office hours: 8:00AM – 8:50AM tuesdays LUMS C85

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office hours: 8:00AM – 8:50AM tuesdays LUMS C85
ECON 102 Tutorial: Week 17 Ayesha Ali office hours: 8:00AM – 8:50AM tuesdays LUMS C85

Today’s Outline Week 17 Planet Money Podcast: #602
This podcast illustrates some of the functions that banks provide in the economy. What are some problems that businesses face if they do not have access to a bank? Week 17 worksheet – Capital Markets: We’ll do Q4, Q5, Q6, and Q7 in today’s tutorial. Please make sure you review all of problems on your own and ask if you have any questions. Last 10 minutes – handing back Test 2.

Question 1(a) Corey has a mountain bike worth €300, a credit card debt of €150, €200 in cash, a Paul McCartney autograph worth €400, €1,200 in a bank account and an electricity bill due for €250. Construct Corey’s balance sheet and calculate his net worth. ASSETS LIABILITIES Bike € Credit card debt €150 Cash Electric bill due Autograph TOTAL 400 Checking acct. balance 1200 TOTAL   Net worth: = Total Assets – Total Liabilities = Corey’s assets have value of €2100 and his liabilities are €400, so his net worth is: net worth = assets – liabilities net worth = € €400 net worth = €1700.

Question 1(b) Corey discovers that his Paul McCartney autograph is a worthless forgery. Explain how the event affects Corey’s assets, liabilities and wealth. Does this event correspond to saving on Corey’s part? From part (a) ASSETS: LIABILITIES: Bike € Credit card debt €150 Cash Electric bill due Autograph TOTAL 400 Checking acct. balance 1200 TOTAL The autograph is worth zero rather than €400. Assets decline to €1700, liabilities are unchanged, so net worth falls by €400 to €1300. This is an example of a capital loss. No saving (positive or negative) has occurred. From part (a) ASSETS: LIABILITIES: Bike € Credit card debt €150 Cash Electric bill due Autograph TOTAL 400 Checking acct. balance 1200 TOTAL

Question 1(c) Corey uses €150 from his wages to pay off his credit card balance. The remainder of his earnings is spent. Explain how the event affects Corey’s assets, liabilities and wealth. Does this event correspond to saving on Corey’s part? From part (a): ASSETS LIABILITIES Bike € Credit card debt €150 Cash Electric bill due Autograph TOTAL 400 Checking acct. balance 1200 TOTAL Liabilities are reduced by €150, assets are unchanged. So, net worth increases by €150 to €1850. Note that paying off a debt out of current income is a form of saving. From part (a) ASSETS: LIABILITIES: Bike € Credit card debt €150 Cash Electric bill due Autograph TOTAL 250 Checking acct. balance 1200 TOTAL

Question 1(d) Corey writes a €150 cheque on his bank account to pay off his credit card balance. Explain how the event affects Corey’s assets, liabilities and wealth. Does this event correspond to saving on Corey’s part? From part (a): ASSETS LIABILITIES Bike € Credit card debt €150 Cash Electric bill due Autograph TOTAL 400 Checking acct. balance 1200 TOTAL Assets decline by €150, as the checking account balance falls from €1200 to €1050. Liabilities also decline by €150, as the credit card debt falls to zero. Net worth (assets minus liabilities) is unchanged. No saving has been done in this case, rather an existing asset was set off against an existing liability. From part (a) ASSETS: LIABILITIES: Bike € Credit card debt €150 Cash Electric bill due Autograph TOTAL 250 Checking acct. balance 1200 Checking acct. balance 1050 TOTAL

Question 2 State whether each of the following is a stock or a flow, and explain. First let’s define stock and flow: Stock: a measure that is defined at a point in time. Flow: a measure that is defined per unit of time. a. The gross domestic product (GDP) Flow. GDP represents production per unit of time, such as a year or a quarter. b. National saving Flow. National saving is measured per unit of time, analogous to individual saving. c. The value of the French housing stock on 1 January 2003 Stock. This value is measured at a point in time. d. The amount of British currency in circulation as of this morning Stock. Again, the value is measured at a point in time. e. The government budget deficit Flow. The deficit is the government’s spending less its receipts. Spending and receipts are measured per unit of time, such as a year or quarter. f. The quantity of outstanding government debt on 1 January 2003 Stock. The quantity of government debt outstanding is measured at a point in time.

Question 3 Q3 looks at the three main reasons that people save money. What are they? Life-Cycle Saving This is saving done to smooth out one’s (or one’s household’s) consumption path. Economists sometimes call this inter-temporal substitution, meaning substituting consumption in one year for consumption in another year. For example, A person might borrow in the early years when they expect their income to be low and their expenses might be high (i.e. buying a house, having a baby, etc.) and then as they gain experience in the workforce, they expect to have a higher income, from which they can repay their earlier borrowing. Precautionary Saving This is saving done for protection against unexpected setbacks. For example, A person could suddenly lose their job or have a medical emergency. Bequest Saving This is saving done for the purpose of leaving and inheritance.

