Economic Growth, Financial Markets, and Asset Valuation

EXAM REVIEW 2

Chapter 12

• A country’s standard of living depends on its ability to produce goods and services. Its ability depends on PRODUCTIVITY.
• Y = real GDP = quantity of output produced L = quantity of labor so productivity = Y/L (output per worker)
• Real GDP per capita: Y/Population
• What determines PRODUCTIVITY?

1. Physical Capital per Worker:

1. What is Physical capital? The stock of equipment and structures used to produce goods and services is called [physical] capital, denoted K.
2. Productivity is higher when the average worker has more capital (machines, equipment, etc.).

1. Human Capital per Worker (H):

1. What is Human Capital? The knowledge and skills workers acquire through education, training, and experience
2. Productivity is higher when the average worker has more human capital (education, skills)

1. Natural Resources Per Worker (N):

1. What are Natural Resources? The inputs into production that nature provides, e.g., land, mineral deposits.
2. Other things equal, more N allows a country to produce more Y.

1. Technological Knowledge (A):

1. What is technological knowledge? Society’s understanding of the best ways to produce goods and services.

• Production Function: The production function is a graph or equation showing the relation between output and inputs:

Y = A F(L, K, H, N)

• Public Policies that can effect long-run growth in productivity and living standards:

1. Saving and Investment: Higher saving can only be achieved by decreasing your consumption. Higher saving will lead to higher physical capital, since saving will turn into investment.

1. The government can implement policies that rise saving and investment.
2. Then K (Physical Capital) will rise, causing productivity and living standards to rise.
3. But this faster growth is temporary, due to diminishing returns to capital:

1. What is diminishing returns to Capital? As K rises, the extra output from an additional unit of K falls.
2. What is Catch-up Effect? The property whereby poor countries tend to grow more rapidly than rich ones

1. Investment from Abroad: To raise K/L and hence productivity, wages, and living standards, the government can also encourage:

1. Foreign Direct Investment:
2. Foreign Portfolio Investment:

1. Education: Government can increase productivity by promoting education–investment in human capital (H). For ex: Public schools, subsidized loans for college.
2. Health and Nutrition: Health care expenditure is a type of investment in human capital—healthier workers are more productive.
3. Property Rights and Political Stability
4. Free Trade: Trade makes everyone better off.
5. Research and Development: Policies to promote tech. progress:

1. Patent laws
2. Tax incentives or direct support for private sector R&D
3. Grants for basic research at universities

1. Population Growth: may affect living standards in 3 different ways:

1. Stretching natural resources
2. Diluting the capital stock

Promoting technologicalprog

Chapter 13- Savings, Investment and Financial Markets

• Financial Institutions:

1. Financial system: The group of institutions that helps match the saving of one person with the investment of another.
2. Financial Markets: Institutions through which savers can directly provide funds to borrowers.

1. The bond market: A bond is a certificate of indebtedness.

1. Long term vs. Short Term Bonds
2. Default Risk
3. Tax Payments

1. The Stock Market: A stock is a claim to partial ownership in a firm.

1. Financial Intermediaries: Institutions through which savers can indirectly provide funds to borrowers. Examples:

1. Banks
2. Mutual Funds

• Understanding Saving and Investment in a Closed Economy:

1. Private Saving: The portion of households’ income that is not used for consumption or paying taxes.

Private Saving=Y-C-T

1. Public Saving: Tax revenue less government spending.

Public Saving=T-G

1. National saving: Public Saving + Private Saving.

= (Y – T – C) + (T – G)

= Y – C – G

1. National Income Identity in a closed economy is:

Y = C + I + G

I=Y-C-G=S

1. Saving = investment in a closed economy.
2. Budget surplus: An excess of tax revenue over government spending

= T – G

= public saving

1. Budget Deficit: = A shortfall of tax revenue from government spending

= G – T

= – (public saving)

1. Examples of Saving and Investment:

1. Saving:

1. Buy corporate bonds or equities
2. Purchase a certificate of deposit at the bank
3. Buy shares of a mutual fund
4. Let accumulate in saving or checking accounts

1. Investment:

1. General Motors spends $250 million to build a new factory in Flint, Michigan.
2. You buy $5000 worth of computer equipment for your business.
3. Your parents spend $300,000 to have a new house built.

