Econ 1021 Midterm: Macro Midterm 2 Study Guide

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Washington University in St. Louis
University College - Economics
University College - Economics Econ 1021
Bandyopadhay Sudeshna

Jack Broitman Macro 1021 Midterm 2 Study Guide I. Chapter 8: Saving, Capital Formation, and Financial Markets A. Saving 1. Why save? a. Individuals save • To meet future expenditures (life cycle motive) • To protect against an economic emergency (precautionary motive) b. Nations save • To produce new capital goods – to promote growth and higher standards of living in the future • National Saving equals savings by households, businesses and governments c. Households save • Life-Cycle Saving: Saving to meet long-term objectives - retirement, college attendance, the purchase of a home • Precautionary Saving: Saving for “a rainy day” - loss of a job, a medical emergency • Bequest Saving: Saving for the purpose of leaving an inheritance - small business, farms, wealthy individuals 2. Saving and Wealth a. Savings = current income - spending on current needs 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 b. Saving Rate = 𝑖𝑛𝑐𝑜𝑚𝑒 c. Wealth: The value of assets minus liabilities • Assets: Anything of value that one owns either financial (cash, stocks, bonds, etc.) or real (real estate, jewelry, consumer durables like cars, etc.) • Liabilities: The debts one owes (credit card balances, loans, mortgages, etc.) d. Net worth = assets - liabilities e. Savings is a Flow: A measure that is defined per unit of time f. Wealth is a Stock: A measure that is defined at a point in time • Capital Gains - increase in the value of existing assets - may decrease the urge to save • Capital Losses - decrease in the value of existing assets - may increase the urge to save • Capital gains and losses are part of wealth NOT savings • Change in Wealth = Saving + Capital gains - Capital loss 3. Low US Savings and US Savings Trends a. National savings determines a country's ability to invest in new capital goods • Household savings has been low • Business saving has been significant b. Since 2002, federal government’s large deficits have contributed to a decline in the US national saving rate c. Bull Market of 1990s • More households acquired stocks and they enjoyed enormous capital gains as stock prices rose • Capital gains on stocks increased household wealth, may have decreased savings d. Reasons for falling savings: • Aging of the US population – increased fraction of the population with higher propensities to consume • Financial Innovations (derivatives) and deregulation of the financial sector – facilitated novel ways of borrowing and hence reduction in precautionary saving • Capital Gains from booming stock and housing markets – Wealth effect • Low interest rates – stimulating consumption through inter-temporal substitution e. Savings rate may be depressed by • Social Security, Medicare, and other government programs for the elderly • Mortgages with small or no down payment • Confidence in a prosperous future • Increasing value of stocks and growing home values • Readily available home equity loans • Demonstration effects and status (positional) goods 4. Positional vs. Non-Positional Goods 5. S – I Identity in a Closed Economy with no Govt a. Y = C + I + G + NX, • Where, Y = Real income or expenditures; C = Consumption; I = Investment; G = Government Expenditure; NX = Net exports b. Assume G = 0 and NX = 0 for closed economy and no govt. c. Therefore Y = C + I and private Saving equals Y – C  Therefore, S = I 6. S – I Identity in a Closed Economy with Govt. a. Once again: Y = C + I + G + NX b. Assume NX = 0, closed economy with govt. • Y = C + I + G Y – C – G = I c. National Saving (S) = Current Income (Y) minus Spending on current needs • S = Y - C – G = I, so again, S = I B. National Savinsg 1. National Saving and Its Components a. I = spending on capital goods, new factories, residential housing - all done to raise a nations future productive capacity; NOT spending on current needs; b. C includes durable goods which may satisfy current and future needs; c. G may also include expenditure on public capital d. S = Y - C - G • Let T = taxes paid by the private sector to the Govt. minus transfer payments and interest payments made by the govt • S = Y - C - G + T - T = (Y - T - C) + (T - G) • Private saving = SprivateY - T – C, Public saving = Spublic T - G • Sprivate Household S (or Personal S) + Business S e. S = S privateSpublic f. Private saving is done by households and businesses g. Public saving and the gov’t budget 2. S – I Identity in an Open Economy with Govt. a. Y = C + I + G + NX (Assume an open economy with govt.) • Y – C – G = I + NX b. Recall that Domestic Savings S = Y – C – G. • So, S = I + NX;  S – NX = I c. In an open economy, foreign savings coming into the US can finance