Chapter 26 Reducing Transaction Costs

Expenses of negotiating and executing a deal

Savings-Investment Spending Identity
Savings and investment spending are always equal for Reducing Financial Risk
the economy as a whole (S=I) Uncertainty about future outcomes involving gains and
losses
Budget Surplus
Difference between tax revenue and government Providing Liquid Assets
spending when tax revenue exceeds government Assets that can be quickly converted into cash
spending (T-G > 0)
Default
Budget Deficit Borrower fails to make payments as specified by the
Difference between tax revenue and government loan or bond contract
spending when government exceeds tax revenue ( T-G Upgrade to remove ads
< 0)
Loan-Backed Security
Budget Balance Asset created by pooling individual loans and selling
Difference between tax revenue and government shares in that pool
spending (T-G)
Financial Intermediary
National Savings An institution that transforms the funds it gathers from
Sum of private savings plus the budget balance is the many individuals into financial assets
total amount of savings generated within the economy
private savings + public savings Mutual Fund
Financial intermediary that creates a stock portfolio
Capital Inflow Equation into individual investors
Imports - export
Pension Fund
Investment Spending Equation Mutual fund holding assets to provide retirement
National savings + capital inflow income to its members

Loanable Funds Market Life Insurance Company

Hypothetical market examining outcomes of demand Sells policies that guarantee a payment to a policy
for funds by borrowers and the supply of funds by holder's beneficiaries when the policy holder dies
lenders
When interest rate RISES...
Rate of Return Definition Stock prices FALL
Profit earned by the project expressed as a percentage
of its cost Efficient Markets Hypothesis
Financial asset prices embody all publicly available
Rate of Return Equation information
[(project revenue - project cost)/project cost]100
Random Walk
If Return is too Low... Fluctuations are unpredictable
Better off putting money in bank to earn interest
Financial system
Shifts in Demand for Loanable Funds: Changes in The group of institutions in the economy that help to
Business Opportunities match one person's saving with another person's
Bright outlook (ROR increases) - shift RIGHT investment
negative outlook (ROR decreases) - shift LEFT
Savers
Shifts in Demand for Loanable Funds: Changes in People who invest their money and expect to see it on
Government Borrowing a later date
runs a deficit - shift RIGHT Upgrade to remove ads
runs a surplus - shift LEFT
Buyers
Crowding Out Demand money with the knowledge they will have to
When government deficit drives up interest rate pay it back with interest on a later date
leading to reduced investment spending
Financial Markets
Shifts in Supply for Loanable Funds: Changes in The institutions through which individuals with savings
Private Savings Behavior can supply these funds to persons or firms that wish to
higher home prices (spend more save less) shift LEFT borrow money to purchase consumption goods or
invest in physical capital
Shifts in Supply for Loanable Funds: Changes in
Capital Inflow Stock market
Investment into US leads to more funds to loan A general term used to describe all transactions
domestically - shift LEFT involving the buying and selling of stock shares issued
Fisher Effect by a company.
Increase in expected future inflation drives up the
nominal interest rate, so the expected real interest Stock
rate is unchanged Represents financial ownership in a company

Three Tasks of Financial System Principal

1. Reducing transaction costs Amount borrowed
2. Reducing financial risks
3. Providing liquid assets Financial intermediaries
Financial institutions through which savers can and uses the money they earn to invest into a new
indirectly provide funds to borrowers factory for their company

Banks Market for Loanable Funds

Financial institutions that accept deposits and make Market where borrowers take out funds and savers
loans. Usually smaller scale businesses take a loan deposit their money
from banks
Loanable funds
Medium of exchange All income that people have chosen to save and lend
An item that buyers give to sellers when they want to out, rather than use for their own consumption
purchase goods and services
Mutual Funds Source of demand for loanable funds
Institution that sells shares to the public and buys a Investment; families taking out money to buy a new
portfolio (stocks, bonds, or stocks and bonds). When home or companies taking out money to invest in a
the value of a portfolio increases the shareholder new production center
benefits and vice versa. They allow people with small
amounts of money to diversify their holdings and are Interest rate
generally less risky than investing a large amount of The price of loanable funds
money into a couple of companies
Supply and demand in relation to loans
GDP Equation a high interest rate makes borrowing more expensive,
Y = C + I + G + NX (y is gdp, c is consumption, i is so the QUANTITY DEMANDED FOR FUNDS FALLS and
investment, g is government spending, and nx is net interest rate rises. Vice versa, QUANTITY DEMANDED
exports) FOR FUNDS INCREASES when interest rate goes down.
Quantity supplied increases as interest rates increase
Closed economy as well
An economy that does not interact with other
economies in the world (Y= C+I+G) because NX= 0
Nominal vs real interest rate
Open economy Nominal interest rate accounts for the monetary costs
An economy that interacts with other economies. GDP of saving and borrowing, while the real interest rate
equation is normal accounts for the inflation rate as well which is
subtracted from the nominal rate.
Savings - economists use the real interest rate when comparing
Total income that remains after paying for government loanable funds
services and consumption.
Equation: Y-C-G= S or I because Savings=Investment If a reform of the tax laws encourages greater saving,
the result would be
How else can savings be written/thought of as? lower interest rates and greater investment
S= Y-C-G
S= (Y-T-C) +(T-G) where T is the amount that the Investment Incentives Increase the Demand for
government collects from households in taxes minus Loanable Funds
the money it pays back to households in the form of results are higher interest rates and greater savings
transfer payments (social security and welfare)
The Effect of a Government Budget Deficit
Private saving when a government is running on a budget deficit, the
The amount of income households have after paying supply will shift back because there is less national
for their taxes and consumption saving. The interest rate rises and investment falls.
S= Y-T-C
Crowding out
Public saving A decrease in investment that results from government
The amount of tax revenue government has left after borrowing. Supply of loanable funds decreases and the
paying for its spending equilibrium quantity of loanable funds also decreases
S= T-G
Budget surplus
Budget surplus A situation in which the government takes in more
When a government's revenue exceeds its than it spends. This would increase the amount of
expenditures during a one-year period investing in the economy, increases the supply of
S= T-G value is POSITIVE loanable funds, and decreases the interest rate