• Market for Loanable Funds: A supply–demand model of the financial system.

1. Assumptions: Only one financial market. All savers deposit their saving in this market. All borrowers take out loans from this market. There is one interest rate, which is both the return to saving and the cost of borrowing.
2. The supply of loanable funds comes from those who spend less than they earn. The supply can occur directly through the purchase of some stock or bonds or indirectly through a financial intermediary (SAVERS).
3. The demand for loanable funds comes from households and firms who wish to borrow funds to make investments. Families generally invest in new homes while firms may borrow to purchase new equipment or to build factories (INVESTORS).
4. The Price of the loan is the interest rate (REAL INTEREST RATE).

1. An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.
2. A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.
3. At equilibrium, the quantity of funds demanded is equal to the quantity of funds supplied.

1. If the interest rate in the market is greater than the equilibrium rate, the quantity of funds demanded would be smaller than the quantity of funds supplied. Lenders would compete for borrowers, driving the interest rate down.
2. If the interest rate in the market is less than the equilibrium rate, the quantity of funds demanded would be greater than the quantity of funds supplied. The shortage of loanable funds would encourage lenders to raise the interest rate they charge.

• POLICIES THAT EFFECT SAVING AND INVESTMENT

1. Policy 1: Saving Incentives:

THREE STEP ANALYSIS: 1) Which curve will be affected from change in policy?(Savers-Supply)2) In which direction will the curve shift? To the right because saving will increase. 3) Compare new and old equilibria?

1. This will cause an increase in saving, shifting the supply of loanable funds to the right.
2. The equilibrium interest rate will fall and the equilibrium quantity of funds will rise.
3. Thus, the result of saving incentives would be a decrease in the equilibrium interest rate and greater saving and investment.

1. Policy 2: Investment Incentives

THREE STEP ANALYSIS: 1) Which curve will be affected from change in policy?(Investors-Demand)2) In which direction will the curve shift? To the right because investment will increase. 3) Compare new and old equilibria?

1. This will cause an increase in investment, causing the demand for loanable funds to shift to the right.
2. The equilibrium interest rate will rise, and the equilibrium quantity of funds will increase as well.
3. Thus, the result of investment incentives would be an increase in the equilibrium interest rate and greater saving and investment.

1. Policy 3: Government Budget Deficits:

THREE STEP ANALYSIS: 1) Which curve will be affected from change in policy?(Supply-Saving)2) In which direction will the curve shift? To the left because saving will decrease. 3) Compare new and old equilibria?

1. The supply of loanable funds will shift to the left.
2. The equilibrium interest rate will rise, and the equilibrium quantity of funds will decrease.
3. When the interest rate rises, the quantity of funds demanded for investment purposes falls.
4. Definition of crowding out: a decrease in investment that results from government borrowing.

Chapter 14- Basic Tools of Finance

KEY TERMS

• Finance—The field that studies how people make decisions regarding the allocation of resources over time and the handling of risk
• Presentvalue—The amount of money today that would be needed to produce, using prevailing interest rates, a given future amount of money
• Futurevalue—The amount of money in the future that an amount of money today will yield, given prevailing interest rates
• Compounding—The accumulation of a sum of money in an account where interest is earned on previously paid interest
• Riskaverse—Exhibiting a dislike of uncertainty
• Diversification—The reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risks
• Firm-specificrisk—Risk that affects only a single company
• Marketrisk—Risk that affects all companies in the stock market
• Fundamentalanalysis—The study of a company’s accounting statements and future prospects to determine its value
• Efficient markets hypothesis—The theory according to which asset prices reflect all publicly available information about the value of an asset
• Informationally efficient—Reflecting all available information in a rational way
• Randomwalk—The path of a variable whose changes are impossible to predict

