Financial Markets, GDP, and Unemployment: Key Concepts

Financial Markets: Core Functions and Definitions

• Markets that channel funds from those who have an excess of available funds to those with a shortage.
• They promote economic efficiency.
• They channel funds from those without a productive use to those with a productive use but who have a shortage of money.

The Necessity of Financial Markets

Financial markets address critical economic issues, including:

• Matching: Connecting borrowers and lenders efficiently.
• Transaction Costs: Reducing the time, energy, and money required to facilitate transactions.
• Asymmetric Information: Addressing information failure that occurs when one party has significantly more knowledge than the other party.
  • Adverse Selection: A problem of asymmetric information that occurs before the loan takes place. Individuals with the least collateral and highest risk often seek to borrow first.
  • Moral Hazard: A problem of asymmetric information that occurs after the loan takes place. It involves a change in behavior where the borrower acts poorly or takes excessive risks with the loaned funds (e.g., AIG and the collapse of the housing market).

Examples of Major Financial Markets

Stocks

• Represents ownership of the corporation.
• Allows corporations to raise money to invest (referring to physical capital investment, not necessarily the stocks or bonds themselves).
• The most widely followed financial market, and is extremely volatile.
• Also affects consumer sentiment and economic confidence.

Bonds

• A debt security promising to make periodic payments for a specified amount of time.
• The bond market allows governments and corporations to raise money.
• This is the market where interest rates are determined.

Understanding Bond Transactions

Why Buy Bonds?

Investors buy bonds because they have excess available funds and no immediate productive use for them. Buying a bond means lending money.

Who Issues Bonds?

Bonds are issued by the government (federal and local) and corporations.

Why Issue Bonds?

Issuers raise money to spend on capital and investment. Issuing a bond means borrowing money.

Key Macroeconomic Indicators

Gross Domestic Product (GDP)

The market value of all final goods and services produced within the borders of a country during a year.

Circular Flow of Income and Expenditures

This model illustrates the flow between corporations and households:

• Goods & Services: Flow from corporations to households.
• Consumer Expenditures: Flow from households to corporations.
• Wages, Rent, Dividends: Flow from corporations to households (as income).
• Factors of Production: Flow from households to corporations.

Fundamental Identity: Income equals Output.

Aggregate Output and Income

Aggregate Output is the total production of goods and services.

Aggregate Income is the total income earned producing all of the goods and services.

Identity: Aggregate Income = Aggregate Output.

Labor Force and Unemployment

The Labor Force

The Labor Force (LF) is the sum of the Employed (E) and the Unemployed (U): LF = E + U.

The Unemployment Rate

Calculated as: (The number of unemployed / Labor Force) x 100.

Types of Unemployment

There are three primary types of unemployment:

1. Frictional Unemployment:
   • Caused by normal job turnover.
   • Generally considered beneficial for the economy.
2. Structural Unemployment:
   • Occurs when the skills people possess are mismatched with the skills employers need.
   • Usually requires new skill training or education to resolve.
3. Cyclical Unemployment:
   • Caused by a contraction in the Business Cycle (recession).
   • Exists because there are simply not enough jobs available for the labor force.
   • This is typically considered the most detrimental type of unemployment.