Security Industry

Essential (S I E)
Chapter 3 Economic Factors RICKY WANG

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Overview
THE FEDERAL RESERVE

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Fiscal Policy
• Fiscal Policy
Monetary Policy Fiscal policy is set by the president and Congress. The Federal Reserve plays no role in
determining fiscal policy. Fiscal policy is implemented through government spending and
Money Supply taxes.

Fiscal policy is often used in conjunction with monetary policy to influence the direction of the
economy. The goals are the same – full employment and price stability.

Federal taxation and spending are its primary tools. Congress can lower taxes to increase
economic activity or raise taxes to decrease economic activity.

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• Fiscal Policy Keynesian Theory

Monetary Policy
John Maynard Keynes is the famous economist
Money Supply who, during the Depression, developed the
economic theory that advocated using fiscal
policy to jump-start the economy to"full
employment." Fiscal policy is the use of
government spending and taxation to influence the
economy. He believed that the economy runs at an
"equilibrium" level that is determined by income and
spending, and aggregate demand.

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Fiscal Policy Monetary Policy

• Monetary Policy Monetary policy is controlled by the Federal Reserve Board (FRB)，Monetary policy refers to
actions taken to influence the money supply and credit in the economy, which in turn affects
Money Supply interest rates. By raising or lowering short-term interest rates, it indirectly controls inflation and
employment. The primary focus of monetary policy is to promote price stability and full
employment.

Supply Side Economics Theory

Supply Side Economics is the opposite of Keynesian economics. says that as long as the
government does not meddle with the economy, business will take care of itself. Stable interest
rates, money supply, and low inflation achieved through monetary policy will enable business to
drive the economy to full employment.

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Fiscal Policy
Three Basic Tools to Control the Money Supply

• Monetary Policy 1. Reserve requirement;

Money Supply 2. Discount rate;

3. Open market operations (OMO)

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Fiscal Policy
1. Reserve requirement

• Monetary Policy The reserve requirement is an overnight cash reserve that each Federal Reserve member
bank must maintain each night. It is the FRB's most powerful tool. The FRB will raise this
Money Supply
requirement to tighten the money supply, and lower it to increase the money supply. The
power of the reserve requirement lies in the fact that it has a multiplier effect that ripples
through the economy.

Federal funds rate

The federal funds rate, a short-term interest rate, is the interest rate member banks charge
each other for overnight loans in order to maintain their bank reserves at the Federal Reserve.
It is the average of all interest rates charged by member banks for these overnight loans.

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Fiscal Policy
2. Discount Rate
• Monetary Policy
The Fed sets the discount rate. This is the rate the main Federal Reserve Bank charges
Money Supply member banks for loans to meet their overnight reserve requirements. If the Fed lowers
the discount rate, the T-bill and Fed Funds rates will decline. When a member bank
borrows from the main Federal Reserve Bank at the discount rate, the member is said
to borrow at the discount window. Borrowing at the discount window may be an
indication that the borrower is experiencing financial trouble, because the main Federal
Reserve Bank is considered the lender of last resort.

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Fiscal Policy 3. Open Market Activities and Impact on Economy

• Monetary Policy Open market operations (OMO) - The third monetary policy tool that the Fed has at its
Money Supply disposal is “open market” operations. OMO is the purchase and sale of securities in the
secondary market by the central bank to implement monetary policy.

The Federal Open Market Committee (FOMC) buys or sells Treasuries in the secondary market
through primary government securities dealers to help stimulate or slow the economy.

If the Fed is buying Treasuries, they are putting money into the economy.

If they are selling Treasuries, they are pulling money out of the economy.

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Interest Rates Lowest to Highest

Fiscal Policy
Discount rate < Federal (or fed) funds rate < Money market rate <Prime rate <Broker call loan rate.

• Monetary Policy
Money market rates
Money Supply
The banks earn money market rates when they invest on a short-term basis. Money market
instruments are highly liquid with very short maturities.

Money market rates include the following:

1, Repurchase Agreement

2, Commercial Paper

3, Certificates of Deposit

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Interest Rates Lowest to Highest

Fiscal Policy
Discount rate < Federal (or fed) funds rate < Money market rate <Prime rate <Broker call loan rate

• Monetary Policy Prime rate

Money Supply The prime rate is the interest rate that individual banks charge their most creditworthy commercial
borrowers for unsecured loans. As such, it is the lowest rate for commercial loans. It is based on
the federal funds rate.

Broker Call Loan Rate

The broker call loan rate is the interest rate that banks charge broker/dealers for money that they
lend to margin account investors.

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Money Supply
Fiscal Policy

Monetary Policy The money supply is the total stock of money circulating in the economy. The U.S. money
supply includes currency and deposits held by the public at commercial banks and other
• Money Supply depository institutions, such as thrifts and credit unions.

M1, M2 and M3 are measurements of the United States money supply, known as the money
aggregates.

