Economic Indicators and Portfolio Theory Flashcards

What does 'GDP' (Gross Domestic Product) measure?

Answer: The total monetary value of all goods and services produced within a country during a specified period

GDP measures the monetary value of all final goods and services produced within a country's borders during a given period (usually quarterly or annually). It is the primary measure of a country's economic output and growth.

What is 'inflation' and how is it measured in the UK?

Answer: Inflation is the general rise in prices over time; in the UK it is primarily measured by the Consumer Prices Index (CPI) and Retail Prices Index (RPI)

Inflation refers to the general increase in prices over time, reducing purchasing power. The UK's main inflation measures are CPI (used by the Bank of England for the 2% inflation target) and RPI (used for gilt indexation and some contracts).

What is a 'recession' in economic terms?

Answer: Two consecutive quarters of negative GDP growth

A recession is defined as two or more consecutive quarters of negative economic growth (falling GDP). It typically involves rising unemployment, falling consumer spending, and reduced business investment.

How does a rise in interest rates typically affect the economy?

Answer: It reduces consumer spending and business investment by making borrowing more expensive, thereby slowing economic growth and reducing inflation

Higher interest rates increase the cost of borrowing for households (mortgages, loans) and businesses, reducing spending and investment. This lowers aggregate demand, slowing the economy and reducing inflationary pressure — the Bank of England's intended effect when fighting high inflation.

What does the 'yield curve' show?

Answer: The relationship between bond yields and their time to maturity — typically showing how yields change as the maturity lengthens

The yield curve plots the yields (interest rates) of bonds of equal credit quality (e.g., gilts) against their maturities. A normal upward-sloping curve reflects higher yields for longer maturities. An inverted yield curve can signal an expected economic slowdown.

What is 'modern portfolio theory' (MPT) and who developed it?

Answer: A theory developed by Harry Markowitz showing how combining assets with different correlations can construct portfolios that optimise return for a given level of risk

Harry Markowitz's MPT (1952) demonstrates that by combining assets with imperfect correlations, investors can construct an 'efficient frontier' of portfolios offering the maximum expected return for each level of risk. Diversification is central to MPT.