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ECON 1012 1 Week of In Class and Textbook Notes

by: Caroline Jok

ECON 1012 1 Week of In Class and Textbook Notes Econ 1012

Marketplace > George Washington University > Economcs > Econ 1012 > ECON 1012 1 Week of In Class and Textbook Notes
Caroline Jok
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In-Class Notes, & Notes on Assigned Readings ECON 1012 Economics Dr. John Volpe Funger 108 Introduction To Macro Economics The George Washington University
Principles of Economics II
Dr. John Volpe
Class Notes
Math, Economics, Macroeconomics, Volpe, notes, Readings, Hubbard & O'Brien




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This 8 page Class Notes was uploaded by Caroline Jok on Thursday January 14, 2016. The Class Notes belongs to Econ 1012 at George Washington University taught by Dr. John Volpe in Spring 2016. Since its upload, it has received 77 views. For similar materials see Principles of Economics II in Economcs at George Washington University.


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Date Created: 01/14/16
WEEK 1 Introduction to Macroeconomics Dr. John Vol e Caroline E. Jok The George Washington University In class Types of firms: • Sole Proprietorship: owned by a single individual and not organized as a corporation o Advantages: Control by owner, No layers of management, easy to get in and out o Disadvantages: Unlimited Liability, difficult to raise money from the bank • Partnership: two or more people o Advantages: Can share work, controlled by owner, no layers of management, sharing risk o Disadvantages: Unlimited Liability, difficult to raise money from the bank • Corporations o Advantages: Limited Liability, easier to raise money (entity in perpetuity) o Disadvantages: costly, possible double taxation of income (pays a tax on the money earned [corporate level] and then a tax on the dividend [personal level], and then possibly pay tax on the interests that it earns in the bank), regulatory oversight Corporate Structure and Corporate Governance: • In sole proprietorships and partnerships, the owners are involved on day-to-day decisions • Corporations have separation of ownership form of control: top management, rather than shareholders, control the day to day operations o Principal Agent Problem: The people that own the company don't run the company. • Structure: o Owners designate a Board of directors • Board of Directors appoints a CEO and other top management • Question: So how do you align the goals and objectives? o Incentivize the CEO to maximize profits • If the CEO advances sales = CEO gets a bonus • Same with Subsidiary, and those below them etc. • Aka: Profit maximization Raising funds as your firm grows: indirect Finance • As a firm gets larger, the need to obtain external funds to grow • The economy's financial system facilitates the transfer of funds from savers to borrowers • Firms can borrow money from banks, as such, the banks are acting as financial intermediaries, permitting indirect finance of the firm by their savers • Indirect finance: A flow of funds from savers to borrowers through financial intermediaries such as banks. Intermediaries raise funds from savers to lend to firms (and other borrowers) • Small corporations: Banks, Family, Credit cards etc. • Large Corporation: Banks, stocks, bonds • Alternatively firms can appeal directly to potential investors for funds. • Direct Finance: the flow of funds from savers to firms through financial markets • Direct Finances generally take the form of financial securities o Bonds: financial security that represents a promise to repay a fixed amount of funds. • What you are not guaranteed: The value of the bond between the day you bought it and the time you redeem it. Depends on interests rates. • Coupon interests rates • If you believe that interests rates are likely to rise, then buying bonds is a mistake unless you will hold them till maturity • You have no say in the corporation • Can be convertible and redeemed before their maturity date § Why would you want to? If interest rates settle. If interest rates rise: the company will not redeem your bond. o Stocks: financial security that represents partial ownership of a firm • Unlike bonds stacks represent partial ownership of the firm • A corporation that sells a stock acts similarly to a partnership taking on a new partner thorough the new shareholder typically owns a tiny fraction of the firm. • When the corporation makes profits, these are either reinvested in the firm causing a capital gain or increase value of the stock or paid out to the firm's shareholders' ad dividends • By law, corporations must repay bond holders before shareholders This helps to ensure that bonds are substantially less risky financial securities tot hold than stock o Preferred Stocks; Notes ~ Hubbard and O’Brian Macro Economics Chapter 6: Firms, The stock market, and Finance 6.1 Types of Firms (US) 3 Main categories of Firms • Sole Proprietorship: firm owned by single individual • Partnership: firms owned jointly by2 or more people • Corporation: Legal form of business that provides owners with protection from losing more than their investment should the business fail • Who Is Liable? Limited and Unlimited Liability o Unlimited liability = no legal distinction between the personal assets of the owners fo a firm and the assets of the firm (Sole & Partnerships) o Asset: anything of value owned by a person or a firm o General incorporation laws: allow firms to be organized as corporations o Limited liability: owners can never lose more than the amount they have invested in the firm • Makes it possible to issue shares of stock to large numbers of investors. Sole Proprietorship Partnership Corporation Advantages • Control by owner • Ability to share work • Limited personal • No layers of and risks liability • management Greater ability to raise funds Disadvantages • Unlimited personal • Unlimited personal • Costly to organize liability liability • Possible double • Limited ability to • Limited ability to taxation of income raise funds raise funds • Corporations Earn the Majority of Revenue and Profits • How Important are Small Businesses to the U.S. Economy? o Large majority are sole proprietorships but only account for a small fraction of total revenues o Small firms are vital to the health of the economy o Brings new product/process to market 6.2 The Structure of Corporations and The principal-Agent Problem • Corporate Governance: The way in which a corporation is structured and the effect that structure has on the corporation's behavior. • Corporate Structure and Corporate Governance o Corporations are legally owned by shareholders: Owners of stock o Board of directors: represents their interests o Chief Executive Officer (CEO) to run day to day operations o Top Management: Chief Financial Officer etc. o These officers are on the board and called inside directors o Outside directors: members of the board who do not have direct management role in the firm o Separation of Ownership