| Term | Definition |
|---|
| financial system | the group of institutions in the economy that help to match one person's saving with another person's investment |
| financial markets | financial institutions through which savers can directly provide funds to borrowers |
| bond | a certificate of indebtedness |
| stock | A claim to partial ownership in a firm |
| financial intermediaries | financial institutions through which savers can indirectly provide funds to borrowers |
| mutual fund | an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds |
| national saving (saving) | The total income in the economy that remains after paying for consumption and government purchases. =private saving + public saving = (Y – T – C) + (T – G) = Y – C – G |
| Private Saving | the income that households have left after paying for taxes and consumption (Y-T-C) Examples of what households do with saving: buy corporate bonds or equities purchase a certificate of deposit at the bank buy shares of a mutual fund let accumulate in saving or checking accounts |
| Public Saving | The tax revenue that the government has left after paying for its spending ( T-G ) |
| Budget Surplus | an excess of tax revenue over government spending ( T-G ) |
| Budget Deficit | a shortfall of tax revenue from government spending. reduces national saving and the supply of L.F. (G-T) |
| Market for loanable Funds | the market in which those who want to save supply funds and those who want to borrow to invest demand funds |
| Crowding Out | a decrease in investment that results from government borrowing |
| 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 today that would be needed, using prevailing interest rates, to produce a given future amount of money.the amount that would be needed today to yield that future sum at prevailing interest rates.helps explain why investment falls when the interest rate rises. ___ = FV/(1 + r )N |
| Future Value | the amount of money in the future that an amount of money today will yield, given prevailing interest rates. 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 |
| 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. It contains assets whose returns are not highly correlated: Some assets will realize high returns, others low returns. The high and low returns average out, so the portfolio is likely to earn an intermediate return more consistently than any of the assets it contains. |
| Firm - Specific Risk | Risk that affects only a single company. Diversification can reduce this. |
| Market Risk | Risk that affects all companies in the stock market. Diversification cannot reduce _______. |
| Fundamental analysis | The study of a company'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. Mutual fund managers use this to to assess value of all publicly traded companies buy shares when price < value, sell shares when price > value continuously monitor and act on any news that affects the valuation of any stock |
| Informational Efficiency | The description of asset prices that rationally reflect all available information |
| Random Walk | The path of a variable whose changes are impossible to predict. The efficient markets hypothesis implies that stock prices should follow a _______. According to this theory, the only thing that can move stock prices is news that changes the market's perception of the company's value. |
| Labor Force | the total number of workers, including both the employed and the unemployed |
| Unemployment Rate (u - rate) | the percentage of the labor force that is unemployed. = 100 x #of employed/labor force |
| Labor- Force Participation Rate | the percentage of the adult population that is in the labor force. = 100 x labor force/adult population |
| Natural Rate of Unemployment | the normal rate of unemployment around which the unemployment rate fluctuates |
| Cyclical Unemployment | the deviation of unemployment from its natural rate |
| Discouraged Workers | individuals who would like to work but have given up looking for a job |
| Frictional Unemployment | unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills. Short term for most workers |
| Structural Unemployment | unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one. Occurs when wage is kept above eq'm. Long term for most workers |
| Job Search | the process by which workers find appropriate jobs given their tastes and skills |
| Unemployment Insurance | a government program that partially protects workers' incomes when they become unemployed |
| Union | a worker association that bargains with employers over wages, benefits, and working conditions |
| Collective Bargaining | the process by which unions and firms agree on the terms of employment |
| Strike | the organized withdrawal of labor from a firm by a union |
| Efficiency Wages | above-equilibrium wages paid by firms to increase worker productivity |
| Money | the set of assets in an economy that people regularly use to buy goods and services from other people |
| Medium of Exchange | an item that buyers give to sellers when they want to purchase goods and services |
| Unit of Account | the yardstick people use to post prices and record debts |
| Store of Value | an item that people can use to transfer purchasing power from the present to the future |
| Liquidity | the ease with which an asset can be converted into the economy's medium of exchange |
| Commodity Money | money that takes the form of a commodity with intrinsic value |
| Fiat Money | money without intrinsic value that is used as money because of government decree |
| Currency | the paper bills and coins in the hands of the public |
| Demand Deposits | balances in bank accounts that depositors can access on demand by writing a check |
| Federal Reserve (Fed) | The central bank of the United States. |
