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Principles of Finance

3.2 Macroeconomics

Principles of Finance3.2 Macroeconomics

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Define inflation and describe historical trends in inflation.
  • Define unemployment and describe how unemployment is measured.
  • Define gross domestic product and describe historical trends in gross domestic product.

Inflation

Macroeconomics looks at the economy as a whole. It focuses on broad issues such as inflation, unemployment, and growth of production. When the managers of an automotive company look at the market for steel and how the price of steel impacts the company’s production costs, they are looking at a microeconomic issue. Rather than being concerned about individual markets or products, macroeconomics is the branch of economic theory that considers the overall environment in which businesses operate.

Perhaps you have heard your parents talk about how much they paid for their first automobile. Or maybe you have heard your grandparents reminisce about spending a quarter to purchase a Coke. These conversations often turn to a discussion of how a dollar just doesn’t go as far as it used to. The reason for this is inflation, or a general increase in price levels.

It is not that just the price of an automobile has increased or that the price of a Coke has increased. Over time, the prices of many other things, from the salt on your table to college tuition, have increased. Also, you were paid a higher hourly wage at your first job than your parents and grandparents were paid; the price of labor has risen.

When economists talk about inflation, they are discussing this phenomenon of the price of many things rising. Instead of tracking the price of one particular item, they consider the price of purchasing a basket of goods. Inflation means that the purchasing power of currency falls. Whenever there is inflation, a $100 bill will not purchase as much as it did before.

How Is Inflation Measured

Each month, the US Bureau of Labor Statistics (BLS) collects price data and publishes measures of inflation. The measure most commonly cited is the consumer price index (CPI). The CPI is based on the cost of buying a fixed basket of goods and services comprising items a typical urban family of four might purchase. The BLS divides these purchases into eight major categories: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services.

Sometimes you will hear a core inflation index being quoted. This index is calculated by excluding volatile economic variables, such as energy and food prices, from the CPI measure. Energy and food prices can jump around from month to month because of weather or other short-lived events. A drought can cause food prices to spike; a temporary rise in gasoline prices can occur as a hurricane approaches the coastline. These types of shocks are transitory in nature and do not represent underlying economic conditions.

While the CPI and the core inflation index are based on the prices that households pay, the producer price index (PPI) is based on prices that producers of goods and services pay for their supplies and raw materials. The PPI captures price changes that occur prior to the retail level. Because it indicates rising costs to producers, increases in the PPI can foreshadow increases in the CPI.

Both the CPI and the PPI are calculated by the BLS. The Bureau of Economic Analysis (BEA) also calculates a measure of inflation known as the GDP deflator. The calculation of the GDP, or gross domestic product, deflator follows a different approach than that used to calculate the CPI and the PPI. Instead of using a fixed basket of items and measuring the price change of that fixed basket, the GDP deflator includes all of the components of the gross domestic product. Prices are taken from a base year and used to calculate what the GDP would have been in a given year if prices were identical to those in the base year.

Historical Trends in the Inflation Rate

Inflation, as measured by the CPI for 1947–2020, is displayed in Figure 3.10. The graph shows that for the past 70 years, inflation has been the norm. Although inflation dipped into negative territory several times, each period of negative inflation was short-lived. Also, you will notice that during the 1970s and early 1980s, inflation was abnormally high; the inflation rate remained above 5% for approximately a decade. This was also the only time period in which the US economy experienced double-digit inflation. By the mid-1980s, inflation had fallen below 5%, and it has remained below 5% for much of the past 35 years.

Rate of inflation measured by the Consumer Price Index for All Urban Consumers between 1950-2020. It shows that the percentage change in the consumer price index was the highest in 1980, while it has remained between -2.5% to 7.5% since then.
Figure 3.10 Rate of Inflation Measured by the Consumer Price Index, 1947–20202

The Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL) is a measure of the average monthly change in the price for goods and services paid by urban consumers between any two time periods. It can also represent the buying habits of urban consumers. This particular index includes roughly 88% of the total population, accounting for wage earners, clerical workers, technical workers, self-employed workers, short-term workers, unemployed workers, retirees, and those not in the labor force.

