Macro Midterm 2

consumption

household spending on goods and services

consumption function

the positive relationship between consumption and income

marginal propensity to consume

the slope of the consumption function; extra consumption that arises from each additional dollar of income

saving

portion of income not spent in consumption (income-consumption)

dissaving

negative saving or borrowing (if consumption exceeds income)

consumption smoothing

the idea that you should maintain a steady path for consumption spending over time using saving and dissaving

permanent income

best estimate of a long-term average income

permanent income hypothesis

people spend based on a permanent income, not current income

hand to mouth consumers

consumers that spend all of their income, so change in consumption behavior is in response to a change in income (no dissaving)

determining aggregate consumption

how many consumption smoothers to hand-to-mouth consumers exist
how easy it is to access borrowing or saving instruments
how easy is it to anticipate changes in income

What causes a movement along the curve in the consumption function?

and increase in income, and thus an increase in consumption

What are the consumption shifters?

real interest rate, expectations, wealth, and taxes

real interest rate

nominal interest rate - inflation rate (purchasing power a saver earns for saving) (the cost of investing

substitution effect if the real interest rate increases

The benefit of saving increases, the opportunity cost of consuming increases, so saving should increase and consumption should decrease

income effect if the real interest rate increases

income earned on saving increases, so savers permanent income increases

What shifts the consumption function right?

increase real interest rate
pessimistic expectations
high taxes
decrease in wealth

What shifts the consumption function left?

low real interest rate
optimistic expectations
low taxes
high wealth

How do expectations shift the consumption function?

optimistic expectations shift left, and pessimistic expectations shift right

How does the real interest rate shift the consumption function

low real interest rates shift left, and high real interest rates shift right

How does wealth shift the consumption function?

high wealth shifts left, and low wealth shifts right

How do taxes shift the consumption function?

low taxes shift left, and high taxes shift right

compounding

process by which an assets earnings from interest are reinvested (interest earned on interest)

discounting

converting future values into their equivalent present value (FV / r^years) 

nominal interest rate

interest rate that includes inflation (dollars a saver earns or a borrower pays)

economic investment

purchase of new capital goods

What do economic investments exclude?

saving, buying stock, and buying gold

capital stock

total amount of goods in the economy at a given time

depreciation

capital goods that wear out, become obsolete, get damaged, or are rendered unusable due to age

capital growth

if investment excedes depreciation (total capital_{next year} = total capital_{this year} - depreciation_{this year} + investment_{this year})

What are the three main categories of investments?

business investment, inventories, and housing investment

business investment

spending by businesses on new capital goods

inventory investments

spending to maintain raw materials, works in progress, and unsold goods

housing investment

spending on building new homes or renovating existing ones

How do you calculate the present value of a stream of payments?

next year’s revenue / (depreciation rate + real interest rate)

rational rule for investors

Invest if the cost of investment is less than or equal to the present value

Investment drives the _________ ________.

business cycle (fluctuations in GDP)

Investment changes ______, but the total capital stock changes ______ over time.

quickly, slowly

Investments are long-term drivers of ________. 

prosperity

What is the cost of investing?

the real interest rate (a direct cost in borrowing, or an opportunity cost in reducing profits today in favor of investing)

What does the investment function look like?

firms demand for investing; a negative relationship between the real interest rate and the quantity of investments

What are the investment shifters?

expectations

taxes

lending standards

technology advancements

How do expectations shift the investment function?

optimistic expectations shift right, and pessimistic expectations shift left

How do taxes shift the investment function?

higher taxes (lower profits) shift left, lower taxes (higher profits) shift right

How do lending standards shift the investment function?

ease in getting loans (cost of borrowing is lower) shift right, and difficulty in getting loans (cost of borrowing is higher) shift left,

How do technology advancements shift the investment function?

increase productivity of capital (profits increase) shift right

market for loanable funds

the market for any funds that are used to buy, rent, or build capital (suppliers are households, and demanders are firms)

neutral real interest rate

the rate that supports the economy operating at its potential without sparking high inflation (the equilibrium in the market for loanable funds)

How does saving impact the market for loanable funds?

an increase in saving shifts the supply curve right, a decrease in saving shifts the supply curve left

How do taxes impact the market for loanable funds?

an increase in taxes (decreasing profits) shifts the demand curve left, a decrease in taxes (increasing profits) shifts the demand curve right

What are the three pillars of the financial sector?

banks, bond markets, stock markets

What are the primary functions of banks?

pools saving of many savers to make loans
spread risk of lending
solve informational problems
provide payment services

create long term loans from short term deposits

maturity transformation

using short term loans to make long term loans

bank run

when customers withdraw savings all at once because of a loss of faith that the bank will remain able to repay its depositors

bond

a loan structured as the borrower making a promise of future payment(s) in exchange for purchase of a bond by the lender for money now

face value

how much the bond pays at the end

present value of a bond formula

\frac{FaceValue}{\left(1+r\right)^{M}}

present value of a bond with coupons

\frac{coupon1}{\left(1+r\right)^1}+\frac{coupon2}{\left(1+r\right)^2}+\ldots+\frac{coupont}{\left(1+r\right)^{t}}

What are the primary functions of the bond market?

channels funds from savers to borrowers

fund government debt

spread risk 

create liquidity

default risk

the risk of not getting paid back

term risk

uncertainty of the future interest rate, there is an opportunity cost in not spending the money going towards the bond on something else

liquidity risk

you may not be able to sell whenever you want if there is an overflow of people wanting to sell

dividend

a share of the profits paid to shareholders

retained earnings

profit the company does not pay out

What are the primary functions of the stock market?

channel funds from savers to borrowers

spread risk

creates liquidity

efficient markets hypothesis

the theory that at any point in time the stock market price reflects all publicly available information about a company

the rule of 70

it takes 70/growth rate for something to double

production function

describes the way inputs are transformed into outputs (total production possible with a set of inputs)

factors of production

inputs of the economy: labor/ hours worked, human capital, and physical capital

human capital

the skills that workers bring to a job that make them more productive (measured through education)

The accumulation of capital

physical capital is a complement to labor

investment depends on the saving rate

there are diminishing returns to capital

institutions for growth of capital

property rights

government stability

efficient regulation

government policy encouraging innovation