Chapter 27: The Basic Tools of Finance

Chapter 27 studies the basic tools of finance, defined as the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk. The time value of money has two values: present and future value. Present value is the amount of money needed to produce another amount of money in the future. Future value is the amount of money that an amount of money today would yield, if interest rates remain constant. This can be calculated through compounding, which is the accumulation of a sum in money where the interest earned remains in the account to accumulate more interest.

Risks are other tools of finance, which explains insurance, diversification, and the risk-return trade-off, especially when risk aversion is involved, which is a dislike of uncertainty. Insurance is based off of risk, when people decide whether or not to take the risk of paying for insurance when it is possible nothing would happen, but the insurance market spreads risks. However, adverse selection and moral hazard prevent the risk from being properly spread because people would behave more carelessly and would not consider insurance if they are low risk.

Diversification is the reduction of risk by replacing a single risk with a large number of unrelated risks. An example is a stock portfolio, where savers would spend money on multiple unrelated stocks rather than a single stock. Diversification eliminated firm-specific risk which is a risk that affects only a single company, but cannot avoid market risk, which is a risk that affects all companies.

Asset valuation is the last basic tool of finance, a big part of it being fundamental analysis. People would study a company’s accounting statements and future prospects to determine its value, and if the price is less than the value, the stock is undervalued, where as if the price is more than the value, the stock is overvalued.

The efficient markets hypothesis is the theory that asset prices reflect all publicly available information about the value of an asset. Information efficiency is the description of asset prices that rationally reflect all available information, and random walks are the paths of a variable whose changes cannot be predicted.

Chapter 26: Saving, Investment, and the Financial System

The financial system is defined as the group of institutions in the economy that help to match one person’s saving with another’s investment. They move money from savers to borrowers.

Financial markets are financial institutions where savers can directly provide funds to borrowers. The first market is the bond market, where borrowers state the time they would repay the savers, which is called the date of maturity. Bonds have three main characteristics: the term (the length of time until the bond matures), the credit risk (the probability that the borrower will fail to pay back the money, junk bonds are offered by sharky corporations, but have high interest rates), and the tax treatment (the way the tax laws treat the interest earned on the bond, such as how municipal bonds issued by governments do not require the borrowers to pay federal income tax). Sale of bonds are called debt finance.

Another financial market is the stock market, where people would buy claims to partial ownership of a firm. Sale of stocks is called equity finance. When companies sell bonds to buyers, they are exchanged on the stock exchange, and people who buy them buy off of speculation, where they try to perceive the corporation’s future profitability.

Financial intermediaries are institutions where savers can indirectly provide funds to borrowers. These include banks and mutual funds. Banks, as well as being an intermediary, they create a medium of exchange, where people can easily engage in transaction. Mutual funds sell shares to the public and uses the money to buy a selection, or portfolio, or many stocks and/or bonds.

A closed economy is one that does not interact with other economie, whereas open economies interact with economies around the world. National saving (or just saving) is equal to income, or GDP-consumption-government expenses. Private saving is the income that households have left after paying for taxes and consumption, measured by GDP-transfer payments-consumption. Public saving is the tax revenue the government has left after paying for its spending, calculated by transfer payments-government expenses. Budget surpluses occur when transfer payments exceed government expenses, and budget deficits occur when it does not exceed government expenses.

Chapter 24: Measuring the Cost of Living

Chapter 24 is about measuring the costs of living. Each year the Bureau of Labor Statistics calculates the consumer price index through five steps: fixing the basket, finding the prices, computing the cost of the basket, choose a base year and compute the index (price of basket in current year/price of basket in base year x 100) and the computing the inflation rate (CPI in year 2 - CPI in year 1/CPI in year 1 x 100).

The Bureau also calculates the producer price index, which is a measure of the cost of a basket of goods and services bought by firms.

There are several problems in measuring the cost of living. The first problem is called substitution bias, meaning that consumers substitute towards goods that have become relatively less expensive. Another problem is the introduction of new goods. This means that when a new good is introduced, consumers have more variety from which to choose, and this in turn reduces the cost of maintaining the same level of economic well-being. The third problem would be unmeasured quality change, meaning that if the quality of a good deteriorates from one year to the next while its price  remains the same, the value of the dollar falls since people are getting a lesser good for the same amount of money.

Interest rates are also relative to CPI because we consider both the interest rates and changes in prices in computer how much a person earns in a savings account. The interest rate that measure the change in dollar amounts is called the nominal interest rate and the interest rate that has been corrected for inflation is called the real interest rate. The real interest rate is computed by subtracting the inflation rate from the nominal interest rate.

Chapter 23: Measuring a Nation's Income

Chapter 23 gives an introduction to macroeconomics, stating that some components of macroeconomics are GDP (gross domestic product), inflation, unemployment, retail sales, and the trade deficit. Macroeconomics is the study of the economy as a whole, and GDP is the best measure of a society’s economic well being.

GDP is extremely useful for measuring income and spending, since both are always equal. For each buyer, a seller receives the amount paid. It is the market value of all final goods and services produced within a country in a given period of time. This means that the market value of all final version of goods and services sold legally (and some illegally) in a certain time period contributes to the GDP of a country.

GDP is composed of four parts: consumption, investment, government purchases, and net exports. Consumption is the spending by households on goods and services, investment is spending on capital, inventories, and structures (including purchasing housing), government purchases are spending on goods and services by federal, local, and state governments, and net exports are the spending on domestically produced goods minus spending on foreign goods.

There are two kinds of GDPs: nominal and real. The nominal GDP is the production of goods and services valued at current prices. This means that the economist would multiply the price of a good for each year and the quantity produced for the same year to get the nominal GDP. The real GDP is the production of goods and services valued at constant prices, meaning that the economist would multiply a constant price with a varying quantity for the year to get the real GDP. These two values can be used to calculate the GDP deflator, which helps measure inflation. The GDP deflator is computed by dividing nominal GDP by the real GDP and multiplying the quotient by 100. An increase in the value represents the inflation rate between the years.