Question 3 a. Ellie learns she is pregnant.
Ellie and Vince are a married couple, both with university degrees and jobs. How would you expect each of the following events to affect the amount they save each month? Explain your answers in terms of the basic motivations for saving. a. Ellie learns she is pregnant. For life-cycle reasons (anticipation of future child-care expenses, tuitions), Ellie and Vince will probably increase their current saving. There is also the possibility that in the future one or both parents may work less in order to be at home; to prepare for the possibility of reduced income in the future the couple should save more today. b. Vince reads in the paper about possible layoffs in his industry Vince’s risk of layoff has increased, so the couple should increase their saving for precautionary reasons. c. Vince had hoped that his parents would lend financial assistance toward the couple’s planned purchase of a house, but he learns that they can’t afford it. More saving is needed to meet a life-cycle objective. d. Ellie announces that she would like to go to law school in the next few years. More saving is needed for a life-cycle objective; as the couple faces both a reduction in their income and tuition expenses in a few years, they need to save more now. e. A boom in the stock market greatly increases the value of the couple’s retirement funds. Less saving is needed to meet the life-cycle objective of retirement.

Some notes for Question 4
In Q4, we need to find national saving, private saving, public saving and the national saving rate. Let’s list the equations for each of these first: Public Saving: Public Saving = government budget surplus Public Saving = T – G Note: T is net taxes, so T = tax collections – government transfers & interest payments G is simply government purchases of goods & services. Private Saving: Private Saving = Household saving + business saving Private Saving = Y – C - T National Saving: National Saving = Private saving + public saving Or, National Saving = GDP – Consumption expenditures – Gov’t Expenditures National Saving = Y – C – G The National Saving Rate: National Saving Rate = National saving/GDP

Question 4(a) Given: Household saving = 200 Government purchases of goods and services = 100 Business saving = 400 Government transfers and interest payments = 100 Tax collections = 150 GDP = 2,200 Find: public saving, private saving, national saving, the national saving rate. Public saving = government budget surplus = (tax collections – gov’t transfers and interest pmts) – gov’t purchases = (150 – 100) – 100 = -50 Private saving = Household saving + business saving = = 600 National saving = Private saving + public saving = 600 – 50 = 550. National saving rate = National saving/GDP = 550/2200 = 25%.

Question 4(b) GDP = 6, Government transfers and interest payments = 400 Tax collections = 1,200 Consumption expenditures = 4,500 Government budget surplus = 100 Find: public saving, private saving, national saving, the national saving rate. Public saving: Public saving = Government budget surplus Public saving = 100 Private saving: Private saving = Household saving + business saving But, we have a problem, we aren’t given household or business saving. How else could we calculate private saving? Is there another relationship that we can use to find private saving? We know that National saving can be calculated in two ways, and one of them involves private saving: National saving = Private saving + public saving Or, National Saving = GDP – C – G So, let’s try to find National Saving using the second equation, and then work back from there to find Private saving.

Question 4(b) ctd. For Monday Tutorials:
GDP = 6, Government transfers and interest payments = 400 Tax collections = 1,200 Consumption expenditures = 4,500 Government budget surplus = 100 National saving: National saving = Private saving + public saving Or, National Saving = GDP – C – G So, we have GDP and C, so let’s see if we can find G, so we can use the second equation. We know that: gov’t. surplus = tax collections – gov’t. purchases – gov’t. transfers and interest pmts. 100 = 1200 – gov’t purchases – 400 gov’t purchases = 700 Now that we have gov’t purchases, we can plug everything in to our equation for national saving: National Saving = Y – C – G National Saving = 6000 – 4500 – 700 – 400 National Saving = 400 Ok, now we can find Private saving: 400 = Private saving + 100 Private saving = 300 We can also now find the National Saving Rate: The national saving rate = national saving/GDP = 400/6000 = 0.07%. Note: This method is incorrect, according to the textbook. Here we are including gov’t transfers & interst pmts as part of G, however, it should be included as part of T, net taxes. See next slide for correct calculation.

Question 4(b) ctd. GDP = 6, Government transfers and interest payments = 400 Tax collections = 1,200 Consumption expenditures = 4,500 Government budget surplus = 100 National saving: National saving = Private saving + public saving Or, National Saving = GDP – C – G So, we have GDP and C, so let’s find G, so we can use the second equation. gov’t. surplus = T - G gov’t. surplus = (tax collections – gov’t. transfers and interest pmts) – gov’t. purchases 100 = 1200 – 400 – G G = 700 Now that we have gov’t purchases, we can plug everything in to our equation for national saving: National Saving = Y – C – G National Saving = 6000 – 4500 – 700 National Saving = 800 Ok, now we can find Private saving: National saving = Private saving + public saving 800 = Private saving + 100 Private saving = 700 We can also now find the National Saving Rate: The national saving rate = national saving/GDP = 800/6000 = 13.3%. This is the correct solution. Note that gov’t transfers & interest pmts is a part of net taxes (T), and not as a part of government expenditures (G).