M1 = Cash and demand deposits, such as checking accounts

M2 = M1 plus savings accounts and some money markets funds

M3 = M2 plus institutional investments and money markets

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Financial Statements
• Financial Statements
The three most important financial statements are the balance sheet, the income statement
Ratio Analysis and the statement of cash flows.

Business Cycle
• Balance sheet provides a snapshot of a company's assets, liabilities, and shareholders'
Indicators equity at a specific point in time.

• Income statement provides a summary of a company's income and expenses over a

period of time.

• Cash flow statement shows a company's inflows and outflows of cash over a specified
period of time, indicating whether a company can meet its expenses.

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Balance Sheet
• Financial Statements • Assets: resources that a company owns, such
as cash, inventory, accounts receivable,
Ratio Analysis investments, land, buildings, equipment, as
well as intangible assets like goodwill and
Business Cycle trademarks.

• Liabilities: debts owed by a company, for

Indicators
example, money owed to lenders, suppliers,
and employees.

• Shareholders' Equity — ownership interest

(stock and retained earnings minus treasury
stock).This is the difference between a
company's assets and liabilities.

• Assets = Liabilities + Shareholders' Equity

• Shareholders' Equity = Assets - Liabilities

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Income Statement
• Financial Statements • Sales — Gross revenues from the company's
Ratio Analysis products or services;

• Gross profits — Profits after subtracting the cost

Business Cycle of making the product or providing the service;

Indicators • Net operating income — Income after

subtracting operating expenses related to selling,
general and administrative, and depreciation and
amortization;

• Net income — Income resulting from operations

and financing activities, after paying taxes.

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Ratio Analysis
Financial Statements
• Working Capital = Current Assets - Current Liabilities

• Ratio Analysis Working capital measures the entity’s liquidity or solvency — its ability to pay its short-term obligations. A positive
number indicates the company has sufficient current assets to pay current debts. A negative number indicates that
Business Cycle
the company is insolvent.

Indicators
• Current Ratio = Current Assets ÷ Current Liabilities

Current ratio is another liquidity measure. It gauges the company’s ability to pay current liabilities. A number greater
than 1 means the company can pay its obligations with current assets. A number less than one means that the
company has insufficient current assets to meet current liabilities.

• Quick Ratio (Acid Test) Ratio = (Current Assets - Inventory) ÷ Current Liabilities

This is a more stringent measure of the company’s ability to pay its short-term obligations because it considers only
cash and cash equivalents. Inventory is subtracted from the other current assets.

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Ratio Analysis
Financial Statements

Earnings per Common Share = (Net Income - Preferred Dividend) ÷ Common Shares Outstanding
• Ratio Analysis
•

EPS measures the portion of earnings available to common stockholders after the preferred stock has received its
Business Cycle dividend.

Indicators
• Price/Earnings Ratio = Market Price ÷ Earnings per Share

The P/E ratio is one of the most commonly-referenced ratios. It compares the price per share of the common stock
to the annual earnings per share. The P/E ratio indicates how fairly priced the stock is relative to comparable
stocks. Fundamental analysts use the P/E ratio to compare the value of different stocks in the same industry sector

• Dividend Payout Ratio = Annual Dividend ÷ Earnings per Share

The dividend payout ratio gauges the "generosity" of the board of directors. It measures the portion of earnings that
the board decides to distribute to the shareholders. The portion of earnings that is not distributed is kept in retained
earnings.
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Ratio Analysis

Financial Statements • Dividend Yield = Annual Dividend / Current Stock Price

• Ratio Analysis Dividend yield measures the amount of dividend income received in relation to the price of the stock.

Business Cycle • Debt/Equity Ratio = Total Liabilities ÷ Stockholders’ Equity

• Net Profit Margin Ratio = Net Profit / Net Sales (Revenue）

Indicators
Net profit margin ratio is a measure of profitability that is calculated by dividing net profit(after all operating expenses,
interest, taxes and preferred stock dividends are paid) by net sales

• Book Value Per Share = (Total Shareholder Equity - Preferred Equity) / Total Outstanding
Common Shares

Book value per share is the liquidation value per common stock share. In other words, if the company was
liquidated and all parties were paid according to priority, book value per share is the residual per share left
for the common stock.

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Business Cycle
The business cycle refers to recurring patterns of expansion and contraction in the economy. The business cycle is
also called the economic cycle. It is a useful tool for analyzing the economy, industries, and companies.
Financial Statements
The four phases of the cycle are：

Ratio Analysis
Expansion — Increasing employment, economic growth

• Business Cycle and upward pressure on prices;

Peak — Economy is topping out or has stopped growing,

Indicators little or no unemployment;

Contraction — Business activity is slowing, unemployment

is increasing, and the economy is struggling;

Trough — Decrease in economic growth to its lowest level

in the current economic cycle, high unemployment, low
consumer demand

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Industry Cycle

Cyclical industries have regular, pronounced cycles of growth and contraction, Cyclical companies
produce durable goods, which sell well in healthy economic environments but do poorly during weak
Financial Statements
phases.