our Investment – called K Inflow d. US savings can flow out to finance foreign Investment – called K Outflow e. For an open economy, Domestic Investment spending can not only be financed by national saving but also by the savings of foreigners – called Net Capital Inflow f. If domestic saving is not enough, may be able to get all those funds from foreigners (not a huge problem for the US) g. Actual and desired investment spending may not be equal • If households save more, they consume less. So unsold inventories build up at firms. These get added to investment, although unintended. • So household saving will equal the desired investment expenditure plus the unintended inventory adjustment. • Actual saving will always equal actual investment. • Desired saving may or may not equal desired investment h. S = Y – C (Savings = Output – Consumption) C. Investment and Capital Formation 1. Three types of Capital a. Physical Capital: Manufactures resources like buildings and machines b. Human Capital: Improvement in the labor force generated by education and knowledge c. Financial Capital: Funds from Savings that are available for Investment Spending 2. Making Investments a. Two important costs: price of the capital good and real interest rates • Opportunity cost of the investment b. Value of the marginal product of the capital is its benefit c. The benefits that we are weighing these costs against are the value of the marginal product of the capital 3. Savings and Real Interest Rates a. Substitution effect: Increases the return on savings and the opportunity cost of consumption: r  S b. Wealth (Income) effect: Increases wealth; reduces the S needed to achieve goals: r  S c. Generally Sub. effect > Wealth effect d. Empirically, r  S 4. Investment Supply and Demand a. Supply of Savings (S) • The quantity supplied of saving is positively related to the real interest rate (r) b. Demand for Saving (I) • The quantity demanded of saving is negatively related to real interest rate (r) c. The market for savings will determine the equilibrium (r) • If r is above equilibrium, a surplus of savings will exist • If r is below equilibrium, a shortage of savings will exist d. Investment demand curve is downward sloping because: • Increasing opportunity cost from diminishing marginal productivity of capital e. Investment supply curve is upward sloping because of income effect f. The Real Interest Rate + Fischer Effect • Demand for loanable funds vs. supply of loanable funds (Fischer effect revisited)  drawn at 0% expected inflation • If inflation: both curves will shift UP by the inflation % 5. Supply and Demand for Savings + Crowding Out a. New Technology raises the marginal productivity of capital • This increases the demand for capital and hence investment funds • New tech will shift demand right (causing saving and investment to increase) b. Increases in the government budget deficit reduces S public and national saving, r will increase, S & I will fall  this is Crowding Out c. Crowding Out • The tendency of govt. budget deficits to reduce Investment spending is called Crowding out • This leads to lower capital formation and eventually a lower rate of economic growth d. Higher national saving rate leads to greater investment in new capital goods and a higher standard of living II. Chapter 9: The Financial System, Money, and Prices A. Financial System 1. Money basics and financial markets a. In Economics, money is any asset that can be used in making purchases b. Financial markets are where households invest their current savings and wealth by purchasing financial assets or physical assets. • Financial Asset: is a paper claim (stocks, bonds, loans, etc) that entitles the buyer to future income from the seller • A loan is a financial asset that is owned by the lender (typically, banks). It is a bank’s asset and your (borrower) liability. • Physical Asset: is a claim on a tangible object (house, machinery, etc) that gives the owner the right to dispose of the object as he or she wishes c. Financial Markets provide information to savers about the most productive (highest rate of return) investments d. Financial Markets help savers to diversify (investing in several assets with unrelated or independent risks) to share the risks of individual investment 2. Loans and Securities a. Loan - is a lending agreement between a particular lender and a particular borrower • Loans are harder to resell because they are not as standardized as bonds b. Bond – is a legal IOU issued by the borrower • The seller of the bond (borrower) promises to pay a fixed sum of interest (called coupon payments) each year and to repay the principal amount (called face-value) at maturity, the interest rate on the bond is called its coupon rate c. Loan-Backed Securities: are assets created by pooling individual loans and selling shares in that pool – a