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.