SV151, Principles of Economics K. Christ 30 January – 3 February 2012 Empirical regularity #1: Okun’s law – output and unemployment DURATE = 1.32 - .44DGDP 1983:4 to 1984:3 Empirical regularity #2: Phillips Curve – inflation and unemployment Mankiw’s Principle #10: Society faces a short-run trade-off between inflation and unemployment. 14.00 12.00 Phillips, A. W., “The Relationship Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom,” Economica 25 (November 1958). Inflation 10.00 Samuelson, Paul A., and Robert M. Solow, "Analytical Aspects of Anti-Inflation Policy." American Economic Review 50:2 (1960): 177-94. 8.00 6.00 1969 1968 4.00 1967 1966 2.00 1965 1963 1964 0.00 0.00 1.00 2.00 3.00 4.00 5.00 6.00 Unemployment 7.00 8.00 9.00 10.00 A Little Aggregate Income Accounting … Y = C + I + G + XFor a closed economy … Y–C–G=I National Savings S=I Investment Demand Adding in taxes … S =S(Y =Y –T –C – C) – G+ (T– G) S= SP + SG A Little Aggregate Income Accounting … Y=C+I+G+X Y–C–G=I+X For an open economy … If X > 0, Then S > I Net Foreign Investment S–I= X NFI = X F If X = 0, Then S = I If X < 0, Then S < I F The economy “exports” its excess savings to the rest of the world. The economy “imports” excess savings from the rest of the world. Private and Public Savings as a Percentage of Gross National Income 15% 10% 5% 0% -5% Total Private Public 2010-I 2005-I 2000-I 1995-I 1990-I 1985-I 1980-I 1975-I 1970-I 1965-I 1960-I -10% The Market for Loanable Funds Examining three types of policy: 1. Saving Incentives 2. Investment Incentives 3. Government Budget Deficits and Surpluses i S i* I S=I S, I (“loanable funds”) Present Value: The Time Value of Money To compare a sums from different times, we use the concept of present value. The present value of a future sum: the amount that would be needed today to yield that future sum at prevailing interest rates Related concept: The future value of a sum: the amount the sum will be worth at a given future date, when allowed to earn interest at the prevailing rate Present Value: The Time Value of Money Example 1: A Simple Deposit Deposit $100 in the bank at 5% interest. What is the future value (FV) of this amount? In one year … In two years … In three years … In N years … In general, FV = PV(1+ r) N and PV = FV/(1 + r) N Present Value: The Time Value of Money Example 2: An Investment Decision Present Value Formula: PV = FV/(1 + r) N Suppose r = 0.06. Should General Motors spend $100 million to build a factory that will yield $200 million in ten years? Suppose r = 0.09. Should General Motors spend $100 million to build a factory that will yield $200 million in ten years? Present Value: The Time Value of Money Example 3: Valuation of Financial Assets (Stocks) If you buy a share of stock in company X today, – you will be able to sell it in 3 years for $30. – you will receive a $1 dividend at the end of each of those 3 years. If the prevailing interest rate is 10%, what is the value of a share of company X’s stock today? Present Value: The Time Value of Money Example 4: Valuation of Financial Assets (Bonds) Suppose the current price of a Ford, Triple-A rated corporate bond (“par” value = $1,000), with a 6% “coupon rate” and maturity date of February 4, 2014 is $850. If your discount rate is 10%, is this bond underpriced or overpriced? Suppose the current price of a Ford, Triple-A rated corporate bond (“par” value = $1,000), with a 6% “coupon rate” and maturity date of February 4, 2014 is $850. If your discount rate is 12%, is this bond underpriced or overpriced? Measuring Risk S&P 500 – Level and Daily Percentage Change 0.1500 4,500 0.1000 4,000 0.0500 3,500 0.0000 Level 3,000 -0.0500 2,500 -0.1000 2,000 -0.1500 1,500 -0.2000 1,000 -0.2500 500 0 1960 1/1/1900 -0.3000 1965 1980 9/9/1913 1985 6/4/1903 1970 11/5/19061975 4/8/1910 1990 2/10/1917 1995 7/14/1920 2000 2005 12/16/1923 5/19/1927 10/20/1930 Daily Percentage Change 5,000 Risk Aversion For economically meaningful decisions, most people are risk averse – ceteris paribus, they prefer outcomes with less variability. Economists model risk aversion by assuming that our “utility” (or level of well-being) can be thought of as a function of wealth: Utility Wealth Reducing or Managing Risk Through Diversification Diversification reduces risk by replacing a single risk with a large number of smaller, unrelated risks. A diversified portfolio contains assets whose returns are not strongly related: – Some assets will realize high returns, others low returns. – The high and low returns average out, so the portfolio is likely to earn an intermediate return more consistently than any of the assets it contains. Reducing or Managing Risk Through Diversification Constructing Portfolios Diversification can reduce firm-specific risk, which affects only a single company. Diversification cannot reduce market risk, which affects all companies in the stock market. Reducing or Managing Risk Through Diversification Constructing Portfolios Standard dev of portfolio return 50 Increasing the number of stocks reduces firmspecific risk. 40 30 20 But market risk remains. 10 0 0 10 20 30 # of stocks in portfolio 40 The Tradeoff Between Risk and Return Efficient Market Hypothesis • Efficient Markets Hypothesis (EMH): The theory that each asset price reflects all publicly available information about the value of the asset 1. Stock market is informationally efficient: Each stock price reflects all available information about the value of the company. 2. Stock prices follow a random walk: A stock price only changes in response to new information (“news”) about the company’s value. News cannot be predicted, so stock price movements should be impossible to predict. 3. It is impossible to systematically beat the market. By the time the news reaches you, mutual fund managers will have already acted on it.