Outline of the Chapter
• The macroeconomy
– Key economic statistics

• • • • •

Demand and supply shocks Fiscal and monetary policy The business cycles Economic indicators Industry analysis
– – – – Define an industry Sensitivity of industries to the business cycle Industry life cycles Industry structure and performance


The Domestic Macroeconomy
• The macroeconomy is the environment in which all firms operate. • Key economic statistics used to describe the state of the economy:
– – – – – – – Gross domestic product Employment Inflation Interest rates Budget deficit Sentiment Foreign exchange (Global Economy)

17-4 The Domestic Macroeconomy (Continued) • Inflation – The rate at which the general level of prices rise.The Domestic Macroeconomy (Continued) • Gross Domestic Product (GDP) – The measure of the economy’s total production of goods and services. – There is a trade-off between inflation and unemployment. It focuses on the manufacturing side of the economy. • Sentiment – Beliefs (optimism and pessimism) of consumers and producers influence the levels of consumption and production and affect the aggregate demand for goods and services. – Rapid growth in GDP indicates an expanding economy and higher sales for the firms. 17-5 The Domestic Macroeconomy (Continued) • Budget Deficit – The difference between government spending and revenues. • Employment – Unemployment rate=number of those who are not working/total labor force (people who are either working or actively seeking employment) – Measures the extent to which the economy is operating at full capacity. – The deficit should be closed by borrowing. • Interest Rates – Determinant for business investment expenditures. – The government borrowing can increase interest rates and crowd-out the private borrowing and decrease investment and affect economic growth negatively. – Industrial production (IP): another measure of total output. – As interest rates increases the investment decreases so does the economic growth. 17-6 . – High rates of inflation are associated with overheated economies.

– Affects the international competitiveness of the country. increases in foreign exports. – Examples of supply shocks: changes in prices of intermediate goods such as oil. 17-8 Demand and Supply Shocks (Continued) • Supply shock – An event that influences production capacity and costs. – The depreciation of domestic currency makes the domestic products cheaper in foreing countries and increases the exports and hence the GDP growth. increase in money supply. – Supply shocks cause the aggregate output move in the opposite direction of inflation and interest rates. increases in government spending. 17-9 . changes in the education level of an economy’s workforce or changes in the wage rate.The Global Economy • Exchange rate – The rate at which domestic currency can be converted into foreign currency. – Examples for positive demand shocks: reduction in tax rates. – Usually characterized by aggregate output moving in the same direction as interest rates and inflation. 17-7 Demand and Supply Shocks • Demand shock – An event that affects the demand for goods and services in the economy.

17-10 Fiscal and Monetary Policy (Continued) • Monetary Policy – The change in money supply to affect the macroeconomy. Business Cycles • Business Cycle: – The recurring pattern of recession and recovery. – The economy recurrently experiences periods of expansion and contraction but the length and depth of those cycles can be different. – If budget deficit>0 then government spend more than it earns and stimulate the economy. – Increase in money supply will decrease short-term interest rates and cause an increase in investment and consumption demand. is the interest rate the CB charges banks on short-term loans. the fraction of 17-11 deposits banks have to keep in the CB.Fiscal and Monetary Policy • How can government affect the demand and supply of goods and services? • Fiscal Policy – The government’s spending and tax actions. – Implementation: • Changing monetary base (consists of currency and banks’ deposits in the central bank) by open market operations • Changing the discount rate. – Interbank rate • Changing the required reserves ratio. – Decrease in government spending decrease the demand for goods and services while increase in tax rates decrease the income of consumers (households). – The transition points across cycles are called peaks and troughs • A peak is the transition from the end of an expansion to the start of a contraction • A trough occurs at the bottom of a recession just as the economy enters a recovery 17-12 .

• _______beta stocks – Choose _______ industries when you are optimistic about the economy and choose _______industries when you are pessimistic about the economy.Business Cycles (Continued) • Presents graphs of several measures of production and output. •The bottom graph of capacity utilization shows a cyclical pattern. state of the economy. manufacturing and trade sales 17-15 . 17-13 Business Cycles (Continued) • Cyclical vs Defensive Industries – Cyclical industries are the ones that show aboveaverage sensitivity to the business cycle. measure. • _______ beta stocks – Defensive industries are the ones that show little sensitiviy to the business cycle. • Examples: average weekly hours of production workers. 17-14 Business Cycles (Continued) • Economic Indicators – Set of cyclical indicators helps to forecast. •Shaded areas show recessions. •Threre is a generally rising trend with variations. coincident and lagging. stock prices – Coincident indicators tend to change directly with the economy • Examples: industrial production. and interpret short-term fluctuations in economic activity. – These indicators can be divided into three general groups as leading. – Leading indicators tend to rise and fall in advance of the economy.