Context and Purpose

The purpose of Chapter 14 is to introduce you to some tools that people use when they participate in financial markets. We will learn how people compare different sums of money at different points in time, how they manage risk, and how these concepts combine to help determine the value of a financial asset, such as a share of stock. Chapter Review

Introduction Financial markets coordinate saving and investment. Financial decisions involve two elements—time and risk. For example, people and firms must make decisions today about saving and investment based on expectations of future earnings, but future returns are uncertain. The field of finance studies how people make decisions regarding the allocation of resources over time and the handling of risk. We will learn how people compare different sums of money at different points in time, how they manage risk, and how these concepts combine to help determine the value of a financial asset, such as a share of stock.

Present Value: Measuring the Time Value of Money

The present value of any future value is the amount today that would be needed, at current interest rates, to produce that future sum. The future value is the amount of money in the future that an amount of money today will yield, given prevailing interest rates. Suppose r = the interest rate expressed in decimal form, n = years to maturity, PV = present value, and FV = future value. Furthermore, suppose that interest is paid annually and that the interest is put in the account to earn more interest—a process called compounding. Then:

(1)PV(1 + r)n = FV,and

(2)FV/(1 + r)n =PV.

For example, suppose a person deposited $100 into a bank account for three years earning 7 percent interest. Using equation (1) where r = 0.07, PV = $100, and n = 3, we find that in three years the account will hold about $122.50. That is, the future value is $122.50.

Alternatively, suppose you were offered a bank deposit that would provide you with $122.50 three years from now. At an interest rate of 7 percent, what would you pay for that account today? Using equation (2) where r = 0.07, FV = $122.50, and n = 3, we find that the present value of $122.50 three years from today is $100. Finding the present value of a future sum is called discounting. The relationship between present value and future value demonstrates the following:

• Receivingagivensuminthepresentispreferredtoreceivingthesamesuminthe future. The larger the interest rate,the more pronounced is this result.
• Inordertochoosebetweentwosums—avaluetodayoralargervalueatsomelater date—find the present value of the larger future sum and compare it to the value today.
• Firmsundertakeinvestmentprojectsifthepresentvalueofthefuturereturnsexceeds the cost. The larger the interest rate, the less likely the project will be undertaken becausethepresentvalueoftheprojectbecomessmaller. Thus,investmentdeclinesas interestratesrise.

Small differences in growth rates can make enormous differences in a country’s level of income after many years. This result is also true for an individual’s income or for money deposited in a bank. The concept of compound growth shows why. Each year’s growth is based on the previous year’s accumulated growth, or in the case of interest, interest is earned on previously earned interest. The effects of compound growth are demonstrated bytheruleof70,whichstatesthatifsomevariablegrowsatarateofxpercentperyear,its valuewilldoubleinapproximately70/xyears.Ifyourincomegrowsat1percentper year, itwillaboutdoublein70years.However,ifyourincomegrowsat4percent,itwilldouble inapproximately17.5years.

Managing Risk

Most people are risk averse, which means that they dislike bad things more than they like comparable good things. Peoplecanreduceriskbybuyinginsurance,diversifying theirrisk,andacceptinga lower returnontheirassets.

