Chapter 12: Basic economic variables

Question 1

What are the main economic variables to consider (5)

Answer 1

1. Short-term interest rates
2. Economic growth
3. Unemployment
4. Inflation
5. Exchange rates

Question 2

What happens when the government cuts short-term interest rates

• Economic growth
• Unemployment
• Inflation
• Exchange rate
• Short-term bond yields

Answer 2

Economic growth
- Increases: borrowing cheaper and consumer/investment spending increases.

Unemployment
- Reduces: economic growth stimulating corporate expansion.

Inflation
- Increases: demand-pull inflation caused by increased spending.

Exchange rate
- Depreciates: demand for sterling falls as ‘hot money’ chases higher interest rates in other countries.

Short-term bond yields
- Fall: short-term bonds and money market instruments are substitute goods, so short-term bond yields and short-term interest rates are similar.

Question 3

What happens with an expectation of high economic growth

• Dividend growth
• Equity risk premium

Answer 3

Dividend growth
- High: dividend growth and economic growth strongly correlated.

Equity risk premium
- Low: companies likely to be doing well, good prospects for profits/dividends, low default risk, good marketability.

Question 4

What happens with an uncertainty of future inflation

• Demand for index-linked bonds
• Demand for equities

Answer 4

Demand for index-linked bonds
- Increases: index-linked bonds provide inflation protection as they provide a real return, over and
above inflation.

Demand for equities
- Increases: (similar to index-linked bonds) equities provide a long-term, real return.

Question 5

What happens with an expectation of depreciation of the exchange

• Inflation
• Demand for overseas assets

Answer 5

Inflation
- Increase - if depreciation occurs since there will be cost-push inflation caused by more expensive imported raw materials and demand-pull inflation caused by increased demand for exports.

Demand for overseas assets
- Increase – if can buy the assets before the depreciation is priced in and then benefit from proceeds on those assets being worth more in the domestic currency post depreciation.

Question 6

What are the main factors affecting short-term interest rates?

Answer 6

• Government policies that target:
• Economic growth
• Unemployment
• Inflation
• Exchange rate
• Actual level of inflation
• Number of buyers and sellers of a currency