Business Cycles (Continued) – Lagging indicators tend to follow the lag economic performance. and transportation are highly sensitive to the state of the economy. • Examples: ratio of trade inventories to sales 17-16 Industry Analysis • Defining an industry – Employing North American Industry Classification Codes (NAICS). • First 2 digit denotes very broad industry classification and the next digits define the industry grouping narrowly. and medical services will show little sensitivity to business conditions. financial leverage. • Firms in the industries such as steel. operating leverage. 17-18 . auto. 17-17 Industry Analysis (Continued) • Sensitivity to the Business Cycle – Three factors decide the sensitivity of a firm’s earnings to the business cycle: sensitivity of sales of the firm’s product to the business cycles. drugs. – Sensitivity of sales • Necessities such as foods.

Industry Analysis (Continued) – Operating Leverage • Division between variable and fixed costs. They can _______ costs as output falls in response to falling sales during economic downturn. • Firms with high fixed costs are said to have high operating leverage because small changes in business conditions may have large impacts on profitability. (Total debt/total equity) • The interest payments on debt is a fixed costs and _________ the sensitivity of the firms to the changes in the business cycle. • Firms with more variable costs are _____ sensitive to business conditions. DOL=1+(Fixed costs/profits) – Financial Leverage • The use of borrowing. 17-21 . 17-20 Industry Analysis (Continued) • Sector Rotation – Portfolio is adjusted by selecting companies that should perform well for the stage of the business cycle. 17-19 Industry Analysis (Continued) • In order to quantify the operating leverage: Degree of operating leverage (DOL)=percentage change in profits/percentage change in sales.

and then expand. transportation or construction. such as equipment. minerals and petroleum • Contraction (recession)-the economy is getting smaller – Time to invest in defensive industries such as pharmaceuticals and food • Trough – the economy is ready to recover. – Some will be very successful some will fail 17-23 Industry Analysis (Continued) 17-24 . – Time to invest in capital goods industries.Industry Analysis (Continued) • Peaks –the economy might be overheated with high inflation and interest rates – Time to invest in natural resource extraction firms. • Expansion – the economy is growing – Time to invest in cyclical industries such as 17-22 consumer durables and luxury items Industry Analysis (Continued) • Industry Life Cycles – The industry life cycle might be described as four stages: • Start-up stage: characterized by extremely rapid growth of sales and earnings – Early stages of an industry – New technology – Difficult to predict which firms are going to be leaders.

17-26 Industry Analysis (Continued) • Industry Structure and Performance – Porter’s (1985) determinants of competition • Threat of entry – High prices and profit margins will encourage entry by new competitors. – Barriers to entry is a key determinant of industry profitability » Secure distribution channels » Brand loyalty » Patent protection » Experience in the market 17-27 . – Producers compete on the basis of price – Narrow profit margins 17-25 Industry Analysis (Continued) • Relative decline stage: characterized by the growth less rapidly than the rest of the economy – The product become obsolent – Competition from new low-cost suppliers (or new products) • Generally industries at the high-growth stages are more attractive for investment unless the stock prices already reflects likelihood for high growth.Industry Analysis (Continued) • Consolidation stage: characterized by growth that is less rapid but still faster than the general economy – Industry leaders begin to emerge – Survivors from the start-up stage are more stable and the performance of the survivors closely track the performance of the industry • Maturity stage: characterized by the growth no faster than the general economy – The product has reached its full potential for use by the consumers.

• Bargaining power of suppliers – If a supplier of a key input has monopolistic control over the product. it will have considerable bargaining power and ask for price reductions and reduces the profitability of the supplier. 17-29 . it can demand higher prices for the good and decrease the profits of the industry.Industry Analysis (Continued) • Rivalry between existing competitors – More price competition and lower profit margin – Factors that affect the rivalry » Slow industry growth » High fixed costs » Homogeneous products • Pressure from substitute products – Availiability of substitutes limits the prices that can be charged. 17-28 Industry Analysis (Continued) • Bargaining power of buyers – If a buyer purchases a large fraction of an industry’s output.