The CPIs are based on prices for food, clothing, shelter, fuels, transportation fares, service fees (e.g., water and sewer service), and sales taxes. Prices are collected monthly from about 4,000 housing units and approximately 26,000 retail establishments across 87 urban areas. To calculate the index, price changes are averaged with weights representing their importance in the spending of a particular group. The index measures price changes (as a percent change) from a predetermined reference date. In addition to the original unadjusted index distributed, the BLS also releases a seasonally adjusted index. The unadjusted series reflects all factors that may influence a change in prices. However, it can be very useful to look at the seasonally adjusted CPI, which removes the effects of seasonal changes such as weather, the school year, production cycles, and holidays.

The CPI can be used to recognize periods of inflation and deflation. Significant increases in the CPI within a short time frame might indicate a period of inflation, and significant decreases in CPI within a short time frame might indicate a period of deflation. However, because the CPI includes volatile food and oil prices, it might not be a reliable measure of inflationary and deflationary periods. For more accurate detection, the core CPI, or CPILFESL—the CPIAUCSL minus food and energy—is often used. When using the CPI, please note that it is not applicable to all consumers and should not be used to determine relative living costs. Additionally, the CPI is a statistical measure vulnerable to sampling error because it is based on a sample of prices and not the complete average.

Unemployment

Unemployment is a measure of people who are not working. For the individuals who find themselves without a job, unemployment causes financial hardship. From a macroeconomics standpoint, unemployment means that society has labor resources that are not being fully utilized.

Not everyone who is without a job is unemployed. To be considered unemployed, a person must be (1) jobless, (2) actively seeking work, and (3) able to take a job. The official unemployment rate is the percentage of the labor force that is unemployed. It is calculated as

UnemploymentRate = NumberUnemployedLaborForce = NumberUnemployedNumberEmployed + NumberUnemployedUnemploymentRate = NumberUnemployedLaborForce = NumberUnemployedNumberEmployed + NumberUnemployed

Note that the unemployment rate is calculated as the percentage of the labor force that is unemployed, rather than the percent of the total population. Only those who are currently employed or who meet the definition of being unemployed are counted in the labor force. In other words, someone who is retired or a stay-at-home parent and is not seeking employment is not counted as unemployed and is not part of the labor force.

The Bureau of Labor Statistics (BLS) of the US Department of Labor reports the unemployment rate each month. These figures are attained through an interview process of 60,000 households conducted by the Census Bureau. (See Figure 3.11 for a graphic representation of historical trends in unemployment from 1950 to early 2021.)

A line graph depicts Historical Trends in the Unemployment Rate by Year, 1950–2021. It shows that before 2020, the highest rates of unemployment were in 1980, at just above 10%, and in 2010 when unemployment was right at 10%. Unemployment shot up to about 15% in 2020, but quickly went below 7.5%.
Figure 3.11 Historical Trends in the Unemployment Rate by Year, 1950–20213 The unemployment rate represents the number of unemployed as a percentage of the labor force. Labor force data are restricted to people 16 years of age and older who currently reside in one of the 50 US states or the District of Columbia, who do not reside in institutions (e.g., penal or mental facilities, homes for the aged), and who are not on active duty in the US Armed Forces.

Gross Domestic Product

Gross domestic product (GDP) is a measure of the size of an economy. A country’s GDP is the dollar value of all of the final goods and service produced within that country during a year. GDP measures the value of all of the automobiles produced, apples grown, heart surgeries performed, students educated, and all other new goods and services produced in a current year.

How Is GDP Measured?

GDP can be measured by adding up all of the items that are purchased in the economy. Purchases are divided into four broad expenditure categories: consumption spending, investment, government spending, and net exports. Consumption spending measures the items that households purchase, such as movie theater tickets, cups of coffee, and clothing. Consumption expenditure accounts for about two-thirds of the US GDP.4

Investment spending refers primarily to purchases by businesses. It is important to note that in this context, the term investment does not refer to purchasing stocks and bonds or trading financial securities. Instead, the term refers to purchasing new capital goods, such as buildings, machinery, and equipment, that will be used to produce other goods. Residential housing is also included in the investment-spending category, as are inventories. Products that producers make but do not sell this year (and so are not included in consumption spending) are included in this year’s GDP calculation through the investment component. The investment spending category is roughly 15% to 18% of the US GDP.

