Econ 1015 Midterm 2 Chikhladze Mizzou

growth rate equation

%change M+ % change = % change P + % change Y -assuming constant velocity of money, -% change P > 0 if % change M > % change Y -% change P < 0 if % change Y > % change M -% change P = 0 if % change M = % % change Y

Shoe-Leather Costs (cost of inflation)

-as inflation increases of becomes unpredictable, people will try to hold less money and immediately purchase goods with money -people bear time, effort, and fuel costs when they try to use more money -typically a bigger problem in countries with hyperinflation

Underwriting

-behind the scenes, typically arranged between an investment bank and a company -investment bank buys shares of guarantees a certain price and later resells on secondary markets

Default Risk

-bond price and interest rate depends on default risk -the risk that the borrower will not pay the bond -the greater the risk of default, the lower the price and higher the interest rate of the bond -therefore, riskier corporations or government pay higher interest rate and incur higher cost of borrowing

Tax Distortion (cost of inflation)

-capital gains taxes are taxes on the gains realized by selling an asset for more than purchase price -problem: often, the price rises due to inflation rather than an increase in the value of the good

Demand of Loanable Funds

-comes form people wanting to borrow money -interest rate is the cost of borrowing

Supply of Loanable Funds

-comes from people saving money -interest rate is a reward for saving

Primary Markets

-companies only get paid by selling securities at primary markets -EX: Initial Public Offerings (IPO)

Demanders for Loanable Funds

-demand of loanable funds are borrowers -demand is driven largely by firms that need to borrow for large capital projects -(borrowing must occur to build capital goods)

Government Borrowing Needs

-depends of the level of spending and budget deficit/ surplus -budget deficit: spending exceeds tax revenue during a year -budget surplus: tax revenue exceeds spending

Banking Industry

-dominated by very large numbers -top four banks control 36% of all the deposits in the US

Computing the CPI

-each month, the BLS collects price information -then BLS uses the data to come up with a cost of the basket now vs a cost of the basket in the reference year, called base year -Price Index= basket price/ basket price in base year X 100

Deflation

-falling average price level

Direct Finance

-firms sell a security (stock or bond) directly to the public in exchange for funds -security provides an ownership (investor) future income and/or gives part ownership of the firm

Inflation

-general increase in price level -measured as the average price level growth rate -sometimes also referred as increase in a cost of living

Business Confidence

-if a firm is optimistic, it will borrow more today

Productivity of Capital

-if capital becomes more productive, the demand for funds will increase -the returns on current physical investment will be greater -EX: fracking and transformation of oil industry

Rule of 70

-if the annual growth rate is X%, the size of that variable doubles every 70/X years

Tax Distortion EXAMPLE

-if you buy a house in 1980 for $80,000 and sell the house in 2012 for $230,000 -capital gains= $150,000 and to pay taxes on this $150,000 -however, CPI rose from 80 to 230 in those years, so the real value of the house if the same

Firm's ability to borrow and raise money

-important for physical capital accumulation -most firms need huge sums of money to expand, build and purchase equipment -without loanable funds market, their expansion will be very limited, hence dragging the economic growth

Consumption Smoothing (shift of supply of loanable funds)

-income changes (sometimes significantly) over the course of the typical lifetime -most individuals would like to keep consumption more of less stable throughout the lifetime -this stable or "smooth" consumption requires borrowing when young and saving when older

changes in Income/ Wealth (shift of supply of loanable funds)

-increases in income generally increase savings -wealthier households set aside bigger portion of their income

Mortgages

-individuals use loans to pay for homes -A 30-year loan between home buyers and a lender -typically given to borrowers with a credit history and a stable job -quickly expanded before 2007 exceeding $12 trillion -the government encouraged home ownership -securitization of mortgage loans -real estate markets collapse and the financial crisis triggered defaults and home foreclosures

Default

-is defined when the borrower is unable to pay the face value of a loan

Equations of Exchange

-long-run relationship between the price level and quantity of money (MxV=PxY) -M: quantity of money -V: velocity of money (number of times dollar changes hands) -P: price level -Y: real GDP -(right side (PxY) is nominal GDP)

