Midterm 2 ECON 102

What is investment?

Purchases of new capital, which increase the economy’s productive capacity

What is capital?

Equipment, structures, and intellectual property —> produce output

What is capital stock

the total quantity of capital at a point in time

What is depreciation

The decline in capital due to wear and tear, obsolescence, accidental damage, and aging 

What are the 3 types of investment

Business, housing, and inventories

What is business investment

the money that businesses spend on new capital assets

What is housing investment

the money spent on building or improving houses or apartments

What is compounding

the accumulation of money over time, as you earn interest on both your principal and interest

what is the formula for future value in one year

Present Value(1 + r)

what is the future value in t years 

Present Value(1 + r)^t

What is future value

the amount that our money will grow into by a specific future date, as a result of accumulating interest

What is discounting

converting future values into their equivalent present values

What is the formula for present value

Present Value = Future value in t years / (1 + r)^t

What is Rational Rule for Investors

pursue an investment opportunity if the present value of future profits exceeds the up from cost, C

Next years profits / r + d > C

What is the formula for user cost of capital

d c + r c

What is user cost of capital

The extra cost associate with using one more machine next year

What are some investment shifters

1) Technological advances

2) Expectations 

3) Corporate taxes

• tax breaks —> increase in investment 

4) Lending standards and cash reserves 

What is the market for loanable funds

the market for funds used to buy, rent, or build capital

• savers are the suppliers and buyers are the demanders 

What is neutral real interest rate

The real interest rate at which real GDP is equal to potential GDP

What is real interest rate

interest rate that is accounted for with inflation

What are some supply shifters

1) Changes in personal savings by privates savers

2) Government saving shifts due to changing budget surpluses and deficits

3) Foreign saving shifts due to global shocks 

What is crowding out

the decline in private investment due to a larger budget deficit

What is foreign saving

the funding that comes from foreigners lending money to Americans

How do banks make money

By charging higher interest rates than they pay

What are some functions of banks

1) Banks pool savings from many savers

2) banks spread the risk of lending money across many borrowers 

3) banks solve information problems 

4) banks provide payment services 

5) banks create long-term loans from short-term deposits 

What is maturity transformation

using short-term loans to make long-term loans

What is a bank run

when many customers try to withdraw their savings at the same time

What is deposit insurance

A guarantee that you won’t lose the money yo deposit in the bank

What are shadow banks

financial firms that act like banks but do not have to follow bank rules because they are not a bank 

What is a bond

a promise to pay back a loan with interest (IOU)

What does the bond market do

1) The bond market channels funds form savers to borrowers

2) funds government debt

3) spreads risk

4) creates liquidity 

What is liquidity

the ability to quickly and easily convert your bonds into cash, with little or no loss in value

What are some risks with bonds

Default, term, and liquidity risk

What is default risk

the risk of not getting paid

what are credit ratings

credit scores for businesses and governments (AAA is the highest)

What is term risk

arises when there’s uncertainty about future interest rates

What is liquidity risk 

arises when your bond will be hard to sell 

What is a stock

partial ownership in a firm

What is a dividend

a share of profits that a company pays to its shareholders

What is retained earnings

the profits that a company chooses not to give as dividends to shareholders

What are 3 key functions of stocks 

1) Stocks channel funds from savers to investors 

2) Stocks spread risk 

3) Stocks reallocate control 

What is a speculative bubble 

When the price of an asset rises above what appears to be its fundamental value (shows up in stocks) 

What is initial public offering (IPO)

when a company first sells stock directly to the public 

What does the supply curve represent in financial prices

Describes how many shares of stock investors will sell at each price 

What does the demand curve represent in financial prices

Describes how many shares of stock investors will buy at each price

What are two approached used to value financial assets

1) Fundamental value 

2) Relative valuation 

What is fundamental value

the present value of the future profits that a company will earn

the goal is to assess an asset’s fundamental value 

What is relative valuation

an assessment of the value of an asset by comparing it to similar assets

What is price to book ratio and what is the formula

measures a firm’s stock price relative to the book value per share

Price to book ratio = price per share / book value per share

what is book value per share

a measure of the business’s net assets per share

What is price to earning ratio and what is the formula

measures a firm stock price, relative to last year’s profits, measured as earning per share

price to earning ratio = price per share / earning per share 

what is the efficient market hypothesis

the theory that, at any point, stock prices reflect all public available information