Government spending includes spending by federal, state, and local governments. Federal spending would include purchases of items such as a new military fighter jet and services such as the work of economists at the BLS. State governments purchase products such as concrete for a new highway and services such as the work of state troopers. Local governments purchase a variety of goods and services, such as books for the city library, playground equipment for the community park, and the services of public school teachers. In the United States, government spending accounts for nearly 20% of the GDP.

Some items that are produced in the United States are sold to individuals, businesses, or government entities outside of the United States. For example, a bottle of Tabasco sauce produced in Louisiana may be sold to a restaurant in Vietnam, or tires produced in Ohio may be sold to an auto producer in Mexico. Because these items represent production in the United States, these exports should be included in the US GDP. Conversely, some of the items that US consumers, businesses, and government entities purchase are not produced in the United States. A family may purchase maple syrup from Canada or a Samsung television that was produced in South Korea. A business may purchase a Toyota vehicle that was produced in Japan. These items are imported from other countries and represent production in the country of origin rather than the United States. Because we already counted these items when adding consumption, investment, and government spending, we must subtract the value of imports in our GDP calculation. Net exports equals exports from the United States minus imports from other countries. Including net exports in the GDP calculation adjusts for this international trade.

Historical Trends in GDP

US GDP over the past 70 years is represented by the blue line in Figure 3.12. At the turn of the millennium, the yearly GDP of the United States was approximately $10 trillion. By 2020, the GDP exceeded $21 trillion, indicating that the US economy had more than doubled in size in the first 20 years of the 21st century.5

Because GDP is the market value of all goods and services produced, it can increase either because more goods and services are being produced or because the market value of these goods and services is rising. If 100 cars were produced and sold for $30,000 each, that would contribute $3,000,000 to the GDP. If, instead, the cars were sold for $33,000 each, the same 100-car production would contribute $3,300,000 to the GDP. The $300,000 increase in GDP would be due simply to higher prices, or inflation.

Multiplying the current price of goods by the number of goods produced results in what is known as nominal GDP. In order to determine what the actual increase in production is, nominal GDP must be adjusted for inflation. This adjustment results in a calculation known as real GDP. To calculate real GDP, the amounts of goods and services produced are multiplied by the price levels in a base year. Thus, real GDP will rise only if more goods and services are being produced. The red line in Figure 3.12 represents the real GDP. Although its growth has not been as large as that of nominal GDP, real GDP has also grown significantly over the past 70 years.

Graph of Gross Domestic Product (GDP) in the US from 1950 to 2020. This graph compares real GDP to GDP. It shows that the real GDP was higher than GDP from 1950 to 2010. Since 2010 GDP has been higher than Real GDP.
Figure 3.12 Growth of the US GDP6 Gross domestic product (GDP), the featured measure of US output, is the market value of the goods and services produced by labor and property located in the United States. Real gross domestic product is the inflation-adjusted value of the goods and services produced by labor and property located in the United States. For more information, see the NIPA Handbook: Concepts and Methods of the US National Income and Product Accounts and the US Bureau of Economic Analysis.

Footnotes

  • 2Data from US Bureau of Labor Statistics. “Consumer Price Index for All Urban Consumers: All Items in US City Average (CPIAUCSL).” FRED. Federal Reserve Bank of St. Louis, accessed July 7, 2021. https://fred.stlouisfed.org/series/CPIAUCSL
  • 3Data from US Bureau of Labor Statistics. “Unemployment Rate (UNRATE).” FRED. Federal Reserve Bank of St. Louis, accessed July 6, 2021. https://fred.stlouisfed.org/series/UNRATE
  • 4US Bureau of Economic Analysis. “GDP and the Economy: Advance Estimates for the First Quarter of 2020.” Survey of Current Business 100, no. 5 (May 2020): 1–11. https://apps.bea.gov/scb/2020/05-may/0520-gdp-economy.htm
  • 5“GDP (Current US$): United States.” The World Bank. 2020. https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=US
  • 6Data from US Bureau of Economic Analysis. “Gross Domestic Product (GDP).” FRED. Federal Reserve Bank of St. Louis, accessed July 27, 2021. https://fred.stlouisfed.org/series/GDP
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