2nd Half Flashcards
Ch.13 - Ch.16
Consumption
Household spending on final goods and services.
- Single largest component of GDP.
Consumption Function
A curve plotting the level of consumption associated with each level of income.
-Visual summary of household spending.
-Upward sloping
Marginal Propensity to Consume
Fraction of each extra dollar of income that households spend on consumption.
Describes how consumption responds to a change in income
Saving and Dissaving
Saving:
-Putting unspent income in bank or investing
-Paying debt
Dissaving
-Your loans
Consumption Smoothing
Maintaining a steady or smooth path for your consumption spending over time.
Permanent Income / Hypothesis
Your best estimate of your long-term average income.
Hypothesis: the idea that consumption is driven by permanent income rather than current.
-Economic fluctuations matter only to a the extent that affect a permanent income.
5 Insights of Relationship Between Consumption and Income
- Temporary change = small change in consumption.
- Permanent change = large change in consumption.
- Anticipated change = no change in consumption.
- Learning about a future income change = change in consumption.
- It’s hard to forecast changes in consumption.
Credit Constraints
Limits on how much you can borrow.
-Banks are often reluctant to lend money when a loan isn’t backed by collateral.
Hand-to-Mouth Consumers
Spend their income as they receive it.
-MPC is 1
-Do not smooth consumption
-Their consumption reflects their current income not permanent.
5 Hybrid Insights about Relationship Between Consumption and Income
- Small for smoothers, large for hand-to-mouth
- Large change from both
- No change for smoothers and large change for hand-to-mouth
- Large for smoothers but no change to hand-to-mouth
- Depends on the share of hand-to-mouth consumers.
4 Factors that Shift Consumption Curve
- Real Interest Rates
- Expectation
- Taxes
- Wealth (but not a change in income)
Substitution and Income Effect
Substitution: high interest rate reduces current consumption.
Income: high interest:
- rate boosts income for lenders -> higher consumption.
- decreases income for borrowers –> reduce consumption
Types of Investment
- Business Investment
- Inventories
- Housing Investment
Compounding
Accumulation of money over time, as you earn interest (or return) on both principal and accrued interest (or return).
Discounting
Converting future values into their equivalent present values using a discount rate.
-Should reflect on: opportunity cost (time), inflation, risk (uncertainty).
Discount Rate (r)
The interest rate you use in discounting should be the rate of return you could get from investing your funds in your next best alternative at an equivalent level or risk.
Perpetuity and Annuity
Perpetuity: a stream of equal and equally spaced out payments occurring indefinity.
Annuity: steam of equal and equally spaced out payments occurring for a period of time.
User Cost of Capital and Depreciation Rate
Extra cost associated with using one more machine next year. “Rental Cost”
Depreciation Rate (d): proportion of an investment’s remaining productive capacity you lose each year due to depreciation.
4 Investment Shifters
- Technological Advances
- Expectations
- Corporate Taxes
- Lending Standards and Cash Reserves
Market for Loanable Funds
Market for the funds used to buy, ren, or build capital.
-It brings together savers who want to lend their funds and investors who want to borrow those funds.
Supply Shifters of Loanable Funds
- Changes in Personal Saving Rates
- Government Saving Shifts Due to Changing Budget Surpluses and Deficits
- Foreign Saving Shifts Due to Global Shocks
The Financial Sector
Any firm that manages with transactions, capital flow, and risk.
-Why is it important?
3 Key Pillars of Financial Sector
- Banks
- The Bond Market
- The Stock Market
What Banks Do
- Pool savings from many savers
- Spread the risk of lending money across many borrowers
- Solve information problems
- Provide payment services.
- Create long-term loans from short-term deposits
Bank Run
When many bank customers try withdrawing savings at the same time but bank doesn’t have enough on hand.
Deposit Insurances
Makes bank runs much less likely.
It is a guarantee that you will not be losing the money you deposit in the bank.
- Breaks the interdependence that leads to self-fulfilling panics
-Does not cover stocks, mutual funds, bonds, etc.
Shadow Banks
Non-bank financial institutions that provide lending, investment, and financial services but without the same regulations.
What Bond Market Does
- Channel funds from savers to borrowers
- Funds government debt
- Spreads risk
- Creates liquidity
Bond Risks
- Default Risk
- Term Risk
- Liquidity Risk
What Stocks Do
- Channel Funds from Savers to Investors
- Spread Risk
- Reallocate Control
How to Asses a Business’s Fundamental Value
- Forecast future profits
- Discount these profits to the present
- Add up the sum of those discounted future profits
- Divide the company’s fundamental value by the total number of shares
Big Caveat Investment Strategy
Buy stock when price is lower than fundamental value.
1. Sell for a profit
2. Or keep it and enjoy a stream of dividends that’s more valuable than price you paid.
The Efficient Market Hypothesis
The theory that at any point in time, stock prices reflect all publicly available information.
Mutual Funds
A fund that buys a portfolio of stocks (and sometimes bonds) on your behalf.
-Actively Managed
-Index Funds: buys every stock that is in the S&P 500 automatically
A mutual fund pools your money with other investors to buy a diversified portfolio of
stocks or bonds.
Financial Bubbles (Speculative Bubbles)
When the price of an asset above what appears to be its fundamental value.
Greater Fool Theory
The idea that people buy an investment because they expect other people to buy it from them at a higher price.
Six Financial Lessons (Personal Finance)
- Harness the power of compound interest.
- You need to be more than an expert to pick individual stocks.
- Diversify your portfolio to reduce risk.
- Past performance is no guarantee of future performance
- Minimize Fees( low expense ratios)
- Follow all five rules with low-cost index funds.
International Trade
Occurs when people buy or sell goods and services across national borders.
- Financial Inflows: investments by foreigners in Canada
- Financial Outflows: investments by Canadians in foreign countries.
Forms of Financial Investment Flows
- Foreign direct investment (investment in physical assets)
- Portfolio investment
- Deposits and loans
Reasons why Financial Flows Rose Sharply
- Removal of capital controls and deregulation of the financial sector both Canada and abroad
- Capital controls were rules designed to limit the flow of money across boarders- Large institutional investors (pension funds and mutual funds) have become more important, sophisticated over time.
- Seeking to diversify their portfolios
- Technology has made investors more comfortable sending their money overseas
Characteristics of globalization has also increased comfort levels for investors
- Large institutional investors (pension funds and mutual funds) have become more important, sophisticated over time.
Nominal Exchange Rate
The price of a country’s currency in terms of another country’s currency.
-Appreciation
-Depreciation
Savings Motives
- Changing income over the life cycle
- Changing needs over the life cycle
- Bequests
- Precautionary saving
