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by: Harrison Fahey


Harrison Fahey
GPA 3.9

R. Stahl

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R. Stahl
Class Notes
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This 15 page Class Notes was uploaded by Harrison Fahey on Tuesday October 13, 2015. The Class Notes belongs to ECON 2035 at Louisiana State University taught by R. Stahl in Fall. Since its upload, it has received 31 views. For similar materials see /class/223016/econ-2035-louisiana-state-university in Economcs at Louisiana State University.




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Date Created: 10/13/15
Chapter 2 212012 94300 PM money class of assets that serves as an economy s medium of exchange medium of exchang whatever people use to purchase goods and services money yields a poor return compared to other assets such as bonds dollar bill pays no interest some checking accounts pay interest though very low compared to bonds money demand the amount of wealth that people choose to hold in the form of money barter system of exchange in which goods and services are traded directly with no money involved double coincidence of wants condition needed for barter each party to a transaction must have something the other wants unit of account measure in which prices and salaries are quoted store of value form in which wealth can be held commodity money valuable good that serves as a medium of exchange fiat money money with no intrinsic value dollarization use of foreign currency often US dollars as money this occurs due to unusually high inflation rates ex Argentina or Zimbabwe and Ecuador currency board institution that issues money backed by a foreign currency if foreign currency is then people can trade money for dollars at a fixed rate and board must ensure they hold enough dollars to back all money created currency union group of countries with a common currency o Ex Europe Euros Money supply total amount of money in economy Monetary aggregat measure of money supply M1 M2 m all currency held by public primary measure of money supply medium of exchange transaction money o Checking deposits o Traveler s checks only accounts for money issued by institutions that are NOT banks o Currency o NOT ATM money or bank vault money M2 near money less liquid assets all M1 all timerelated deposits o Savings deposits MMDAs moneymarket deposit accountpart of money market funds o Small Time deposits CD credit cards 6 months 3 years lt100000 o Retail money funds mutual fund that holds bonds with maturities Tbills and commercial paper payments system arrangements through which money reaches the sellers of goods and services Payments You paygt Store depositgt Store s bank deposits to its account with Fedgt Fed reserve debits your bankgt Your bank Storedvalue card card issued with a prepaid balance that can be used for purchases currently not part of M1 according to Fed o Calling cards o Gift cards etc Emoney funds in an electronic account used for Internet purchases o PayPal Google Checkout Amazon etc also NOT part of M1 Liquidity ease of trading an asset for money o The more liquid it is the easier it can be traded for money Degrees of liquidity More liquid to less liquid CurrencyChecking DepositsltgtSavings deposits ltgt SecuritiesltgtReal Estate Sweep program banking practice of shifting funds temporarily from customers checking accounts to moneymarket deposit accounts Functions of Central Bank 1 Clearing checks and electronic payments making sure money is where it s supposed to be 2 Monetary policy managing the money supply 3 Emergency lending lender of last resort 4 Financial regulation discourage banks from making loans with high default risk 2035 212012 94300 PM Financial markets people and firms that buy and sell two kinds of assets currencies and securities Security a claim on some future flow of income such as a stock or bond Bond a xedincome security issued by corporations or government treasury bills aka tbills promises to pay buyer predetermined amounts coupons at certain times and then the full amount face value on maturity date also called debt securities since the bond issuer owes money corporations issue bonds to finance new projects government issue bonds when they need to cover budge deficits interest payment for the use of borrowed funds default failure to make promised payments on debts stock equity ownership share in a corporation issued to raise funds for investment 1 securities markets exist to channel funds from savers to investors with productive uses for the funds 2 Securities markets help people and firms share risks diversification the distribution of wealth among many assets such as securities issued by different firms and governments mutual funds financial institution that holds a diversified set of securities and sells shares to savers asymmetric information situation in which one participant in an economic transaction has more information than the other participant two types o adverse selection the people or firms that are most eager to make a transaction are the least desirable to parties on the other side of the transaction occurs before the transaction when the institution or firm is chosen based on misinformation o moral hazard the risk that one party to a transaction will at in a way that harms the other party financial institution financial intermediary banks firm that helps channel funds from savers to investors m financial institution that accepts deposits and makes private loans o raises funds by accepting institution deposits including savings deposits and checking deposits that people and firms use to make payments o uses its funds to make loans to companies and individuals private loans 0 savings and loan associations privately to people 0 commercial banks large and lend various other businesses financial institutions are not banks because they do not collect deposits they are merely finance intermediaries investment banks indirect finance savers deposit money in banks that then lend to investors direct finance savers provide funds to investors by buying securities in financial markets covenant provision in a loan contract that restrict the borrower s behavior economic growth increases in productivity and living standards growth in real GDP real gross domestic product real GDP measure of an economy s total output of goods and services differences in financial systems among nations 1 government regulation some regulate securities markets to reduce the problem of asymmetric information in US companies that issue securities must publish annual reports on their investments and earnings 2 government policies also affect banks they provide deposit