• Peoplecanreducetherisktheyfacebybuyinginsurance.Insuranceallowstheeconomyto spread the risk more efficiently because it is easier for 100 people to bear 1/100 of the group’s risk of a house fire than for each to bear the entire risk of one house fire alone. Therearetwoproblemswithinsurancemarkets.Adverseselectionoccursbecause ahigh-riskpersonismorelikelytobuyinsurancethanalow-riskperson.Moralhazardoccursbecauseafterpeoplebuyinsurance,theyhavelessincentivetobecareful.Some low-risk people don’t buy insurance because these problems may cause the price of insurance to be too high for low-risk people. Health insurance is poorly designed becauseitcoversroutineexpenses,smallrandomexpenses,andisconnectedwithemployment. Thesethreefeaturesresultfromthetax-exemptstatusofemployer-provided healthinsurance,whichleadstoexcessivespendingonhealthcare.
• People can reduce the risk they face through diversification. Diversification is the reductionof riskachievedbyreplacingasingleriskwithalargenumberofsmallerunrelatedrisks. This is summarized by the phrase, “Don’t put all of your eggs in one basket.” Risk isdiversifiedthroughinsurancebecauseitiseasierfor100peopletobear1/100of the group’s risk of a house fire than for each to bear the entire risk of one house fire alone. Theriskonaportfolioofstocks,asmeasuredbythestandarddeviation(volatility) ofthereturns,isreducedbydiversifyingtheportfolio—buyingasmallamountof alargenumberofstocksinsteadofalargeamountofonestock.Diversificationcan eliminatefirm-specificrisk—theuncertaintyassociatedwithspecificcompanies.It cannot eliminate market risk—the uncertainty associated with the entire economy, whichaffectsallcompaniestradedonthestockmarket.
• Peoplecanreducetherisktheyfacebyacceptingalowerrateofreturnontheirinvestments. People face a trade-off between risk and return in their portfolio. In order to earn greater returns, people must accept more risk. In order to have less risk, people must accept lower returns. The optimal combination of risk and return for a person depends on the person’s degree of risk aversion, which depends on the person’s preferences.

Asset Valuation

The price of a share of stock is determined by supply and demand. People often try to buy stock that is undervalued—shares of a business whose value exceeds its price. If the price exceeds the value, the stock is considered overvaluedand if the price and value are equal, the stock is fairly valued. The price of the stock is known. The value of a stock is uncertain because it is the present value of the future stream of dividends and the final sales price.

Fundamental analysisisadetailedanalysisofacompany’saccountingstatementsandfutureprospects todetermineitsvalue. Youcanperformfundamentalanalysisyourself,relyonWallStreet analysts,orbuyamutualfundwhosemanagerdoesfundamentalanalysis.

Accordingtotheefficientmarketshypothesis,assetpricesreflectallpubliclyavailable information about the value of an asset. This theory argues that professional money managersmonitornewstodetermineastock’svalue. Thestock’spriceissetbysupplyand demand, so at any point in time, shares sold equal shares bought, implying that an equal number believe that the stock is overvalued as think it is undervalued. Thus, the average analyst thinks it is fairly valued all the time. According to this theory, the stock market is informationallyefficient,whichmeansthatpricesinthestockmarketreflectallavailable informationinarationalway.Ifthisistrue,stockpricesshouldfollowarandomwalk, thepathofwhichisimpossibletopredictfromavailableinformationbecauseallavailable informationhasalreadybeenincorporatedintotheprice.Asaresult,nostockisabetter buythananyotheris,andthebestyoucandoistobuyadiversifiedportfolio.

Index funds provide evidence in support of the efficient markets hypothesis. Index funds are mutual funds that buy all of the stocks in a particular stock index. Actively managedfundsuseresearchtotrytobuyonlythebeststocks.Activelymanagedfundsfail tooutperformindexfundsbecausetheytrademorefrequently,incurringtradingcosts,plus theychargefeesfortheirallegedexpertise.

Some people suggest that markets are irrational. That is, stock prices often move in waysthatarehardtoexplainonthebasisofrationalanalysisofnewsandsoappeartobe driven by psychological trends. However, if this were true, traders should be able to take advantage of this fact and buy better than average stocks, but beating the market is nearly impossible.Sincethevalueofastockdependsonitsdividendsandfinalsalesprice,itmay notbeirrationaltopurchaseastockatapricethatappearstoexceeditsfundamentalvalue (speculativebubble)ifothersarewillingtopayevenmoreforitatalaterdate.