process called securitization • Typically provide more diversification and liquidity compared to loans d. Mortgage-Backed securities are a special kind of the above where individual home mortgages are pooled and sold as shares to investors 3. Bonds a. The coupon rate that a newly issued bond depends on • The term of a bond – length until maturity, longer term  higher coupon rate • Credit Risk – the risk that the borrower will go bankrupt and hence default • Tax Treatment - Municipal bonds are federal tax free and so offer a lower coupon rate b. Bondholders are free to sell their bonds any time before maturity in the bond market c. The market value of a particular bond at any time is called its price. • The price of a bond may be equal to, greater than or less than the face-value of the bond, depending on how the bond coupon rate compares with the prevailing market interest rates d. Bond prices are inversely related to market interest rates 4. Stocks a. Stock: is a share in the ownership of a company • A financial asset from the owner’s point and a liability for company b. Stockholders receive regular payments called dividends (a share of the company’s profits) for each share of stocks they own c. Stockholders also receive returns in the form of capital gains when price of their stock increases d. Stock prices are determined by the demand and supply at stock exchanges e. Risk aversion – few individuals are risk tolerant enough to internalize the risks involved in owning a large company, stocks help minimize risk f. Stock prices and real interest rate are negatively related g. The difference between the required rate of return to hold risky assets and the rate of return on safe assets is called Risk Premium B. Financial Institutions 1. Financial Intermediaries a. A Financial Intermediary is an institution that extends credit to borrowers using funds raised from savers • Examples – banks, Savings and Loan, and Credit unions, Mutual Funds, Pension Funds and Life Insurance Funds b. Financial intermediaries are firms, such as commercial banks, that extend credit to borrowers by using funds raised from savers c. By specializing, banks and other intermediaries have developed a comparative advantage in gathering information and evaluating borrowers • Most savers do not have the time or knowledge to determine which investments would be the best use of their money d. Furthermore, banks are able to pool the savings of many individuals to make large loans and bypass the cost of hundreds of individual evaluations • Principle of Comparative Advantage: They have lower cost of evaluating opportunities than an individual would 2. Advantages of Banking a. Banks gather information, evaluate potential investments, and direct savings to higher-return, more productive investments, provide service to depositors b. When banks make loans, they earn interest which, in turn, is paid by the bank to its depositors c. As an intermediary, the bank offers services to both the supply and the demand sides of the financial market • For the supply side, the depositors, the bank gathers information, evaluates potential investments, and directs savings to higher-return, more productive investments • For the demand side, the loan seekers like small businesses and homeowners, the bank provides access to, and may sometimes be the only source of, credit d. When a bank makes a loan, it requires that the loan seeker pay back the money taken out with some percent interest • Interest is then paid to the bank’s depositors and as an incentive to save e. Having bank deposits makes payments easier • Checks, ATMs, debit card, checks and debit cards are safer than cash, banks provide a record of your transactions • Earning interest is one way to encourage individuals to save • Another incentive is that having a bank deposit makes payments easier 3. US Stock Market a. Current Stock Prices depend on the expectations of buyers of stock about • Future dividends: (+)vely related • Future stock prices (capital gains): (+)vely related • Required Rate of Return = r on safe assets + Risk Premium: (-)vely related b. Stock prices depend on the purchasers’ expectations about future dividends and stock prices and on the rate of return required by potential stockholders • An increase in stock prices could therefore be due to increased optimism about future value or a fall in required return, which is the sum of the interest rate on safe assets and the risk premium c. An increase in stock prices could be the result of • Increased optimism about future dividends and/or capital gains • A fall in the Required Rate of Return C. Money 1. Basics a. Money is any asset that can be used in making purchases • Barter is trading goods directly b. Money has 3 principal uses: Medium of exchange, Unit of account, Store of value c. M1 = currency held outside banks + traveler’s