Secondary Markets

-most stock trading happens in secondary markets -New York Stock Exchange (NYSE) -National Association of Securities Dealers Automated Quotations (NASDAQ) -however, companies do not see a cent from these trades -can buy stocks through a broker

Real Wage (cost of inflation)

-nominal wage adjusted for inflation

Indirect Finance

-occurs when savers deposit funds into banks, and banks then loan these to borrowers -banks pay lower interest rates ti savers than they charge borrowers in order to earn profit

Dow Jones Industrial Average (DJIA)

-one of two well-known stock indices -tracks price of ONLY 30 large corporate stocks as a simple average -first published in 1895 -list of corporations is updated infrequently

Consumer Price Index (CPI)

-only things we consume -a measure of the price level based on consumption pattern of a typical consumer -Goal: measure the cost of living or a cost of typical things average Americans buy

Time Preferences (shift of supply of loanable funds)

-people generally prefer goods sooner rather than later, and funds are no different -less patient people prefer now to later and will save less -time preferences help determine interest rate

Money Illusion (cost of inflation)

-people misinterpret NOMINAL wage or price changes -if cost of living and wages all go up by 2%, there is no real change in purchasing power. people with money illusion think they are richer in this case. your real wage has stayed the same

Quality Changes (concerns about CPI accuracy)

-prices may rise because the quality of goods is better -EX: 2016 price of BMW $41,850 and 2017 price of BMW $42,150 -BLS tries to account for the quality a couple of years

Banks

-private firms that accept deposits and extend loans -banks help connect borrowers (demanders of funds) with the savers (supplier of funds) -other financial intermediaries (pension funds, investment funds, mutual funds, hedge funds, insurance companies)

Bond Ratings

-rating agencies (Moody's, Standard and Poor's (S&), Fitch's -purpose: evaluate the default risk of all borrowing and give a grade showing the likelihood of defaulting

Fisher Equation

-relates inflation to the real and nominal interest rate

Equilibrium in the Market for Loanable Funds

-savings= investment -supply of loanable funds is savings -demand for loanable funds depends on firms wanting to borrow in order to invest in physical capital -relationship between saving and borrowing (every dollar borrowed requires a dollar saved -accumulation of physical capital on any nation depends on how much of its residents saved

NASDAQ

-secondary market -an electronic system of dealers and brokers linked bidding or selling stocks -mostly lists tech stocks, like Apple, Facebook, Amazon, etc.

NYSE

-secondary market -still maintains the trading floor or "pit" where brokers meet face to face

Parts of the Financial System

-stock exchanges -investment banks -mutual fund firms -commercial banks

Stocks

-stocks represent partial ownership of the firm, claim to its current and future profits -share holders have some influence in the operations of the firm, number of shares determines number of votes -stocks are riskier for savers, since firm profitability varies. in some cases, stocks may not pay anything and may become worthless (in recessions) -if the company goes bankrupt, bond holders get paid first and stockholders get paid last

Money Illusion EXAMPLE

-suppose nominal wages increase by 3% and prices go up by 5% -money illusion may cause you to think of yourself as wealthier, but your real wages have actually decreased

Menu Cost (cost of inflation)

-the costs of changing prices in store, catalogs or online -EX: a restaurant will have to print new menus for price changes

Securitization

-the creation of a new tradeable security as a combination mortgages and other types of loans agreements -rising security called MBS (Mortgage Backed Security -diversifies risk, lowers interest rates -offers new opportunities for lenders but can potentially conceal true risk if lenders are not transparent

The Loanable Funds Market

-the financial system has a very important role of channeling funds from one place to another -good: loanable funds: savings available for a loan -price= interest rate -seller/suppliers: savers -buyers/ demanders: borrowers

Bureau of Labor Statistics (BLS)

-the government agency that reports inflation and unemployment data -determines how much "weight" to put on certain consumer prices -BLS doesn't by constructing "consumer basket"

nominal Interest Rate

-the interest rate before it is corrected for inflation

Real Interest Rate

-the interest rate corrected for inflation real interest rate= nominal interest rate- inflation rate

Interest Rates

-the price of loanable funds -savers: the reward for saving -borrowers: the cost of borrowing -like other prices, it rises and falls -affected by price and demand

Nominal Wage (cost of inflation)