Budget deficit Chapter 27

When the government spends more than it takes in
S=T-G value is NEGATIVE
S=I Rule
For the economy as a whole, saving must equal
investment. Determinants of these factors are all parts
of the economy, from the bond market, stock market,
banks, mutual funds, and other financial markets and
intermediaries
Difference between saving and investing
Saving= when income exceeds consumption, even if
you put some of that money into the stockmarket
investment= the purchase of new capital, such as
buildings. Example could also be if someone buys stock
Finance
The field that studies how people make decisions
regarding the allocation of resources over time and the
handling of risk.
Present Value
the amount of money that would be needed,
prevailingg interest rates, to produce a given future
amount of money.
Future Value
The amount of money in the future that an amount of
money today will yield giving prevailing interest rates.
Compounding
The accumulation of a sum of money in, say, a bank
account, where the interest earned remains in the
account to earn additional interest in the future.
Risk Aversion
A dislike of uncertainty.
Diversification
The reduction of risk achieved by replacing a single
risk with a large number of smaller, unrelated risks.
Firm-specific Risk
Risk that affects only a single company.
Market Risk
Risk that affects all companies in the stock market.
Fundamental Analysis
The study of a compnay's accounting statements and
future prospects to determine its value.
Efficient Markets Hypothesis
The theory that asset prices reflect all publicly
available information about the value of an asset.
Informational Efficiency
The description of asset prices that rationally reflect alll
available information.
Random Walk
The path of a variable whose changes are impossible
to predict.
The interest rate is 7 percent. Use the concept of
present value to compare $200 to be received in 10
years and $300 to be received in 20 years.
X/(1+r)^N
200/1.07^10 = $102
300/1.07^20 = $78
Present Value Formula:
If "r" is the interest rate, then an amount "X" to be
received in "N" years has a present value of X/(1+r)^N
Ex: Interest rate is 5%, the present value of $200 to
be paid in 10 years is $200/(1.05)x^10 or $123. This
means that $123 deposited today in a bank account
that earned 5% would produce $200 after 10 years.
What benefit do people get from the market for
insurance?
It spreads out the risks to be shared by multiple
people and not just by you alone. It covers your risk of
something happening to you by spreading it out.
What two problems impede the insurance market
from working perfectly?
One problem is adverse selection: a high risk person is
more likely to apply for insurance than a low risk
person because a high-risk person would benefit more
from insurance protection. The second problem is
moral hazard: after people buy insurance they have
less incentive to be careful about their risky behavior
because the insurance company will cover much more
of the resulting losses.
What is diversification? Does a stockholder get a
greater benefit from diversification going from 1
to 10 stocks or from 100 to 120 stocks?
Diversification is the reduction of risk achieved by
replacing a single risk with a large number of smaller,
unrelated risks. The stock holder would benefit more
from diversification going from 1 to 10 because it
would reduce the risk a lot more than going from 100
to 120 becasue they've already started with a lower
risk.
Comparing stocks and government bonds, which
type of asset has more risk? Which pays higher
average return?
Stocks have more risk because their value depends of
the future of their firm, and because of the higher risk,
shareholders demand a higher return.
What factors should a stock analyst think about
determining the value of a share of stock?
The future probability of a firm.
Describe the efficient markets hypothesis and
give a piece of evidence consistent with this
hypothesis.
It's the theory that asset prices reflect all publicly
available information of an asset. It says the changes
in stock prices should follow a random walk, making
them impossible to predict from available information,
so choose your stocks randomly.
Explain the view of those economists who are
skeptical of the efficient markets hypothesis.
Efficient markets hypothesis assumes that people
buying and selling stock rationally process the
information they have about the stock's underlying
value. But stock prices sometimes deviate from
reasonable expectations of their true value. When you
evaluate a stock, you have to estimate not only the
value of the business but also what other people think
the business is worth in the future.
Future Value Formula:
(1 + r)^N x (base price) r = 0.07
(1 + 0.07)^10 x $200 = $393.43
(1 + 0.07)^20 x $300 = $1160.90
Intrinsic value
Means that an item would have value even if it were
