Chapter 2 · The Economic Environment

GDP = total value of goods and services produced within a country's borders in a given period.

Three equivalent ways to measure it:

1. Production / output approach — sum of value added across industries
2. Expenditure approach — consumption + investment + government + net exports (C + I + G + NX)
3. Income approach — sum of wages, profits, rents, taxes minus subsidies

Ireland famously has GDP > GNI because much production is by foreign-owned multinationals that repatriate profits.

Nominal GDP: at current prices — includes inflation.

Real GDP: adjusted for inflation using a base year. Better measure of true output growth.

1. Expansion — GDP rising, low unemployment, rising confidence
2. Peak — top of the cycle, capacity constraints, inflation pressures
3. Contraction / recession — falling GDP, rising unemployment
4. Trough / recovery — bottom, policy easing, gradual rebuild

Standard textbook definition: two consecutive quarters of negative real GDP growth.

In practice, national authorities use broader definitions: NBER (US) considers labour market and income data; ONS (UK) similar. The "two-quarter rule" is what the exam tests.

• Leading: change BEFORE the economy — building permits, stock market, consumer confidence, PMI, yield curve slope
• Coincident: move WITH the economy — GDP, employment, industrial production
• Lagging: change AFTER — unemployment rate (peaks after recession end), inflation, corporate profits

A GENERAL, sustained rise in the price level. Erodes the real purchasing power of money.

CPI (Consumer Price Index): standard inflation measure globally. UK target: 2%. EXCLUDES housing costs (mostly).

RPI (Retail Price Index): older UK measure. INCLUDES housing costs (mortgage interest, council tax). Typically runs ~1% higher than CPI. Used for some index-linked gilts and older wage/pension escalation.

UK has moved toward CPIH (CPI + owner-occupier housing costs) for many uses.

Aggregate demand OUTSTRIPS supply capacity. "Too much money chasing too few goods." Typically appears late in an expansion.

Input costs rise (oil, wages, imports) → producers pass costs to consumers via higher prices. Classic examples: 1970s oil shocks, 2022 European gas shock.

• Hurts: people on FIXED nominal incomes (pensioners on non-inflation-linked income, savers with fixed-rate deposits). Real value falls.
• Helps: BORROWERS with LONG-TERM FIXED-RATE debt. Real debt burden erodes.
• ASSET OWNERS often benefit if asset prices keep pace with inflation.

Deflation: falling general price level. Sounds nice, is corrosive — consumers delay purchases, debt burdens rise, spirals possible. Japan post-1990s the classic case.

Hyperinflation: extreme, out-of-control inflation. Weimar Germany 1923, Zimbabwe 2008, Venezuela 2010s.

• US Federal Reserve (Fed) — dual mandate: price stability + maximum employment. FOMC sets the federal funds rate.
• Bank of England (BoE) — inflation target 2% CPI. MPC sets Bank Rate.
• European Central Bank (ECB) — primary mandate: price stability (near 2%). Governing Council sets rates for the euro area.
• Bank of Japan (BoJ) — historically fought deflation via yield curve control + QE.

1. Policy rate — set the short-term interest rate (Bank Rate, fed funds, ECB deposit rate). Primary tool.
2. Reserve requirements — minimum reserves banks must hold. Less used in modern central banking.
3. Open market operations — buy / sell government bonds to adjust liquidity in the banking system.
4. Quantitative Easing (QE) — large-scale asset purchases (bonds, sometimes MBS) to inject liquidity when policy rates are near zero. Deployed post-2008 and post-2020.
5. Forward guidance — communicating future policy path to shape expectations.

Rate HIKE (tightening): borrowing becomes more expensive → demand cools → inflation eases → typically strengthens the currency + weakens equities + weakens bond prices.

Rate CUT (easing): borrowing gets cheaper → demand rises → typically weakens the currency + supports equities + supports bond prices.

Fiscal deficit: annual FLOW — how much MORE the government spent than it received in tax in one year.

National debt: cumulative STOCK — total outstanding government borrowing.

Features of the tax + welfare system that AUTOMATICALLY dampen the cycle. In a recession: tax receipts fall (less income) + unemployment benefits rise (supports demand). Reverses in an expansion. Works without new political action.

When market interest rates RISE, existing fixed-coupon bond prices FALL. When rates FALL, existing bond prices RISE. Cross-referenced in Ch 4.

Higher rates tend to reduce equity valuations via:

• Higher discount rate applied to future cashflows
• More attractive alternative in bonds → capital flows out of equities
• Higher borrowing costs squeeze corporate profits

Growth stocks (long-duration cashflows) tend to be MORE rate-sensitive than value stocks.

Higher relative interest rates typically strengthen a currency (attracts capital seeking yield). Lower rates typically weaken it. Central bank policy divergence is a major FX driver.