insurance that compensates people who lose deposits because of bank fails microfinance microlending small loans that allow poor people to start businesses around 2 centrally planned economy command economy system in which the government decides what goods and services are to be produced who receives them and what investment projects are undertaken o Ex North Korea amp Cuba Financial crisis major disruption of financial system typically involving sharp drops in asset prices and failures of financial institutions Major Threats to economy 1 Volatile stock markets availability of credit lack of exports 2 Government because of their policies gt cut taxes increased spending etc if current law stays the same and tax cuts occur along with increased government spending the US GDP will decrease by 25 in 2013 3 Housing crisis distressed homes are on market and banks are selling them at much lower rate lower than face value thus decreasing value mortgage debt is an increasing problem Positive homeowner debt however is decreasing nonfinancial firms have done well at fixing their problems gt corporations have record profits financial system has recapitalized itself credit quality has gone up morebetter loans and bank incentives centrally planned economy command economy system in which government decides what goods and services are produced who receives them and what investment projects are undertaken Communist economies Soviet Union Cuba and North Korea financial crisis major disruption of the financial system typically involving sharp drops in asset prices and failures of financial institutions US financial crisis began in 2007 due to losses in subprime mortgages which led to falling stock prices thus leading to a loss of economic confidence Chapter 3 212012 94300 PM future value value of a dollar today in terms of dollars at some future time o 1 today 1i n o n years present valu value of a future dollar in terms of today s dollars o 1 in n years 11i n o a higher interest rate reduces the present value of future money given the same number of years classical theory of asset prices asset prices present value of expected asset income o 1 An asset price equals the present value of expected income from the asset o 2 Expectations about income are rational Expected income is the best possible forecast based on all available information o 3 The interest rate in the prevent value formula is a riskadjusted rate It equals the safe interest rate plus a risk premium 0 i isafe Premium bond prices C1i C1iA2C1iAt1 CF1i T o T years to maturity o C coupon rate o i interest rate o F face value 0 At maturity the bond pays coupon rate plus the face value Stock prices D1i D21i 2 D31i 3 o D dividends payment from a firm to its stockholders 0 Though sometimes firms reinvest their earnings in the long run earnings are tied closely to dividends o A rise in earnings mean a rise in dividends longrun o Rational expectations theory that people s expectations of future variables are the best possible forecasts based on all available information thus price of company stock determined by future earnings The riskier the asset the higher the interest rate Safe interest rate iAsafe interest rate that savers can receive for sure riskfree rate Risk premium payment on an asset that compensates the owner for taking on risk Riskadjusted interest rate i safe premium sum of the riskfree interest rate and the risk premium on the asset Gordon Growth Model theory in which the price P is determined by an initial expected dividend the expected growth rate of dividends and the risk adjusted interest rate o P price o Initial dividend D o Expected growth rate G o Riskadjust premium i o P D1ig A higher interest rate reduces asset prices of stocks because it reduces the present value of any income flow dividends o Increase in i decrease in stock price A change in interest rates has a larger effect on prices of longterm bonds than on prices of shortterm bonds An increase in interest rate causes bond prices to fall The size of the effect depends on the maturity Assetprice bubble rapid rise in asset prices that is not justified by changes in interest rates or expected asset income Priceearnings ratio PE ratio company s stock divided by earnings per share of recent past can be the foreshadowing of a bubble bursting if ratio is too high Crash of 1929 too much short selling due to not enough regulation Crash of 1987 program trading increased rate of crash Bond prices rising is the same as interest rates on bonds falling Margin reguirements limits on the use of credit to purchase stocks Circuit breakers requirement that SEC shut down temporarily if prices drop by a specified percentage yield to maturity interest rate that makes the present value of payments from a bond equal to its price Return P1 P0 X o X direct payment can be coupon payment or dividend o current yield capital gains or loses Rate of return C Pel POP0 o print coupon expected price price paid todayprice paid today o return on a security as a percentage of its initial price o current yield coupon paymentprice paid for bond yield to maturity is different that rate of return unless you hold the bond until it matures in which case the yield to maturity is now the rate of return nominal interest rate interest rate offered by a bank account or bond real interest rate nominal interest rate minus inflation rate 0 r i pi ex ante real interest rate nominal interest rate minus expected inflation over loan period 0 ex ante l39 i piexpected ex post real interest rate nominal interest rate minus actual o ex post r i piactual if actual inflation gt expected inflation 9 ex ante gt ex post inflationindexed bonds bond that promises a fixed real interest rate the nominal rate is adjusted for inflation over the life of the bond o TIPS Treasury Inflation Protected Securities 212012 94300 PM Cleveland Fed uses a number of different sources updated monthly estimates what the inflation rate would be they focus on what the 10 year expected inflation rate using that information you can calculate what the exante real interest rate will be using this data we can see that in 2006 economy fell into a liquidity trap occurs when you have a negative or low nominal interest rate and a negative inflation rate when your nominal rate is higher than your real rate what determines changes in interest rate specifically real interest rate first link for chapter 4 we can see that interest rates tend to move together in the same directions o corporate will have the highest yield because there is a lower perceived level of default 0 loanable funds theory focuses on the real exante interest rate also assumes that savers and investors work directly with each