2. Today’s objectives Understand the basics of financial markets, operations of the Federal Reserve and international trade Draw on this understanding to clarify understanding of markets more broadly

3. iClicker questions

4. Efficient Markets Theory says A. It is nearly impossible to choose stocks that will outperform the market with any degree of consistency. B. Investors who understand the theory will consistently outperform the average investor. C. Current interest rates are an accurate reflection of how markets assess future risks. D. None of the above E. All of the above

6. Financial markets fill 4 needs 1. Raising capital Borrowing money Selling ownership interests (shares) Raising capital has a price Borrowing—interest paid Shares—a share of future profits (return on investment)

7. 2. Storing, protecting and making profitable use of excess capital “Individuals, companies, and institutions with surplus capital are renting it to others who can make more productive use of it” At a price!

8. 3. Insuring against risk Insurance  The price of certainty Diversification  Spreading risk 4. Speculation Betting on short-term price movements

9. Efficient Market Theory “The problem is that everyone else has access to the same information.”

10. Warren Buffet “I’d be a bum on the street with a tin cup if markets were always efficient.”

12. “… the most important economic post in a democratic government is appointed, not elected.”

13. Money Means of exchange Unit of account Portable and durable Relatively scarce “… the value of modern currency: It has purchasing power.”

14. Roles of the Federal Reserve Regulation of commercial banks Supporting banking infrastructure E.g., clearing checks and other financial transactions Monetary policy

15. “The Federal Reserve controls the money supply and therefore the credit tap for the economy.” “When the tap is open wide, interest rates fall and we spend more freely on things that require borrowed money …” Trade-off Enough money and credit to keep the economy growing Keep inflation in check

16. Interest rate tools Federal Reserve Discount Rate The interest rate at which commercial banks can borrow directly from the Federal Reserve Why would this carry a stigma? Federal Funds Rate The rate that banks charge other banks for short-term loans

17. iClicker questions

18. Which is worse? A. Inflation B. Deflation C. Both about the same

19. Which is the more effective tool for managing today’s economy? A. Federal fiscal policy B. Monetary policy C. Both need to work together D. Neither works very well E. We don’t know

20. Inflation How is inflation caused by government policy an indirect tax on citizens?

21. Inflation: Higher prices for the same product or service

22. Changing prices

24. What is purchasing power parity? The amount of money needed in one currency to achieve a comparable standard of living in another country’s currency

25. Currency exchange issues “Basic economic logic suggests that exchange rates should roughly align with purchasing power parity” What is the “Big Mac PPP” index?

26. “If the US dollar is weak, meaning that it can be exchanged for fewer yen or euros than normal, then foreign goods become more expensive.” “At the same time, a weak dollar makes American goods less expensive for the rest of the world.”

27. Euros per US Dollar

28. “In general a weak currency is good for exporters and punishing for importers.”

29. How do governments affect the strength of their currency? Trade in the international currency markets Monetary policy Import/Export policies Fix the exchange rates Gold (or dollar) standard Fixed (pegged) exchange rates

30. What happened in Iceland?

31. So what’s up with Greece? Years of unrestrained spending, cheap lending and failure to implement financial reforms left Greece badly exposed when the global economic downturn struck. Result: debt levels and deficits that exceeded limits set by the eurozone. Debts = 120% of GDP National deficits of 12.7% of GDP

32. So what? Greece’s credit rating downgraded to the lowest in the eurozone Investors unwilling to loan to Greece Interest rates on existing debts will rise Government must either cut spending in order to balance its budget or default on its debts Financial markets are betting Greece will default

33. Actions and Reactions Government: Cut spending drastically Raise taxes on fuel, tobacco and alcohol Raise retirement age by 2 years Public sector pay cuts Aggressively go after tax evaders Reactions: Nationwide strikes

35. Why can’t Greece use other tools?

36. Fears Financial instability may spread to Portugal, Ireland and maybe even Italy and Spain Concerns that if Greece defaults, the euro may not survive as a currency

37. Financial Times, 9/28/2010

38. Not just Ireland

39. Will China save the world?

40. iClicker questions

41. How is the US doing? Is the trade balance with China a problem? A. Definitely Yes B. Probably C. Probably Not D. Definitely No E. Can’t tell yet

42. International Institutions What do these organizations do? World Bank International Monetary Fund

44. 1. Efficient markets require complete information available to all market participants 2. Market prices regulate both supply and demand As prices fall, buyers can and will buy more Example: Lower interest rates = more borrowing

45. Example from the mortgage market: A payment of $733.76/month Higher cost of borrowing Lower cost of borrowing Interest rate: 8%/year Amount that can be borrowed: $100,000 Payment: $733.76 Interest rate: 5%/year Amount that can be borrowed: $136,686 Payment: $733.76

46. Supply response If prices fall, suppliers are less willing to produce Investors seek the highest return they can get Holding risk constant Adjusting for inflation expectations

47. Mortgage debt outstanding