checks + balances held in checking accounts by individuals and businesses d. M2 = M1 + additional assets that are useable in making payments but at greater cost (including inconvenience) than currency or checks e. Checks, credit cards, debit cards are not money • The bank deposits that they take the money from is the actual money • The cards are just a form of ID, sort of like your driver’s license. f. Currency inside the bank (bank reserves) is not money 2. Commercial Banks and Money Creation a. As long as reserve:deposit ratio is greater than the goal ratio, bank has space to continue lending out b. Reserves are not part of the money supply c. Deposits are part of the money supply d. Deposits are liabilities for the bank e. Bank Reserves - Cash or similar assets held by commercial banks for the purpose of meeting depositor withdrawals and payments f. 100% Reserve Banking - Banks hold 100% of their deposits (liabilities) as reserves g. Reserve-Deposit ratio - Reserves/Deposits h. Fractional Reserve Banking System - Banks may also hold a fraction of the deposits as reserves and loan out the rest to individuals and businesses; reserve- deposit ratio < 100% 3. Money Expansion a. The use of a fractional-reserve banking system allows the money supply to grow as a multiple of the reserves b. Bank reserves/bank deposits = desired reserve-deposit ratio c. Bank deposits = bank reserves/desired reserve-deposit ratio d. Money multiplier = 1/ reserve ratio, only deposits are scaled by the multiplier D. Federal Reserve System 1. The Fed a. Two Main Responsibilities of the Fed: Monetary policy, oversight and regulation of financial markets b. Monetary policy is deciding and managing the size of the nation's money supply c. The Federal Open market Committee (FOMC) controls money supply by Open Market Operations (OMO)– the purchase and sale of government bonds by the Fed that leads to a change in bank reserves and hence the money supply 2. Changing the Money Supply a. Increasing The Money Supply - Open Market Purchase • The Fed purchases government bonds from the public • Public deposits funds  increase in deposits  increased bank reserves  money supply increases by a multiple of the increase in reserves b. Reducing The Money Supply - Open Market Sale • The Fed sells government bonds to the public • Fed presents checks to banks  banks’ reserves fall when checks cleared  money supply falls by multiple of decrease in reserves 3. Money and Prices a. In the short run inflation can arise from various sources, but in the long run inflation is almost always caused by too much money chasing too few goods b. Velocity = the speed at which money circulates – the number of times a year the typical dollar changes hands 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙 × 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃×𝑌 𝑉𝑒𝑙𝑜𝑐𝑖𝑡𝑦 = 𝑚𝑜𝑛𝑒𝑦 𝑠𝑡𝑜𝑐𝑘 = 𝑀𝑜𝑛𝑒𝑦 𝑠𝑡𝑜𝑐𝑘 = 𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 = 𝑀 • V(velocity)*M(money supply) = nominal GDP = P(price level)*Y(real GDP)  the quantity equation from the quantity theory of money c. From the equation: 𝑉 = 𝑃×𝑌 𝑀 • M x V = P x Y  Assuming V & Y are constant over the time period, then P is directly proportional to M d. If high rates of money growth lead to inflation, why do countries allow their money supplies to rise quickly: huge govt. budget deficits III.Chapter 10: Short-Term Economic Fluctuations A. Economic Fluctuations 1. Short vs. Long Term a. Long Term Economic “Climate” = Small changes in the rate of economic growth has enormous effects on the living standards of individuals b. Short Term Economic “Weather” = short-term economic fluctuations are what people mostly react to 2. Short Term Economic Fluctuations a. Recession (or contraction) is a period in which the economy is growing at a rate significantly below normal b. Depression is a particularly severe or protracted recession c. Expansion is a period in which the economy is growing at a rate significantly above normal d. Boom is a particularly strong and protracted expansion 3. Recessions and Expansions a. Peak = the beginning of a recession, the high point of economic activity prior to a downturn b. Trough = end of a recession, the low point of econ activity prior to a recovery c. The Business Cycle Dating Committee (several economists) of the NBER call the shots and determine when we are in a recession or expansion d. They look at the following coincident indicators: Industrial Production (output of factories and mines), Total sales in Manufacturing/wholesale/retail trade, Non- farm employment, real after-tax income received by households, excl transfers a. Expansions have generally been longer than recessions in history 2. The Business Cycle a. Short-term economic fluctuations = business cycles or cyclical fluctuations • They a
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