Conclusion

Theconceptofpresentvalueshowsusthatadollartodayisworthmorethanadollarata laterdate,anditallowsustocomparesumsatdifferentpointsintime.Riskmanagement shows us ways that risk-averse people can reduce their risk exposure. Asset valuation reflectsafirm’sfutureprofitability. Thereiscontroversyregardingwhetherstockpricesare arationalestimateofacompany’struevalue.

Helpful Hints

1. Compound growth is the same as compound interest. Compound interest is when you earn interest on your previously earned interest. Assuming annual compounding, when you deposit $100 in a bank at 10 percent, you receive $110 at the end of the year. If you leave it in for two years, you receive compound interest in that youreceive $121attheendoftwoyears—the$100principal,$10interestfromthefirst year,$10 interestfromthesecondyear,plus$1interestonthefirstyear’s$10interestpayment.Next year,interest would be earned not on $100,or $110,but on $121,and so on. In like manner, after a number of years, a faster growing economy is applying its percentage growth rate to a much larger base (size of economy), and total output acceleratesawayfromeconomiesthataregrowingmoreslowly.Forexample,applying the rule of 70, an economy that is growing at 1 percent should double in size after about70years(70/1).Aneconomygrowingat4percentshoulddoubleinsizeevery 17 1/2 years (70/4). After 70 years, the 4 percent growth economy is 16 times its original size (24) while the 1 percent growth economy is only twice its original size. If both economies started at the same size, the 4 percent growth economy is now eight times the size of the 1 percent growth economy thanks to compoundgrowth.
2. Risk-aversepeoplebenefitfrominsurancebecause,duetotheirdiminishingmarginal utility of wealth, the reduction in utility from a single big expense exceeds the reduction in utility from a number of small payments into the insurance fund. For example, suppose there are 50 people in town. One house burns down each year so each person has a 1 in 50 chance of losing his entire home in any given year. People can pay 1/50 of the value of their home into the insurance fund each year,and thus, they will have paid premiums equal to the value of their home after 50 years. Alternatively, they can fail to buy insurance but they will replace their home once every 50 years due to fire. Although the expected values of these two expenses are thesame,risk-aversepeoplechoosetobuyinsurancebecausethereductioninutility from paying once for one entire home exceeds the reduction in utility from paying 50 times for 1/50 of a home.
3. The volatility of the return of a stock portfolio decreases as the number of stocks in theportfolioincreases. Whenaportfolioiscomprisedofjustonestock,thevolatility of the portfolio is the same as the volatility of the single stock. When a portfolio is comprised of two stocks, it could be that when one stock is paying a return that is lessthanitsaverage,theothermaybepayingmorethanitsaverage,andthetwotend to cancel out. As a result, the portfolio has less volatility than each of the stocks in theportfolio. Thiseffectcontinuesasthenumberofstocksintheportfolioincreases. However, the majority of the risk reduction occurs by the time there are 20 or 30 stocks in the portfolio. Note that in order to achieve the projected risk reduction from diversification, the risks on the stocks must be unrelated. Therefore, randomly choosing stocks should generate more risk reduction than choosing stocks of firms that are, for example, all in the same industry or all located in the same geographic area.
4. The price of a stock depends on supply and demand. The demand for a stockdepends onthepresentvalueofthestreamofdividendpaymentsandthefinalsalesprice. Therefore,anincreaseineithertheexpecteddividendsorthefinalsalesprice,or adecreaseintheprevailinginterestrate,willincreasethedemandforastockand increaseitsprice. Thedemandforastockalsodependsonriskfactorsassociatedwith thestock.Becausepeopleareriskaverse,anincreaseinaggregateriskwillreducethe demandforallstocksandallstockpricesshoulddecrease.Oddly,anincreaseinfirm- specificrisk(theportionofthestandarddeviationinthereturnsonaparticularstock that are associated with the specific company) should not affect the demand for the stockbecausethistypeofriskcanbeeliminatedthroughdiversification.