other for simplicity sake demand for loanable funds serves as a proxy for a demand for investment when interest rate goes up the quantity demand for investment goes down supply of loanable funds domestic vs international component o savings o foreign savers are free to lend funds to domestic savers o capital inflows vs capital outflows o net capital inflows inflows outflows thus savings net capital inflows supply of loanable funds if the domestic real interest rate increases capital inflows increase outflows decrease thus net capital inflows also goes up Graph interest rate vs loanable funds demand downward sloping supply upward equilibrium is r Factors that affect demand for loanable funds o new technology will increase demand shift right thus increasing r o investor confidence increase will increase demand shift rigiht Factors that affect supply some factors affect domestic saving while others affect net capital inflows o Domestic saving o sum of public savings private savings 0 Changes in private savings increases income level etc supply increases shift right r down public savings decrease shift left for example an increase in budget deficit generally caused by a change in budget surplus decrease in budget surplus decrease supply o Net capital inflows 0 Changes in foreign interest rate increases supply decreases 0 Factors that explain differences among interest rates o 1 Maturity term o 2 Default risk 0 3 Liquidity o 4 Taxation term structure of interest rates relationships among interest rates on bonds awith different maturities expectations theory of the term structure the nperiod interest rate is the average of the current oneperiod rate and expected rates over the next n1 pe ods Bonds of different maturities must produce the same expected earnings If they don t nobody will buy the bonds with lower expected ea rnings term premium extra return on a longterm bond that compensates for risk Chapter 1 The Financial System I Financial Markets a Financial Market a collection of people and firms that buy and sell securities or currencies b Currencies foreign egtltchan e c Security claim on some future flow of income such as a stock or bond d Bond loans i Bond figtltedincome security Security thta promises predetermined payments at certain points in time At maturity the bond pays its face value Before that the owner may receive coupon payments 0 Coupon Bond figtlted payment loan a 1000 Face Value Syrs will mature in 2014 to receive face value Coupon Rate the percentage of face value paid every year a 5 50 per year Medium Term 9 about 5 yrs Longterm 9 more than 5 rs Discount Bond zero coupon bond aka Commercial Paper an IOU of 2270days a Usually 1 yr or less b No coupon rate no yearly payment c Buy at discount and receive face value at maturity o T Bills government discount Bond 0 Default Risk probability of paying back the bond ii Interest payments for the use of borrowed funds iii Default failure to make promised payments on debts s i Stocks equity ownership share in a corporation erally more risk than a bond ii Stock holders Residual Clammits iii Purpose 0 Help flow of fund from savers to investors a Savers 9 Financial Market 6 Investors i Savers have fund but don t have opportunity to invest estors have opportunity to invest but don t have funds Financial Market will diversify to spread RISK II Economic Functions of Financial Markets a Matching Savers and Investors i Savers people who accumulate wealth by spending less than they earn ii Investors people who expand the productive capacity of businesses b Risk Sharing c Diversification the distribution of wealth among many assets such as securities issued by different firms and governments i One the functions of the financial markets is help saver share the risks d Mutual Fund financial institution that holds a diversified set of securities and sells shares to savers III Asymmetric Information a Asymmetric information the problem that one side of an economic transaction knows more than the other 39 Can potentially bring down the market b Adverse Selection before the transaction i Adverse selection the problem that the people or firms who are most eager to make a transaction are the least desirable to parties on the other side of the transaction 0 The borrowers that are the most untrustworthy are the ones who will get that loan If the bank isn39t sure about the level of default risk they just the bank will raise the interest rate Moral Hazard after the transactionthe risk that one party to a transaction takes actions that harm another party 39 Receiver of the loan does something to increase the probability of denial 5quot IV Banks a In general are in a class of institutions called Financial Institutionaries Links savers to investors b Commercial banks 39 avins and Loan I n iv Contractual Institutions Funds are based on savings they receive from contracts c What is a Bank i They reduce transactions cost 0 can use one contract for all savers and borrowers 0 Banks use economies of scale and economies of sco e Economies or scope reduce the cost of production by producing them jointly ii Financial Institution firm that helps channel funds for savers to investors iii Bank financial institution that accepts deposits and makes private loans iv Private loan loan negotiated between one borrower and one lender d e Bank versus Financial Markets i Indirect fianc savers deposit money in banks that then lend to investors ii Direct finance savers provide funds to investors by buying securities in financial markets 0 Going straight from savers to investors a Egtlt Cajun con Wants to sell you a bond Problem you don39t know why they want the money Why banks egtltist i Reducing Adverse Selection ii Reducing Moral Hazard o Covenant provisions in a loan contract that restricts the borrower s behavior iii Who Needs Banks V The Financial System and Economic Growth a b Thf39D on onomic Growth increases in productivity and living standards growth in real GDP Saving and Growth i Real gross domestic product real GDP the measure of an economy s total output of goods and services The Allocation of Saving Evidence of Growth Microfinance small loans that allow poor people to start businesses Markets versus Central Planning i Centrally planned economy command economy system which the government decides what goods and services are produced who receives them and what investment projects are undertaken Nominal GDP the total value of goods and services produced in an economy in a given period Aggregate price level an average of the price of all goods and services Inflation rate percentage change in the aggregate price level over a period of time


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