on family life’s and lifestyles as well. Families that were not able to pay their bills had to sell their undervalued houses, they could not afford vacations and even some parents could not send their children to college (Quilt, 2018)
Figure 6. US unemployment rate
Source: Trading Economics
5. Give a full and detailed explanation of the paragraph in bold font in the article above.
| Local governments have been ordered to “front-load” fiscal stimulus. Combined credit and bond issuance is running at 17.2pc, and the M1 money supply has been growing at annual pace of over 40pc over the last six months. |
Local governments wanted to stimulate their economy by issuance credit and bonds. By stimulating the economy, they wanted to have more money available in the countries to invest (I) and consume (C), as seen in question 3. M1 money supply is the most liquid portions of the money supply because the money can easily and quickly be converted to cash. This includes travelers checks, demand deposits, physical currency, and coin. M1 money supply is usually used for payments. Compared to M2 money supply, M1 money supply does not include savings deposits, retail money funds, and retail time deposits (Staff, 2018).
Credit and bond combined were running at a high 17.2 percent. The rates in China were high because they were risky. People in those countries were forced to consume (C) and invest (I) instead of saving money. As seen above, M1 money supply does not count the saving deposits, retail funds, and retail time deposits. As a conclusion, central banks wanted to stimulate their habitats to invest (I) and consume (C) due to fiscal stimulus. Low yield rates ensured that people could borrow money at a low rate and investors were forced to consume (C) or invest (I) instead of saving money. The annual growth of M1 money supply of over 40 percent over the last six months show that people are nog saving their money, which will lead to a higher M2 money supply, but indicates that money is used to consume (C) and invest (I) (Staff, 2018).
6. Give a full and detailed explanation of the paragraphs in italic font in the article above.
| Tim Congdon from International Monetary Research says his tool for taking the global pulse – broad M3 money – points to a healthy world recovery for the next twelve to eighteen months. M3 growth has quickened to 5.3pc (annualised) in the US over the last three months, up from 4.5pc over the preceding year. |
In addition to question 5, M3 money supply is the broadest measure. It includes M2 money supply (so, also M1) and besides, the measurement includes less liquid assets. As Tim Congdon mentions, M3 money includes all the components of the money supply, or in his words: taking the global pulse (Staff, 2018).
Economist uses M3 money supply to estimate the entire money supply in a certain economy. The government uses M3 money to control inflation over medium and long-term periods and to direct policy. A positive growth of M3 money supply indicates that over the medium (1 year) and long-term period (3 years) there will be a healthy recovery.
However, M3 money supply is no longer tracked by the Fed since 2016, because they did not use it in their monetary policy decision anymore. The less liquid components did not give more useful information than M2 money supply (Staff, 2018).
Altogether, the measuring of the money supply is the total quantity amount of money at a certain point of time. Measuring the money supply is important for economist because it directly connects to activities taking place in an economy. In addition, the Fed is using the money supply data as a basis for their monetary policy (Nash, 2018).
7. What does it mean to say “Yields have fallen below zero” and what are the consequences of this?
A yield is a way of calculating a return on an investment over a particular period of time. It measures the cash flow an investor gets out of his investment. Yield only exist of the dividends or interest received from holding a security. It does not include the variations of the price of the security. As an example, a share price raised from € 150, – to € 200, – in one year. The dividend paid over that year is € 5, -. Yield will only exist the € 5, – of dividend paid without counting the € 50, – price rise. The price rise is part of the total return.
The price of yield depends on the risk of an investment. If an investor invests in a company with high risks, there will be a high yield. The yield compensates the risk of not being paid back. Investing in countries is usually a low-risk investment. Especially countries in economic health such as Germany, Switzerland, and Holland are countries you can invest without risk. In 2016, yields of 10-year German bonds are below zero. One of the main reasons was the fear in the stock market because of the Brexit. Investors were anxious and wanted to take away their money from the UK and invest it somewhere else; at a safe place. The demand for German bonds raised, and the returns ended below zero (Waard, 2016).
At the same time, the European Central Bank (ECB) cut the deposit rate below zero. The deposit rate is the amount of money the commercial banks are paid as interest for leaving their money at the central bank. Or in this case, the amount of money they had to pay(!) for leaving their money at the central bank. As a result, the banks passed the cost to the customers. The cost of leaving money on a bank account led investors to seek for other safe assets. Corporate bonds are relatively safe and as long as the yields are better than the cost of leaving cash on deposit with a bank it will result in investors buying yields below zero (Jackson, 2016).
Figure 7. Interest rate of German bonds
Source: Thomson Reuters
In addition, even when yields are below zero there is still a change that yields fall even further. This will increase the price of corporate bonds and investors may be selling their bonds at a higher price, so the total return will grow (Jackson, 2016).
As a consequence, investors have to pay money to invest their money instead of receiving money and debt becomes more affordable. Central banks decide to lower the yield below zero to stimulate the economy. As a result, consumers and businesses are more likely to consume (C) and invest (I), often by taking on additional debt.
Figure 8. German Sovereign Yield Curve
Source: Pacific Funds
Another consequence of negative yield in the Eurozone is the shifting of investors to other currencies. Although the yield rate in the US was at a low rate as well, compared to the negative yield in the Eurozone investors could benefit from the better yield in the US (Pacific life fund advisors, 2016).
References:
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