Macro Economics Ch. 14: The Basic Tools of Finance

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 that would be needed, prevailingg interest rates, to produce a given future amount of money.
Future Value the amount of money in the future that an amount of money today will yield giving prevailing interest rates.
Compounding the accumulation of a sum of money in, say, a bank account, where the interest earned remains in the account to earn additional interest in the future.
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.
Firm-specific Risk risk that affects only a single company.
Market Risk risk that affects all companies in the stock market.
Fundamental Analysis the study of a compnay’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.
Informational Efficiency the description of asset prices that rationally reflect alll available information.
Random Walk the path of a variable whose changes are impossible to predict.
The interest rate is 7 percent. Use the concept of present value to compare $200 to be received in 10 years and $300 to be received in 20 years. X/(1+r)^N200/1.07^10 = $102300/1.07^20 = $78
Present Value Formula: If “r” is the interest rate, then an amount “X” to be received in “N” years has a present value of X/(1+r)^NEx: Interest rate is 5%, the present value of $200 to be paid in 10 years is $200/(1.05)x^10 or $123. This means that $123 deposited today in a bank account that earned 5% would produce $200 after 10 years.
What benefit do people get from the market for insurance? It spreads out the risks to be shared by multiple people and not just by you alone. It covers your risk of something happening to you by spreading it out.
What two problems impede the insurance market from working perfectly? One problem is adverse selection: a high risk person is more likely to apply for insurance than a low risk person because a high-risk person would benefit more from insurance protection. The second problem is moral hazard: after people buy insurance they have less incentive to be careful about their risky behavior because the insurance company will cover much more of the resulting losses.
What is diversification? Does a stockholder get a greater benefit from diversification going from 1 to 10 stocks or from 100 to 120 stocks? Diversification is the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks. The stock holder would benefit more from diversification going from 1 to 10 because it would reduce the risk a lot more than going from 100 to 120 becasue they’ve already started with a lower risk.
Comparing stocks and government bonds, which type of asset has more risk? Which pays higher average return? Stocks have more risk because their value depends of the future of their firm, and because of the higher risk, shareholders demand a higher return.
What factors should a stock analyst think about determining the value of a share of stock? The future probability of a firm.
Describe the efficient markets hypothesis and give a piece of evidence consistent with this hypothesis. It’s the theory that asset prices reflect all publicly available information of an asset. It says the changes in stock prices should follow a random walk, making them impossible to predict from available information, so choose your stocks randomly.
Explain the view of those economists who are skeptical of the efficent markets hypothesis. Efficient markets hypothesis assumes that people buying and selling stock rationally process the information they have about the stock’s underlying value. But stock prices sometimes deviate from reasonable expectations of their true value. When you evaluate a stock, you have to estimate not only the value of the business but also what other people think the business is worth in the future.
Future Value Formula: (1 + r)^N x (base price) r = 0.07 (1 + 0.07)^10 x $200 = $393.43(1 + 0.07)^20 x $300 = $1160.90
Intristic value means that an item would have value even if it were not used as money.
Federal Reserve System (Fed) Is the central of the U.S Money System.
Functions of Fed in the whole economy: Provides Fiat Currency and Controls money supply withe its monetary policy tools.
Functions of Fed in Banks: Supervises the activities of member banks, serves as depositing institution for banks (hence called Bankers Bank), Serves as a lender of last resort, and serves as cleaning house/agent for banks.
Functions of Fed for the Government: Serves as a fiscal agent for treasury and serves as a government bank.
List of Monetary Policy Tools: Open market operation, reserve required by law ratio, discount rate, and payment of interest on excess reserves on Banks.
Open market operation: Is the puchase/sell of U.S Govt. bonds in the financial market.
Flow chart for open market operation: “fed sells U.S Govt. bonds” —-> “Individuals + Institutions pay Fed through their banks” —–>”Reserves decreases(-)” —–> “Ms (Money supply) decreases(-)” “fed purchases U.S Govt. Bonds” —-> “fed pays Individuals + Institutions through their banks” —> “Reserves increases(+)” —> “Ms increases (+)”
Reserve required by law ratio: Is the minimum amount of reserves the banks must keep in order to comply with Fed regulation.
Flow chart of reverve required by law ration: If rRR decreases —> Ms increasesIf rRR increases —> Ms decreases
Reserve required by law ratio symbol: rRR
Discount rate (rD) Is the interest rate charged by Fed whenever it grants loans to banks.
Discount rate flow chart: If rD decreases —> Ms increasesIf rD increases —> Ms decreases
DD = lialbility RR = required reservesER = excess reserves DD = RR + ER
Formula for finding total money supply (Ms^t) Ms^t = 1 / rRR + rER (DD)
Problems with controlling money supply: The fed has no control over how much banks chose to lend or to hold in the form of excess reserves (ER).The fed has no control over how much households choose to deposit or to hold in the form of currency.
Inflation Is the rise in the overall price level
Price level symbol P
Causes of inflation Demand side causes –> increas

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