-the wage in current dollars

Standard & Poor's 500 (S&P 500)

-tracks price of 500 shares weighted by their market capitalization -market capitalization: share price and number of shares (basically a company's value) = share price X number of shares -first published in 1957

Wealth Redistribution (cost of inflation)

-unexpected changes in inflation redistributes wealth between borrowers and lenders -EX: you borrow %50,000 for your business & expect to pay back $60,000 in 5 years -if unexpected inflation occurs you are better off, bank is worse -if unexpected deflation occurs you are worse off, bank is better off

Bonds

-used by large established firms when they need an infusion of money -securities are issued and sold to the public -this is an example of direct finance -funds generated by sale of bonds are used for physical capital goods -bond is basically a promise by issuer: a contract specifying who owes how much and a date fo payment

Bond Buyers

-want to pay the lowest possible price at inception -want to get the highest interest rates (highest return)

Bond Sellers (lenders)

-want to sell the bonds at the highest price possible, close to face value -want to pay the lowest interest rate possible

Historical Prices

-we can use CPI to compare prices of amounts from different time periods -amount in today's dollars = amount in earlier time X CPI today/ CPI in earlier time

Substitution Bias (concerns about CPI accuracy)

-when prices of A rises, consumers buy more B (substitute cheaper for more expensive goods) -requires frequent update of consumer basket

Interest rates as a cost of borrowing

-when you borrow money, you are demanding funds -interest rate is the price of the cost of borrowing -lower the interest rate, lower the cost of borrowing funds, more likely firms are to borrow money -the quantity of funds demanded increases as the interest rate decreases

Interest rates as a reward for saving

-when you save money, you are supplying funds -the price of the reward you receive is the interest (expressed as a percentage of funds supplied (rather than dollars)) -EX: savings account at a bank: --interest rate is 3% annually (500 X 0.03 = $15)

Importance of Primary and Secondary Markets

-without primary markets, companies would have a hard time to go public and we would not know how much to pay for stock -secondary markets keep shareholders investment liquid and also helps investment banks to come up with a valuation

Information on every Bond

1) name of borrower 2) repayment date (maturity date) 3) amount due at repayment (face value) 4) dollar price --price at inception/ issuance --collar amount what the buyer originally pays and seller recieves

Bond Principles

1) the dollar price of a bond determines its interest rate 2) the dollar price and interest rate on a bond have and inverse relationship

Economic Growth

=% change nominal GDP= % change prices- % change population = % change per capita GDP

Financial System

through financial system firms, corporations and governments borrow funds (financial capital) from households who provide their saved money -links borrowers (firms and governments) to savers (households) -different parts of this system then allow firms and governments to access savings of households

Advantages and Disadvantages of stocks for corporations

-Advantages: no commitments to repay the money (that is) no interest payments -Disadvantages: diluted profits, bad for existing owners

Concerns about CPI accuracy

-CPI overstates true inflation (upward bias) for three possible reasons) -all of these requires BLS to keep updating weights in consumer basket as well as constant monitoring of online prices

What Factors Shift the Demand of Loanable Funds

-SHIFT in the DEMAND of loanable funds caused by: --changes in the productivity of capital -changes in business confidence -government borrowing

What Factors shift the Supply of Loanable Funds

-SHIFTS in the SUPPLY of loanable funds is caused by -changes in income/ wealth -changes in time preferences -consumption smoothing

Treasury Securities

-US government borrows by selling treasury securities on the primary market -an auction determines the bond price and its interest rate -resold on very active secondary markets -popular among foreign investors. around 30% of total national debt of 22 trillion is owned by foreign countries (China and Japan are primary foreign holders of US treasury) -low risk, low interest rate -critical for monetary policy

Stock Market Index

-aggregate price or value or many stocks expressed as a single number

Price Confusion (cost of inflation)

-are price changes as a result of demand shifts or inflation? -implications are very different

Interest rate formula

Interest Rate = (face value- price at inception)/ price at inception

Trouble Asset Relief Program (TARP)

in 2008 allocated $700 billion to the U.S. Treasury to make emergency loans to critical financial and other U.S. firms -help struggling banks by providing monetary assistance -very unpopular, as many labeled it as wall street bailout