from control: a situation in a corporation in which the top management, rather than the shareholders, controls day-to-day operations • May decrease the firms profits by spending money to purchase private jets or schedule management meetings at resorts o Principal-agent problem: caused by an agent pursuing personal interests rather than the interests of the principal who hired him. • Solution: tie the salaries of the top managers to the profit of the firm or price of the firms stock (actually reduced the profits of the firm in the long run. 6.3 How Firms Raise Funds • Goal: earn profit o Raise funds to pay for operations (wages, rent etc.) • Making a profit: reinvest the profit back into your firm (retained earnings = not paid to the firm's owners) • Recruiting additional owners to invest in the firm. This arrangement would increase the firms financial capital • Borrow from relatives, friends, or a bank • Sources of External Funds o External funds (not retained earnings) o Financial system: transfer funds from savers to borrowers o Raising external funds: • Indirect finance: financial intermediaries (banks) • Financial markets: raising funds in the Stock exchange § Direct Finance: flow of funds from savers to firms through financial markets such as the New York Stock Exchange § Borrower sells the lender financial security: a document that states the terms under which the funds are passed from the buyer of the security to the borrower. • Bonds and Stocks • Bonds o Bonds: Financial Securities that represent promises to repay a fixed amount of funds o Principal: end of term o Face Value: initial amount each bond purchaser is lending o Coupon payments: interest payments on a bond o Interest rate/coupon rate: cost of borrowing funds expressed as a percentage of the amount borrowed • Calculated by dividing the coupon by the face value o Maturities: terms • The Rating Game: Is the U.S. Treasury Likely to Default on its Bonds? o Fed regulation: firms and governments must first have bonds rated by a credit rating agents. • Moody's Investors • Standard and Poor's Corp • Fitch Ratings o Investors use the ratings to decide the risk they are willing to accept o The lower the rating the higher the interest rate an investor will receive but the higher the risk that the issuer of the bond will default o Do rating agencies face a conflict of interest? (Firms issuing bonds can choose which of the agencies to hire to rate their bonds, therefore the agencies may have an incentive to give higher ratings than might be justified….) • Stocks o Stock: financial Security that represents partial ownership of a firm o Many small investors buy shares of mutual funds rather than directly buying stocks of companies. Mutual funds sell shares to investors and use the funds to invest in a portfolio of financial assets such as stocks and bonds. This reduces the cost they would have to pay to buy many individual stocks and bonds and lowers investment risks o Share holder is entitled to part of corporations profits paid in dividends o Share price rises=capital gains for investors o If a corporation is unable to profit, it will not pay dividends, debt payments come first. o Stocks do not have a maturity date so the firm is not obliged to return the investor's funds at any particular date. • Stock and Bond Markets Provide Capital - and information o The original purchaser of stocks/bonds may resell them to other investors making up the stock markets o The price of a bond is affected by the changes in default risk (investor perceptions of the issuing firms ability to make the coupon payments. • Why do stock prices fluctuate so much? o Stock market indexes measure the performance of the U.S. stock market • Dow Jones • S&P • NASDAQ o Stock prices rise when the economy is expanding and fall when the economy is in recession 6.4 Using Financial Statements to Evaluate a Corporation • In most high-income countries, government agencies require firms to disclose specific financial information to the public before they are allowed to sell securities such as stocks or bonds • Securities and Exchange commission requires publicly owned firms to report their performance in financial statements prepared using standard accounting methods (Generally accepted accounting principles) • Liabilities: anything owned by a person or a firm • The Income Statement o Income statement: shows revenues, costs, and profit over a period of time o Using the fiscal year • Accounting Profit: Firm revenue minus operating expenses and taxes = net income o Provides information on a firms current net income measured according to accepted standards o Not the ideal measure of a firm's profits because it neglects some of the firms costs • Economic Profit o Calculated using all of a firm's costs. o Opportunity cost: highest valued alternative that must be relinquished o Explicit Cost: involves spending money o Implicit cost: nonmonetary opportunity cost o Normal rate of return: minimum amount that investors must earn on the funds they invest in a firm, expressed as a percentage of the amount invested. o Economic Profit: a firm's revenues minus all of its implicit and explicit costs • The Balance Sheet: o The Balance sheet: financial statement summing up a firm's financial position on a particular day (usually the end of a quarter or year) o Assets - liabilities = net worth 6.5 Corporate Governance Policy and the Financial Crisis of 2007 - 2009 • Top Management reasons to attract investors and keep firm's stock price high o Higher stock price increases the funds the firm can raise when it sells a given amount of stock o To reduce the principal=agent problem, boards of directors often tie the salaries of top managers to the firm's stock price or to the profitability of the firm • The Accounting Scandals of the Early 2000s o Falsified financial statements o New federal legislation was enacted in 2002: Sarbanes- Oxley act : requires that CEOS personally certify the accuracy of financial statement and that financial analysts and auditors disclose whether any conflicts of interests might exist that would limit their independence in evaluating a firm's financial condition. • The Financial Crisis of 2007 - 2009 o Problem in the market for home mortgages o Securitizing: groups of mortgages were bundled together and sold to investors --> Mortgage backed securities. o Wall street reform and consumer protection act (Dodd Frank act): Legislation passed during 2010 that was intended to reform regulation fo the financial system. • Did Principal-Agent Problems Help Cause the 2007-2009 Financial Crisis? o Investment Banking, riskier than commercial banking because banks can suffer substantial losses on underwriting • Glass-Steagall Act 1933: prevented financial firms from being both commercial banks and investment banks • Reduced competition • Why take on risk? § Change in how investment banks were organized • The Ups and Downs of Investing in Facebook o Initial Public Offering: first time a company sells stock


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