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Business Cycles

Business Cycles. Chapter 15. Stabilization Theory. Chapter 16. Equity Markets. Chapter 21. Corporate Profits. We find that corporate profits are strongly pro-cyclical and volatile. When the economy is doing well, corporations tend to earn high real profits.

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Business Cycles

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  1. Business Cycles Chapter 15

  2. Stabilization Theory Chapter 16

  3. Equity Markets Chapter 21

  4. Corporate Profits • We find that corporate profits are strongly pro-cyclical and volatile. • When the economy is doing well, corporations tend to earn high real profits. • Corporate profits fluctuate far more than the economy as a whole.

  5. HK Corporate Earnings & the Business Cycle

  6. Objectives • Use the Gordon model to characterize dividend yields. • Analyze the characteristics of business cycles • Use the AS-AD model to understand the events that drive short and medium run fluctuations and stabilization policy. • Use the CAPM model to characterize expected returns of individual stocks (if time)

  7. Equity Markets Chapter 21

  8. Stocks for the Long Run • Over time, stocks pay consistently higher returns than other types of financial investment like bonds or gold. • Stocks can also be risky. For relatively long periods, stocks can under-perform bonds or even lose money. • What are stocks and where does this risk come from? • Equities (or shares or stocks) Paper asset reflecting part ownership of company and the future stream of income that it earns.

  9. Stocks • Equities like common or ordinary stocks are a claim to the profits of a corporation • Stocks have no maturity date. Firms may buy back stock at market prices as they choose. • Stock owners receive periodic but not fixed payments called dividends. Dividends reflect the profitability of the business and are not known in advance. • Stock owners are the owners of the firms. Holders of shares vote for the directors of firms on a one share-one vote basis. • Stock owners are the residual claimants to a firms income meaning a firm that goes out of business must repay all debt before stock owners get any income. • Stock owners enjoy limited liability. Unlike the owners of private firms, stock owners cannot lose more than the value of their stock.

  10. Stock Markets in Hong Kong • Stocks in HK are traded at the HK Stock Exchange. • Stock Index: A stock index is a price aggregate for stocks. Calculate the weighted sum of the prices of a set of stocks which represent an average of the market. • Hang Seng Index is a weighted average of prices of the equities of major (“blue chip”, “large cap”) stocks in HK

  11. Economic Function of the Stock Market • Stock markets can be an important means for companies to raise funds to finance investment. • Stock markets are a liquid market in which assets can be traded. • Stock markets allow savers to efficiently diversify assets. • Stock markets allow for efficient corporate ownership of assets.

  12. Stocks and Business Cycles • The payoff to stocks represent a share of the profits of firms in an economy. • In general terms, as an asset class, stocks will generate payments that reflect the profits generated by the economy. • Profits which are a share of income are volatile over the business cycle. • Risk of stocks may also vary over business cycles.

  13. Stock Returns • Gross returns on any asset are the payoff divided by the initial price. • Stocks pay-off of stocks is dividend plus price next period • Gross Return for Stocks Capital Gain + Dividend Yield

  14. Required Return • Define req as the return required by investors to get them to hold a share of stock. • Stocks may be volatile and risky. Typically required returns will be equal to the risk free interest rate plus a risk premium req = rrf + heq

  15. Fundamental Value of Stock

  16. Dividend Yields: Gordon Equation • Assume that dividends grow at a constant rate g . This implies Dt+j = (1+g)j Dt • If x < 1, • For price,

  17. Determinants of the Dividend Yield • The dividend yield plus capital gains is like an interest rate earned on stocks which in a free market must be equal to interest rates on other assets (adjusted for the risk of owning stocks). • In the long run, the growth rate in stock prices (capital gains) will be equal to growth rate of dividends which will be equal to the growth rate of corporate profits which will be equal to the growth rate of the economy. • What determines the risk premium on individual stocks?

  18. FAQ • What are the implications of the Gordon Growth model for stock prices? Relative to current dividends, stock prices will be high when • expected growth of dividends is high. • interest rates are low (the return on other assets are low. • the risk premium is low.. • Is the Gordon Growth Model a nominal model or a real model? It works either way.

  19. Business Cycles Chapter 15

  20. Business Cycles • Business cycles are medium term fluctuations in real output and other variables. • Business cycles are characterized by co-movement. All expenditure, production and income categories move with business cycle. • Degree of business cycle co-movement varies across sectors which is important for asset pricing.

  21. Recessions and Booms • Business cycle positions are sometimes characterized as booms and recessions. • These names have many definitions but a boom occurs roughly when real output is above the trend growth path (detrended output is positive). A recession occurs roughly when real output is below trend growth.

  22. HK Booms & Recessions

  23. Business Cycles & Co-movement • Business cycles are fluctuations in the economy as a whole. • Different sub-categories of GDP tend to co-move with business cycles though to different degree. • Business cycles tend to co-move across countries though not as strongly as within countries.

  24. Business Cycles & Sub-Categories • Expenditure. Consumption and Investment co-move with output. Investment is more volatile than consumption. Consumer durables are most volatile part of consumption. • Production – Production sectors co-move with business cycles. Manufacturing & Construction most volatile. Services least volatile. • Income – Worker Compensation & Capital Income are both pro-cyclical. Capital Income tends to be more volatile.

  25. Hong Kong Expenditure Cycles

  26. AS-AD Framework • Microeconomists use supply/demand framework for thinking about markets. • Macroeconomists use Aggregate Supply/ Aggregate Demand as the central framework for thinking about business cycles. • AS/AD framework examines the relationship between the level of output (real GDP) and the aggregate price level (GDP deflator). • We use the AS/AD to show how different events will affect output & prices in the medium and long run.