not used as money.
Federal Reserve System (Fed)
Is the central of the U.S Money System
Functions of Fed in the whole economy:
Provides Fiat Currency and Controls money supply
withe its monetary policy tools.
Functions of Fed in Banks:
Supervises the activities of member banks, serves as
depositing institution for banks (hence called Bankers
Bank), Serves as a lender of last resort, and serves as
cleaning house/agent for banks.
Functions of Fed for the Government:
Serves as a fiscal agent for treasury and serves as a
government bank.
List of Monetary Policy Tools:
Open market operation, reserve required by law ratio,
discount rate, and payment of interest on excess
reserves on Banks.
Open market operation:
Is the puchase/sell of U.S Govt. bonds in the financial
market.
Inflation
Is the rise in the overall price level
Price level symbol
P
Causes of inflation
Demand side causes --> increase
The Present Value of a Future Sum
The amount that would be needed today to yield that
future sum at prevailing interest rates
The Future Value of a Sum
The amount the sum will be worth at a given future
date, when allowed to earn interest at the prevailing
rate
Compounding
The accumulation of a sum of money where the
interest earned on the sum earns additional interest
The Rule of 70
If a variable grows at a rate of x % per year, that
variable will double in about 70/x years
Risk Averse
They dislike uncertainty
Utility
A subjective measure of well being that depends on
wealth
Diminishing Marginal Utility
The more wealth a person has the less extra utility he
would get from an extra dollar
How insurance works
A person facing a risk pays a fee to the insurance
company, which in turn accepts part or all of the risk
Adverse Selection
A high risk person benefits more from insurance, so
they are more likely to benefit it.
Moral Hazard
People with insurance have less incentive to avoid
risky behavior.
Signaling
The idea that one party (termed the agent) CREDIBLY
conveys some information about itself to another party
Screening
One method of addressing the problems associated
with asymmetric information, especially adverse
selection and moral hazard
If a consumer is taking initiative to resolve adverse
selection it is called.... __________
Signaling
Standard deviation is used to measure the risk of
_______
An asset
Standard deviation
A statistic that measures a variables volatility, how
likely it is to fluctuate
Mean
Average
Variance
A measure of the dispersion from the mean
VARIANCE
Standard deviation is the square root of....
Diversification
Reduces risk by replacing a single risk with a large
number of smaller and unrelated risks
Firm Specific Risk
Affects only a single company
Market Risk
Affects all companies in the stock market
Diversification CAN eliminate firm specific risk but not
market risk
Random Walk
Stock prices only change in response to new
information/news about the company's value. News
cannot be predicted, so stock price movements should
be impossible to predict.
What are the three assumptions of the Efficient
Market Hypothesis?
1. The stock market is informationally efficient
2. Stock Prices follow a RANDOM WALK
3. it is impossible to systemically beat the market
Robert Shiller
-The market prices DO NOT reflect all available
information instantaneously
-It is possible to constantly make a profit in the stock
market in the long-run
Index Fund
A mutual fund that buys all stocks in a given stock
index
An activley managed mutual fund
Chapter 28
Unemployment
When a worker who is not currently employed is
searching for a job without success.
Unemployment rate
% of the labor force that's unemployed.
Creative destruction
When the intro of new products and technologies leads
to the end of other industries and jobs.
Structural unemployment
Unemployment caused by changes in the industrial
make up (structure) of the economy.
Frictional unemployment
Unemployment caused by delays in matching available
jobs and workers.
Unemployment insurance
Government program that reduces the hardship of
joblessness by guaranteeing that unemployed workers
receive a % of their former income while unemployed.
Cyclical unemployment
Unemployment caused by economic downturns.
Natural rate of unemployment
The typical rate of unemployment that occurs when the
economy is growing normally.
Full employment output
The output level produced in an economy when the
unemployment rate is equal to its natural rate.
Labor force
Includes people who are already employed or actively
seeking work.
Discouraged workers
Those who are not working, have looked for a job in
the past 12 months and are willing to work, but have
not sought employment in the past four weeks.
Underemployed workers
Those who have part time jobs but who would prefer
to work full time.
Labor force unemployment rate
The % of the population that is in the labor force.