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I. The Economic Environment The level of economic activity is determined by the level of total spending. The more spending there is, there will be greater production, increasing the use of resources, leading to the increase in income. The water level in the bathtub is the gross domestic product (GDP), the broadest measure of economic activity. The GDP measures the market value of all final goods and services produced in one year. A. The Bathtub Model 1) Consumption Spending: spending by households on clothes, groceries, cars, etc 2) Government Spending: defense, infrastructure, schools, etc. 3) Investment Spending: spending by firms on tools, machineries, building to produce goods 4) Net Exports (Balance of Trade):purchases of American goods by foreigners A rising water level marks an economic expansion as more goods are produced, more jobs are available, and the family income increases. This is economic expansion. There are also drains in the bathtub 1) Savings: money saved is not spent 2) Taxes: income that is taxed cannot be spent 3) Imports: purchases of foreign goods by Americans When the water level falls, this is an economic contraction. An economic contraction that lasts for more than 2 consecutive quarters is known as recession. Lost water is returned to the bathtub as taxes are returned through government spending. Imports provide foreigners with money to buy American goods, and savings are returned through financial sectors. Firms may borrow savings to purchase their tools and machineries, and government may sell bonds. B. Real vs. Nominal Income There are two ways to perceive the value of any asset: its real and nominal value. The real value of money is its purchasing power. It is determined by its usefulness and the benefits we derive from owning it. The use value does not depreciate. The nominal value is its market value, the amount of money we would get from selling it. C. Economic Fluctuations and the Value of Assets 1) Economic Expansions a) Price level rises (usually): greater spending means that the demands for goods and services are rising, giving firms the opportunity to raise their prices. Moreover, as the need for labor increases, workers take this opportunity to demand higher wages, which can be passed onto consumers. b) Real value of nominal assets falls: inflation (rising PL) diminishes the real value of nominal assets. As the PL increases, the real value decreases for the fixed nominal asset. c) Nominal Value of real assets rises i. Sometimes by a proportional amount ii. Sometimes by an amount greater than the price level d) Important phenomena affecting nominal value of real assets: the nominal value of a real asset will rise by a greater degree then than the PL,
i.thus increasing the real market value of the real asset. on leveraged rate of return in COURSE DOCUMENTS section) ii. Financial leverage: purchase of a physical asset with a little bit of your own money and a whole lot of other people's money. Leverage the investment by borrowing money. exemptions. (see prob. Speculative Bubbles: purchase of an asset with the intent of selling them at a profit without adding value 2) Economic Contractions a) Price level falls (usually) b) Real value of nominal assets rises: deflation (decrease in PL) would cause the real value of a nominal asset tor rise c) Nominal value of real assets falls II) The Time Value of Money (see problems in COURSE DOCUMENTS section) A) Compounding 1) Future Value of a Dollar 2) Compound Interest B) Discounting 1) Accounting for Inflation (Turning Nominal into Real Values) 2) Comparing Investment Opportunities a) using the inflation rate as a discount rate b) using the required rate of return as a discount rate C) Annuities 1) FV of an annuity 2) PV of an annuity a) “Annuity value” of a stream of payments b) Required “nest egg” III) Miscellaneous Topics from Chapter 1 A) Computing Total Economic Cost B) Making decisions at the margin (sunk costs are irrelevant) IV) Managing Taxes A) Definitions 1) Progressive. deductions & credits B) Computing Tax Liability . regressive & proportional Progressive: imposes higher tax on taxpayers with higher income Regressive: places a disproportionate burden on those taxpayers with lower income 2) Marginal & average tax rates Marginal: 3) Capital gains 4) Exclusions.
non-taxable income (see explanation in COURSE DOCUMENTS section) a) Exclusions b) Exemptions i. in COURSE DOCUEMENTS section) . Dependents c) Deductions i. Personal ii. Standard ii.1) Taxable vs. Itemized d) (Direct) Tax Credits – deducted from tax liability C) Tax Avoidance & Minimization Strategies 1) Reduce Taxable Income 2) Defer Taxable Income 3) Receive Income Subject to Lower Tax Rates 4) Increase Deductions & Exemptions 5) Maximize Tax Credits D) How much income would you need to buy a good or service? (see prob.