All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

We have examined a variety of price and quantity measures in the output and labor markets and now we will turn our attention to the capital market. At this time we will direct our attention to the question: How has the capital market performed? A complete review of the wide array of capital markets would be well beyond the scope of this analysis, but we can look briefly at two important prices - stock prices and interest rates which are related to the price of bonds.

What has happened to the price of stock?

• When we talk about the performance of stocks, the price of stock quoted is generally some average of the prices of a market basket of stocks. In this sense it is very much like the CPI which is a weighted sum of prices. The various measures that you hear about in the nightly news are simply different market baskets. As you can see in the following diagram, the various indexes tend to move together but the fit is not a perfect one. By 1996, the NYSE Composite was nearly 17 times greater than it was in 1955, while the Dow Jones Industrial was approximately 13 times larger. In both cases, however, we saw a general increase in stock prices for the entire period.

• What happens when you account for inflation? There is no question that you cannot buy as much with a dollar today as you could 10, 20, or 40 years ago and thus the increase in stock prices overstates the return on the investment and during the period 1955-1996 some of the increase in the price of stock could be attributed to a general increase in the price level. If we were to 'correct' the stock price data to reflect changes in the level of overall prices [the technique is the same as you would use to adjust wages / earnings] we would see a substantially different picture. In the late 1960s, the real price of stock began a decline that did not end until the early 1980s when it began its latest rise.

What has happened to the price of bonds? the price of money?

• When we talk about the price of bonds and money we are essentially talking about the same thing. For example, if you go to a bank and borrow some money for your tuition bills, you will be charged an interest rate - the price of money. If you happened to be a city or a corporation and you needed to borrow money you might issue a bond, print up a piece of paper that promised to pay someone money at some date(s) in the future. As you know from our discussion of present value, the price of the bond would be very closely related to interest rates which is why we will look briefly at a few interest rates - holding off a more detailed treatment until a later date.
• When we talk about interest rates, we seldom talk about specific rates, although what you care about are the specific rates. You care about the rates on your loan or your bank account while policy makers may care about the government pays on it's debt. The good news is that they are closely related. Interest rates tend to move together, although the fit is not a perfect one which is why we will simply talk about interest rates. When we talk about interest rates rising in our discussions, you should expect to see your loan and bank account rates rising. The relationship between various interest rates is evident in the graph below where you see that interest rates on loans to local governments (municipals), low risk corporations (AAA), and the federal government (GS) tend to move together.

• When we look at interest rates, however, we have the same problem of dealing with inflation. For example, if you pay 5% interest in zero inflation world, when you repay $105 in one year, the lender can buy $105 worth of 'stuff'. The lender's buying power has been increased by 5% by waiting a year. The real rate of return is 5%. But what if you pay 5% interest in 5% inflation world. When you repay $105 in one year, the lender can buy $105 worth of 'stuff', but the cost of living has risen 5%. This means that it now costs $105 just to stay even, to buy what we used to buy with $100. The lender's buying power has not been increased by waiting a year. The real rate of return is 0%.
• Are there any generalizations we can make from our simple example? If we ignore all of the other components/dimensions of the interest rate, we can specify the relationship between real and nominal interest rates as follows and when you examine the folowing graph you will see that the adjustment matters - that the real rate on government rates looks very little like the nominal rate in the earlier graph.
  r_n = r_r + i_e
  or
  r_r = r_n - i_e

  r_r = real rate

  r_n = nominal rate

  i_e = expected inflation rate

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