Ratio Analysis
Countercyclical industries in direct contrast to cyclical industries, prosper during economic

• Business Cycle declines and underperform when the economy is growing strongly.

Indicators Defensive industries Stocks in defensive industries do not experience dramatic growth
swings in up markets or declines in weak markets. They tend to have relatively steady
performance through all economic phases.

Growth industries They are typically fueled by new technological advances. There have been
many innovations in recent decades

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Indicators
Financial Statements
Leading indicators are exhibiting predictive value :
Ratio Analysis
• Average weekly hours worked (manufacturing);
• Average weekly initial claims for unemployment insurance;
Business Cycle • Manufacturers' new orders (consumer goods and materials);
• ISM (Institute for Supply Management) new order index;
• Indicators •
•
Manufacturers' new orders (non defense capital goods, excluding aircraft);
Building permits (new private housing units);
• Standard & Poor's 500 (S&P 500) stock index;
• Leading Credit Index;Interest rate spread (10-year Treasury bonds less federal funds);
• Average consumer expectations for business and economic conditions.

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Indicators
Financial Statements

Ratio Analysis Coincident indicators is for things occur at the same time as the related economic activity.

• Payroll employment (excluding agriculture);

Business Cycle • Personal income (excluding Social Security);
• Industrial production (GDP);

• Indicators • Manufacturing and trade sales.

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Indicators
Financial Statements
Lagging indicators only become apparent after the activity has occurred.
Ratio Analysis
• Average length of unemployment (in weeks);
• Inventories to sales ratio (manufacturing and trade);
Business Cycle • Labor cost per unit of output (manufacturing);Average prime rate;
• Commercial and industrial loans;
• Indicators • Consumer installment credit to personal income ratio;
• Consumer price index (CPI) for services

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GDP & GNP

• GDP & GNP Gross Domestic Product (GDP) is a measure of a country's total economic activity. It represents the
monetary value of all goods and services produced within a country in 1 year.
Exchange Rates

Gross National Product (GNP) is a broader measure of economic activity. It includes the GDP plus income
earned by residents from overseas, minus income earned within the domestic economy by overseas
residents.

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Exchange Rates

Exchange rate is the rate at which one currency can be exchanged for that of another.

GDP & GNP Spot exchange rate is the current rate of exchange or the rate at which the currencies can be exchanged
immediately.

• Exchange Rates Exchange rates can be floating, pegged (fixed) or a combination of both

Floating currency - The value of a floating

exchange rate is determined by supply and
demand forces in the market.

A pegged, or fixed system currency is set

and artificially maintained by the government.

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Currency exchange rate

Currency exchange rates are typically based on how much a particular foreign currency is worth relative to
the U.S.dollar.
GDP & GNP
Strong U.S. dollars also make foreign goods more affordable, which increases the demand for imported goods.

• Exchange Rates This causes U.S. exports to decrease, resulting in a trade deficit. To correct a trade deficit, U.S. interest rates
must fall, thereby weakening the dollar and helping to alleviate the trade imbalance.

Currency risk, or exchange rate risk, is a form of risk that originates from changes in the relative valuation
of currencies which, in turn, can influence the overall investment returns.

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Question Time

Which best describes the federal funds rate?

A. Daily average of largest central banks

B. Daily average of reserve member banks

C. Weekly average of reserve banks

D. Weekly average of yield auctions of member banks

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Question Time

Which best describes the federal funds rate?

A. Daily average of largest central banks

B. Daily average of reserve member banks

C. Weekly average of reserve banks

D. Weekly average of yield auctions of member banks

The fed funds rate is the rate at which banks lend money to each other overnight to meet their reserve
requirements.
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Question Time

The current ratio formula is

A. Current assets / current liabilities

B. Quick assets / current liabilities

C. Current assets / total liabilities

D. Current assets / current owners’ equity

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Question Time

The current ratio formula is

A. Current assets / current liabilities

B. Quick assets / current liabilities

C. Current assets / total liabilities

D. Current assets / current owners’ equity

Current ratio measures the entity’s ability to pay its short-term debts. A number less than one means
that the entity has insufficient funds to meet current liabilities.
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Question Time

Under what circumstance would the Federal Reserve sell treasury bonds in the open market?

A. To tighten the money supply

B. To lower interest rates

C. To stimulate the economy

D. To loosen the money supply

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Question Time

Under what circumstance would the Federal Reserve sell treasury bonds in the open market?

A. To tighten the money supply

B. To lower interest rates

C. To stimulate the economy

D. To loosen the money supply

The Federal Reserve would sell treasury bonds in the open market if it were trying to slow the economy.
The sales, which are charged against the reserve balances of the banks, reduces their ability to make
loans. This results in tightening the money supply and raising interest rates.
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