Question 4(c) Consumption expenditures = 4,000 Investment = 1, Tax collections = 1,500 Government purchases = 1,000 Gov’t transfers & interest pmts = 500 Net exports = 0 Find: public saving, private saving, national saving, the national saving rate. As in part (b) we have information here that allows us to find GDP, and from there, national savings, and then we can work backwards to find public saving, private saving, and the national saving rate.

Question 4(c) Consumption expenditures = 4,000 Investment = 1, Tax collections = 1,500 Government purchases = 1,000 Gov’t transfers & interest pmts = 500 Net exports = 0 Let’s start by finding GDP: Using the relationship Y = C + I + G + NX Y = Y = 6000. We know that National saving is: National Saving = Y – C – G National Saving = 6000 – 4000 – 1000 National Saving = 1000. The national saving rate = National Saving/ GDP = 1000/6000 = 16.7%. To find public saving, we’ll use public saving = gov’t surplus = T – G: gov’t. surplus = (tax collections – gov’t. transfers and interest pmts) – gov’t. purchases gov’t. surplus = (1500 – 500) – 1000 gov’t. surplus = 0 To find Private Saving, we use the national saving relationship: National saving = Private saving + public saving 1000 = Private saving + 0 Private saving = 1000

Question 5(a) Simon purchases a bond, newly issued by the Amalgamated Corporation, for €1,000. The bond pays €60 to its holder at the end of the first, second and third years. It may also be redeemed for the face value of €1,000 upon its maturity at the end of the third year. What are each of the following: the principal amount: the term: the coupon rate: the coupon payment: €1000 three years 6% €60

Question 5(b) After receiving the second coupon payment (at the end of the second year), Simon decides to sell his bond in the bond market. What price can he expect for his bond if the 1-year interest rate at that time is 3%? We want to find out is the present value of the total amount that Simon expects to receive one year in the future. First, let’s see how much money Simon expects to receive. At the end of the second year, the only remaining payment is the final €1060 to be paid in one year. Second, let’s find the present value of €1060 one year into the future. We use the equation for finding Future Value of a Present stream of income: 𝐹𝑉=𝑃𝑉 1+𝑖 𝑡 And re-arrange to get Present Value: 𝑃𝑉= 𝐹𝑉 1+𝑖 𝑡 𝑃𝑉= € 𝑃𝑉=€1029

Question 5(b) After receiving the second coupon payment (at the end of the second year), Simon decides to sell his bond in the bond market. What price can he expect for his bond if the 1-year interest rate at that time is 8%? And 10%? We use the same methods as in the previous slide. 𝑃𝑉= 𝐹𝑉 1+𝑖 𝑡 If the interest rate is 8%, the value of the bond today is €1060/1.08 = €981. If the interest rate is 10%, the value of the bond today is €1060/1.10 = €964. Notice anything interesting going on here? Through doing this exercise, we can see the inverse relationship between interest rates and bond prices: if i < r, then bond price < face value if i > r, then bond price > face value

Question 5(c) Can you think of a reason that the price of Simon’s bond after two years might fall below €1,000, even though the market interest rate equals the coupon rate? One possible reason is if there is a chance that Amalgamated Corporation cannot pay off its debt in one year. For example, if there is some bad news about Amalgamated Corporation, that leads financial investors to fear that the firm might go bankrupt – then they would not be able to pay off their debts in one year. So, if there is some chance that the final payment of €1060 will not be made, then financial investors will not be willing to pay €1000 for the bond, because they know they can earn 6% without risk by holding the debt of the government or some other very stable companies. Note: Some students suggested that inflation might be another reason for this occurring. However, inflation would affect both the real interest rate and the real coupon rate. So, if they are initially equal to each other, inflation will not lower the present value of the bond.

Question 6(a-c) Shares in Brothers Grimm Plc, manufacturers of gingerbread houses, are expected to pay a dividend of €5.00 in one year and to sell for €100 per share at that time. How much should you be willing to pay today per share of Grimm: So in this question, we want to find the present value of a future payment of €105. We’ll use our equation for Present value: 𝑃𝑉= 𝐹𝑉 1+𝑖 𝑡 a. If the safe rate of interest is 5% and you believe that investing in Grimm carries no risk? PV = (€100 + €5)/1.05 = €100 b. If the safe rate of interest is 10% and you believe that investing in Grimm carries no risk? PV = (€100 + €5)/1.10 = €95.45 An increase in the interest rate lowers the stock price.    c. If the safe rate of interest is 5% but your risk premium is 3%? The risk premium is the amount you’d have to receive, above the interest rate, in order to be as happy as you would be if you had received the interest and there were zero risk. So how do we take into account the risk premium? We add it on to the interest rate. PV = (€100 + €5)/( ) = €97.22 So an increase in the risk premium also lowers the stock price.