| Central Bank | an institution designed to oversee the banking system and regulate the quantity of money in the economy |
| Money Supply | the quantity of money available in the economy = currency + deposits |
| Monetary Policy | the setting of the money supply by policymakers in the central bank |
| Reserves | deposits that banks have received but have not loaned out |
| Fractional-Reserve Banking | A banking system in which banks hold only a fraction of deposits as reserves. |
| Reserve Ratio | the fraction of deposits that banks hold as reserves |
| Money Multiplier | the amount of money the banking system generates with each dollar of reserves. = 1/R |
| Open-market Operations | The purchase and sale of U.S. government bonds by the Fed. are easy to conduct, and are the Fed's monetary policy tool of choice. |
| Reserve Requirements | regulations on the minimum amount of reserves that banks must hold against deposits |
| Discount Rate | the interest rate on the loans that the Fed makes to banks |
| Federal Funds Rate | the interest rate at which banks make overnight loans to one another. Often causes other interest rates to move in same direction FOMC sets a target federal funds rate every six weeks FOMC hits this target by OMOs Current rate is 0.0% - 0.25%. The prime rate (the rate banks charge on loans to their best customers) and the 3-month Treasury Bill rate are very highly correlated |
| In economics, | investment is NOT the purchase of stocks and bonds! |
| Investment | is the purchase of new capital. Examples: You buy $5000 worth of computer equipment for your business. Your parents spend $300,000 to have a new house built. |
| An Increase in the Interest Rate | makes saving more attractive, which increases the quantity of loanable funds supplied. |
| Demand | The _____ for loanable funds comes from investment |
| A fall in the interest rate | reduces the cost of borrowing, which increases the quantity of loanable funds demanded. |
| Tax incentives for saving | increase the supply of loanable funds |
| An investment tax credit | increases the demand for loanable funds |
| The U.S. Government Debt | The government finances deficits by borrowing (selling government bonds). Persistent deficits lead to a rising govt debt. The ratio of govt debt to GDP is a useful measure of the government's indebtedness relative to its ability to raise tax revenue. Historically, the debt-GDP ratio usually rises during wartime and falls during peacetime – until the early 1980s. |
| There are two reasons why many economists believe it is appropriate to allow the debt ratio to climb during wars. | First, it allows the government to keep tax rates smooth over time. Wars are expensive, and financing them solely with tax increases would be disruptive to the economy and would cause a substantial reduction in economic efficiency. Second, debt finance shifts part of the cost of the war to future generations. This is appropriate, one could argue, because future generations benefit when the government goes to war to defend the nation against foreign aggressors. |
| The Rule of 70 | If a variable grows at a rate of x percent per year, that variable will double in about ??/x years. |
| Utility | is a subjective measure of well-being that depends on wealth. |
| diminishing marginal utility | As wealth rises, the curve becomes flatter due to this. The more wealth a person has, the less extra utility he would get from an extra dollar. |
| Risk Aversion | Look at: insurance, diversification, risk/return trade-off |
| How insurance works | A person facing a risk pays a fee to the insurance company, which in return accepts part or all of the risk. |
| Two Problems in Insurance Markets | Adverse selection and Moral Hazard |
| Adverse Selection | Problem in markets when one of the two parties knows more than the other. A high-risk person benefits more from insurance, so is more likely to purchase it. |
| Moral Hazard | Occurs when an agent is performing some task on behalf of another, the principal Agent tends to put forth less effort than he should. People with insurance have less incentive to avoid risky behavior. |
| standard deviation | We can measure risk of an asset with the standard deviation, a statistic that measures a variable's volatility – how likely it is to fluctuate. The higher the ___________ of the asset's return, the greater the risk. A measure of the volatility of a variable is its |
| Reducing Risk Through Diversification | Increasing the number of stocks reduces firm-specific risk. But market risk remains. |
| A tradeoff between risk and return | Riskier assets pay a higher return, on average, to compensate for the extra risk of holding them. |
| Increasing the share of stocks in the portfolio | increases the average return but also the risk. |
| When deciding whether to buy a company's stock | you compare the price of the shares to the value of the company. |
| overvalued | If share price > value, the stock is |
| undervalued | If price < value, the stock is |
| fairly valued | If price = value, the stock is |
| Value of Share | = PV of any dividends the stock will pay + PV of the price you get when you sell the share |
| Stock Prices are | determined by supply & demand. In equilibrium, the number of people who believe a stock is overvalued exactly balances the number who believe it to be undervalued the typical person perceives all _____ are fairly valued |
| Index Funds | is a mutual fund that buys all the stocks in a given stock index. |
| An actively managed mutual fund | Aims to buy only the best stocks. Most perform worse than index funds (and have higher fees). |
| Labor Force Statistics | Produced by Bureau of Labor Statistics (BLS), in the U.S. Dept. of Labor Based on regular survey of 60,000 households Based on "adult population" (16 yrs or older) |
