Question

How do fixed income investors use short-term actual GDP and potential GDP?

Answer 1

Fixed-income investors use short-term actual GDP to gauge economy performance and potential GDP to assess the economy's capacity without inflation, which impacts interest rates and, subsequently, the Present Discounted Value of bonds. Inflation and government borrowing can affect these values, causing bond prices to fluctuate. The equilibrium in a Keynesian cross diagram may not align with potential GDP and is determined by spending levels in the economy.

Step-by-step explanation:

Fixed-income investors use actual GDP and potential GDP as indicators to assess the economic environment and prospects for their investments. Short-term actual GDP provides insights into the current performance of the economy, indicating whether the economy is expanding or contracting. Potential GDP, on the other hand, reflects the maximum possible level of output an economy can achieve without leading to increased inflation when all resources are fully employed.

Investors are interested in these metrics because they can affect inflation and interest rates, which have a direct impact on the present value of future cash flows from fixed-income securities like bonds. For instance, if the actual GDP is consistently above potential GDP, this might lead to inflation, which generally hurts bond prices as it can lead to higher interest rates. Conversely, if actual GDP is below potential GDP, there may be more room for economic growth without causing inflation, which could be beneficial for bondholders as it suggests a stable interest rate environment.

Additionally, in a situation where government borrowing increases, as shown in the shift from demand curve Do to D1 resulting in higher interest rates, this could affect the Present Discounted Value of a bond. If fixed income investors had locked in bonds at lower interest rates before the shift, the value of their bonds would decrease as newer issues offer higher rates. This is significant because fixed-income investments are sensitive to changes in interest rates - when rates go up, the present value of the future cash flows from the bond goes down, and the price of the bond decreases.

Lastly, with respect to a Keynesian cross diagram, the equilibrium is not always at or near potential GDP. The equilibrium represents the point where planned spending equals actual spending, which can be above, below, or at potential GDP, depending on various economic conditions and policy decisions.

Answer 2

Fixed income investors assess short-term actual GDP and potential GDP to predict economic trends and potential interest rate changes, which affect bond valuations. Increased government borrowing can increase interest rates, affecting the present discounted value of future bond payments. These factors help investors determine the risks and returns associated with their fixed income portfolios.

Step-by-step explanation:

Fixed income investors use short-term actual GDP and potential GDP to assess the state of the economy which, in turn, influences their investment decisions. Short-term actual GDP helps them understand the current economic activity,

while potential GDP indicates the maximum productive capacity of an economy without leading to inflation. Both are critical for evaluating the likelihood of interest rate changes, which directly impact the value of fixed income investments such as bonds.

Regarding government borrowing, if it increases substantially, it can lead to a higher demand for financial capital, shifting the demand curve from D0 to D1. This shift can result in an increase in equilibrium interest rates from 5% to 6% and an equilibrium quantity of 21% of GDP, which affects the return on fixed income investments. Higher interest rates can reduce the present discounted value of future bond payments, thereby decreasing bond prices.

When evaluating investments using present discounted value, fixed income investors consider potential capital gains from future bond sale and possible dividends. The valuation of bonds is influenced by changes in interest rates; if rates fall, existing bonds with higher rates are worth more, and if rates rise, they are worth less.