what is random walk

when a price follows an unpredictable path

what is a mutual fund 

a fund that buys a portfolio of stocks 

what is actively managed in a mutual fund

when a fund is managed by stock pickers 

what is index fund in a mutual fund

a mutual fund that consists of a broad market index

what is the greater fool theory

the idea that people buy an investment because they expect other people to buy it from them at a higher price 

what is a business cycle

short-term fluctuations in economic activity

what is potential output

the level of output that occurs when all resources are fully employed

what is output gap and what is the formula

the difference between actual and potential output, measured as a percentage of potential output

output gap = actual output - potential output / potential output * 100 

what is persistence 

economic conditions today are closely related to those in the near future 

what is comovement

the tendency for economic variables to rise and fall together

What is a leading indicator

variables that tend to predict the future path of the economy (business confidence, consumer confidence, and the stock market)

What is a lagging indicator

variables that follow the business cycle with a delay (unemployment)

what is okun’s rule of thumb

for every percentage point that the output gap rises, the unemployment rate tends to fall by half a percentage point

what is seasonally adjusted

data stripped of predictable seasonal patterns

what is annualized rate 

data converted to the rate hat toweled occur if the current rate had continued throughout the year 

what are revisions

updates to earlier estimates

what is aggregate expenditure

the total amount of goods and services that people want to buy across the whole economy 

what is the macroeconomic equilibrium

occurs when the quantity of output that buyers collectively want to purchase is equally to the quantity of output that suppliers collectively produce 

what is the IS curve

illustrates how total spending and output depend on real interest rate (changes in the real interest rate causes a movement along the IS curve)

what is the formula for interest rate

Interest rate = Risk-free interest rate + risk premium

what is monetary policy

the process of setting interest rates in an effort to influence economic conditions

what is federal funds rate

the interest rate on a set of overnight loans that are almost certain to be repaid the next day 

what is risk premium

the extra interest that lenders charge to account for the risk of loaning money

What is the MP curve

illustrates the current real interest rate

(if r increases, then the MP curve shifts up)

(if r decreases, then the MP curve shifts down) 

what is fiscal policy

the government’s use of spending and tax policies to influence economic outcomes (shifts IS curve) (causes AE to change) 

what is multiplier

a measure of how much GDP changes as a result of both the direct and indirect effects flowing from each extra dollar

what are financial shocks

any change in borrowing conditions that change the real interest rate ® at which people can borrow (shifts the MP curve)

What classifies as the labor force 

the employed plus the unemployed 

what classifies as those not in the labor force 

this in the working-age population who are neither employed nor unemployed 

what is the formula for labor force participation rate 

(Employed + Unemployed / working-age population) * 100

What is the unemployment rate formula

Unemployed / Labor force * 100

what is marginally attached

someone who wants a job and who has looked for a job within the past year

what is underemployed

someone who has some work but wants more hours, or whose job isn’t adequately using their skills 

what is involuntarily part time

someone who wants full-time work and is working part time

what is frictional unemployment

unemployment due to the time it takes for employers to search for workers and for workers to search

what is structural unemployment

unemployment that occurs because wages don’t fall to bring labor demand and supply into equilibrium 

what is cyclical unemployment 

unemployment that is due to a temporary downturn in the economy 

What is total output and what is the formula

Sum of value added = Total sales - cost of intermediate inputs 

what is hysteresis

when a period of high unemployment leads to a higher equilibrium unemployment rate

what is inflation rate and the formula

annual percentage increase in the average price level 

Inflation rate: Price level this year - Price level last year / price level last year * 100

what is gdp deflator and the formula 

a price index that tracks the prices of inputs into the production process 

GDP deflator: Nominal GDP / Real GDP * 100

what is real interest rate and the formula 

the interest rate in terms of changes in your purchasing power 

real interest rate = Nominal interest rate - inflation rate 

what is labor input

number of workers to transform raw materials into products and services that people want to buy

what is human capital

the accumulated knowledge and skills that make a worker more productive

what is physical capital

the total amount of tools, machinery, and structures that can be used in the production of goods and services 

what is a production function

The methods for transforming labor input, human capital, and physical capital into goods and services

What is constant returns to scale 

doubling all inputs (labor input, human capital, and physical capital) leads to a doubling of all outputs

what is diminishing returns

when one input (labor, human, or physical) is held constant, increase in the other inputs will, at some point, begin to yield smaller and smaller increase in output