| Employed | paid employees, self-employed, and unpaid workers in a family business |
| Unemployed | people not working who have looked for work during previous 4 weeks |
| Not in labor Force | Everyone else |
| U-Rate Measures | It is not a perfect indicator of joblessness or the health of the labor market: excludes discouraged workers does not distinguish between full-time and part-time work, or people working part time because full-time jobs are not available. Also, some people may misreport their work status in the BLS survey. |
| Most spells of unemployment are short | Typically 1/3 of the unemployed have been unemployed < 5 weeks, 2/3 have been unemployed < 14 weeks. Only 20% have been unemployed > 6 months. |
| 3 Reasons for Structural unemployment | Minimum-Wage Laws, Unions, & Efficiency Wages |
| Four reasons why firms might pay efficiency wages | Worker Health, Worker turnover, Worker quality, & worker effort. |
| Barter | the exchange of one good or service for another. |
| double coincidence of wants | Every transaction would require a _______ – the unlikely occurrence that two people each have a good the other wants. Most people would have to spend time searching for others to trade with – a huge waste of resources. |
| 3 Functions of Money | Medium of Exchange, Unit of account, & Store of value. |
| Measures of the U.S. Money Supply: M1 | currency, demand deposits, traveler's checks, and other checkable deposits. ____ = $1.6 trillion (May 2009) |
| Measures of the U.S. Money Supply: M2 | everything in _____ plus savings deposits, small time deposits, money market mutual funds, and a few minor categories. ____ = $8.3 trillion (May 2009) |
| The Structure of the Fed | Board of Governors (7 members), located in Washington, DC 12 regional Fed banks, located around the U.S. Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks The FOMC decides monetary policy. |
| Chair of FOMC | Ben Bernanke ( Feb 2006-Present) |
| T-Account | a simplified accounting statement that shows a bank's assets & liabilities. include deposits, assets include loans & reserves. In this example, notice that R = $10/$100 = 10%. |
| In a 100% reserve banking system | banks do not affect size of money supply. |
| A fractional reserve banking system creates money | , but not wealth. |
| To increase money supply, | Fed buys govt bonds, paying with new dollars....which are deposited in banks, increasing reserves ...which banks use to make loans. Fed can lower discount rate, which encourages banks to borrow more reserves from Fed. Banks can then make more loans. |
| To reduce money supply, | Fed sells govt bonds, taking dollars out of circulation, and the process works in reverse. Fed can raise discount rate. Current discount rate is 0.5% |
| The Feds 3 tools of Monetary Control | Open Market Operations (OMOs), Reserve Requirements, & Discount Rate |
| Problems Controlling the Money Supply | If households hold more of their money as currency, banks have fewer reserves, make fewer loans, & money supply falls. If banks hold more reserves than required, they make fewer loans, & money supply falls. Yet, Fed can compensate for household & bank behavior to retain fairly precise control over the money supply. |
| Run-On Banks | When people suspect their banks are in trouble, they may "____" to the bank to withdraw their funds, holding more currency and less deposits.During 1929-1933, a wave of bank runs and bank closings caused money supply to fall 28%. Many economists believe this contributed to the severity of the Great Depression. Since then, federal deposit insurance has helped prevent bank runs in the U.S. |
| Financial Crisis of 2008: Chain of Events | Housing prices fell Sub-prime mortgages Asymmetric information between bank and financial institution Mortgage-backed securities Credit-default swaps Failure of investment banks, insurance companies, money market mutual funds Crisis in commercial paper market Freezing of credit markets |
| Financial Crisis of 2008: Tools used by Fed or Treasury | Cutting interest rates Guaranteeing deposits in money market mutual funds Orchestrated mergers Bail outs Purchase of "toxic assets" Increase in FDIC insurance Purchasing shares of banks Guaranteeing inter-bank loans Lends directly to corporations by purchasing commercial paper |
| Store of Value | Possible __________ are stocks and bonds like bank deposits for the wealth that people have accumulated in past saving, but access to this wealth is not as easy, cheap, and immediate as just writing a check. |
| Intrinsic Value | The item would have value even if it were not used as money. Example, Gold. |
| Decreases | As the reserve ratio increases, the money multiplier |
| employed, unemployed, not in the labor force | The sum of which of the following would necessarily be equal to the adult population in the US statistics on labor? |
| increased for women and decreased for men. | Since World War II, the labor-force participation rate |
| both frictional and structural unemployment | The natural unemployment rate includes |
| structural but not frictional unemployment | Wages in excess of their equilibrium level help explain |
| diminishing marginal utility of wealth, implying that her utility function gets flatter as wealth increases. | If a person is risk averse, then she has |
| risk decreases and so the standard deviation of the return falls. | Other things the same, as the number of stocks in a portfolio rises, |
| the stock market is informationally efficient. | If the efficient markets hypothesis is correct, then |
| raises the quantity of labor supplied and reduces the quantity of labor demanded compared to the equilibrium level. | When a minimum-wage law forces the wage to remain above the level that balances supply and demand, it |
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