Question 6(d) Now we’ll repeat parts (a)–(c), assuming that Grimm is not expected to pay a dividend but that the expected price is unchanged. Shares in Brothers Grimm Plc, manufacturers of gingerbread houses, are expected to pay no dividend and to sell for €100 per share in one year. How much should you be willing to pay today per share of Grimm: a. If the safe rate of interest is 5% and you believe that investing in Grimm carries no risk? €100/1.05 = €95.24 b. If the safe rate of interest is 10% and you believe that investing in Grimm carries no risk? €100/1.10 = €90.91 An increase in the interest rate lowers the stock price.    c. If the safe rate of interest is 5% but your risk premium is 3%? €100/1.08 = €92.59 An increase in the risk premium lowers the stock price. If all else is equal, then a lower expected dividend will lower the stock price.

Some notes for Question 7
For each of the scenarios in Q7, use supply and demand analysis to predict the resulting changes in the real interest rate, national saving and investment. Note: If there is no foreign exchange market, then National Savings = Investment. So, if National Savings increases, then Investment will also increase. Also Note: Pgs in your textbook review how changes in supply and demand for savings and investment can affect the real interest rate. The Supply of and Demand for Savings

Question 7(a) The legislature passes a 10% investment tax credit. Under this programme, for every €100 that a firm spends on new capital equipment, it receives an extra €10 in tax refunds from the government. Use supply and demand analysis to predict the resulting changes in the real interest rate, national saving and investment. Show all your diagrams. This reduces the cost of investment, so leads to an increase in desired investment spending and the demand for savings (that means Investment curve shifts right). Hence, the real interest rate rises, as does national saving.

Question 7(b) A reduction in military spending moves the government’s budget from deficit into surplus. Use supply and demand analysis to predict the resulting changes in the real interest rate, national saving and investment. Show all your diagrams. Public saving is identical to the government budget surplus. If the government lowers its spending without lowering taxes, and assuming that private saving behaviour does not change, national savings increase, the savings curve shifts to the right, real interest rates decrease, and investment increases.

Question 7(d) The government raises its tax on corporate profits. Other tax changes are also made, such that the government’s deficit remains unchanged.Use supply and demand analysis to predict the resulting changes in the real interest rate, national saving and investment. Show all your diagrams. Higher taxes on the revenues generated by capital decreases the willingness of firms to invest in new capital. Desired investment decreases, shifting the investment curve to the left, real interest rates decrease, as does national saving.

Question 7(c) A new generation of computer-controlled machines becomes available. These machines produce manufactured goods much more quickly and with fewer defects. Use supply and demand analysis to predict the resulting changes in the real interest rate, national saving and investment. Show all your diagrams. A technological advance that allows a unit of capital to produce more goods and services would increase the value of its marginal product and rate of return. Hence, this is likely to lead to an increase in desired investment, shifting the investment curve to the right, increasing real interest rates and national saving.

Question 7(e) Concerns about job security raise precautionary saving.
Use supply and demand analysis to predict the resulting changes in the real interest rate, national saving and investment. Show all your diagrams. An increase in precautionary saving increases national saving. This shifts the savings curve to the right, lowering real interest rates, which in turn leads to higher desired investment.

Question 7(f) New environmental regulations increase firms’ costs of operating capital. Use supply and demand analysis to predict the resulting changes in the real interest rate, national saving and investment. Show all your diagrams. An increase in a firms’ costs of operating capital will decrease the willingness of firms to invest in new capital, hence will lead to a decrease in desired investment, shifting the investment curve to the left, real interest rates decrease, as does national saving.

Next Class Week 18 Worksheet – The Goods Market
Read Chapter 22 in your textbook. No Planet Money Podcast for next week. Test 3 (Short Answer) on Friday Next Week 50 minutes; 4 questions, you must answer each question. Material from Weeks (lectures) will be covered on the test. This corresponds to Week Tutorial Worksheets, or any material between Intro to Macroeconomics and Goods Market and Economic Fluctuations. Expect a more general question on the final week’s material. No specimen test – questions will be very similar to Tutorial questions & book questions. A note from Roy: If the students have attended and understood the lectures and tutorials, there should be no problem in passing and getting a decent grade in the test. So, revise your lecture notes, tutorial questions, and textbook chapters & questions.

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