  27. Long Run Aggregate Supply • Central pillar of AS-AD framework is the assumption that there is no long run relationship between prices and firms willingness to produce goods. • In the long run, output may change but it is not affected by nominal level of the economy. • Long run AS is decided outside the AS-AD framework and is thus, exogenous.

  28. LRAS P Y YLR

  29. Why is Supply Exogenous in the Long Run? • Output is determined by labor (workers), capital (structures & equipment) and technology. • These factors are determined in the long run by relative prices like the real wage rate (dollar wages divided by the price level) and the real interest rate which are assumed to be exogenous to the nominal level of the economy in the long run.

  30. Short Run Aggregate Supply • In the short-run, there is thought to be a positive relationship between the aggregate price level and firms willingness to supply goods. • Central element in this story is that dollar wages that firms pay workers are determined by formal and informal wage contracts. • If wages are fixed, a rise in the price level reduces the relative cost of labor for firms. Firms hire more workers, work their existing employees longer hours and produce more output.

  31. LRAS P SRAS PE Y YLR

  32. Q: Why is the SRAS upward sloping? A: Given wages, an increase in prices reduces real wages for firms. Firms increase employment and production. Q: What shifts the SRAS curve? A: If wages rise the real wage rate will increase at any price level. A rise in the real wage causes firms to cut back on employment and production. FAQ

  33. SRAS’ Wages ↑ LRAS P SRAS PE Y YLR

  34. Expected Price Level Q: What is PE? A: PE is where SRAS crosses LRAS Q: What is the significance of PE? A: PE is the expected price level. If the actual price were equal to the expected price level, real wages would be as expected and output would be at its long run level. Q: How does PE affect the business cycle. A: When actual prices are above PE , price expectations will tend to move upward over time. When wages are renegotiated, they change in the same direction as price expectations. When

  35. The AD curve embodies the negative relationship between the nominal price level and the amount of goods that will want to buy. The underlying basis of this is a fixed monetary policy Q: Why is the AD curve downward sloping? A: Under a Fixed Exchange rate, a rise in prices causes a real exchange rate appreciation reducing net export demand. The aggregate demand curve maps a negative relationship between the price level and demand for goods.

  36. FAQ Q: Why is the AD curve downward sloping? A: It depends on the exact monetary policy. • In most large economies, interest rate targets rise when prices rise. This reduces investment & consumption and an exchange rate appreciation (net exports decline). • If central bank sets a fixed level of money supply, a rise in prices reduces the purchasing power of cash held by shoppers. They withdraw funds from banks. In order to meet their own liquidity needs, banks raise interest rates to attract deposits. The interest rate rise in reduces consumption & investment spending and an exchange rate appreciation (net exports decline).

  37. P AD Y YLR

  38. What shifts the AD curve?:

  39. What shifts the AD curve? Pt. 2

  40. Spillovers • A decrease in demand will tend to decrease the level of output and production which will decrease household income which will put downward pressure on consumption. • A decrease in demand will reduce the level of output per unit of capital so this will tend to diminish profit maximizing level of capital putting downward pressure on investment. • A decrease in demand will reduce import demand partially offsetting the multiplier effect on consumption.

  41. AS-AD • The AS-AD model determines the position of nominal prices and real output over time. • Equilibrium output and price level are defined as the intersection between SRAS and AD. • LRAS exists in the background exerting a gravitational pull.

  42. SRAS P [P*,Y*] AD Y YLR

  43. Gravitational Pull: • Whenever the AD curve and the SRAS cross each other away from the LRAS curve, P* will not equal PE. • If the prices that workers and firms observe (P*) are different than the prices they expected when they negotiated labor contracts (PE), real wages are different than long-term levels. • If P* > PE real wages are lower than long-term • If P* < PE real wages are higher than long-term

  44. Gravitational Pull Cont. • If actual prices (P*) are different from expected prices (PE), expectations will be updated for future labor contracts. • If P* > PE, PE will rise over time and workers will demand higher wages. This will cause the SRAS curve to shift upward as firms charge higher prices for their output. Wages rise until P* = YE and Y* = YLR. • If P* > PE, PE will fall over time and firms will demand workers take pay cuts. This will cause the SRAS curve to shift downward. Wages rise until P* = PE and Y* = YLR.

  45. SRAS’ SRAS P [P*,Y*] AD Y YLR

  46. Business Cycles as Shocks • Business Cycles are thought of as being driven by “random” events which destabilize the economy from its long-term path and set in motion a train in events. • These events are separated into those that affect demand (exogenously shift the demand curve) and those that affect supply (exogenously shift the supply curve). • AS-AD theory is set up to examine demand driven shocks.

  47. Contractionary Shock & Recession SRAS P [P*,Y*] [P**,Y**] AD AD’ Y YLR

  48. Short Run • Some Event causes a contraction in Aggregate Demand. • Demand for Goods falls as do equilibrium market prices. This increases real wages and reduces demand for labor. Unemployment rises and production decreases.

  49. SRAS SRAS’ • Medium: Wage Renegotiation P PE [P***,Y***] AD’ Y YLR

  50. Medium Run • After shift in demand curve, P** < PE. When employers have a chance to renegotiate salaries, they will offer lower wages. • Reduced wage costs will reduce production costs. Reduced production costs will reduce the price charged by firms at every level of production. • This is equivalent to a downward shift in SRAS curve.

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