Financialsummary

Summary of Coursesin Finance

(State Exam)

Gábor Bóta

Summary of Courses in Finance, MBA2005B 2

Public Economics

11. Mixed economy–Market economy, communism (What? How? For whom?)–Classic roles of the government–Alleviation of social inequality (equality conceptions)

12. Government regulations–Expenses and revenues of the budget–Desirable tax system, horizontal and vertical equity–Protection of the poor, domestic producers, consumers and

workers

13. Macroeconomic measures–Measures of the value of economic activity (GDP, GNP)–Inflation, measurement of inflation–Types and natural rate of unemployment


14. Fiscal policy–Equilibrium in the long run (Say’s law)

–Determination of output in the short run (Keynesian cross), stabilization options

–Macroeconomic policy: active – passive; conducted by rule – by discretion

15. Economic growth–Steady state

–The golden rule level of capital

–Population growth and technical progress

Public Economics


11. Mixed economy Market economy, communism (What? How? For whom?)

• Three central problems of the economies:–What?–How?–For whom?

• These three problems are fundamental and common to all economies, but different societies try to solve them using different institutions.–command economy–market economy


Mixed economy Market economy, communism (What? How? For whom?)

• Market mechanism – individual consumers and businesses interact through

markets to solve the three central problems of economic organization

• Command economy –the resource allocation is determined by the governments,

commanding individuals and firms in order to follow the state’s economic plan

• Mixed economy–Both public and private institutions exercise economic

control:• the private system through the invisible direction of the market

mechanism• the public or government institutions through regulatory commands

and fiscal incentives



• Market coordination–Prices perform three functions in organizing economic

activity:• they transmit information; • they provide an incentive to adopt least costly methods of production

(use available resources for the most highly valued purposes); • they determine who gets how much of the product: the distribution of

output and income.• Bureaucratic coordination–Bureaucracy (state, government) operates the economy• Suspends (substitutes) market coordination• Corrects market coordination

– income distribution



• What? How? For whom?–Market economy• The dollar votes of people affect prices of goods; these prices serve as

guides for the amounts of different goods to be produced.• The best way for producers to meet price competition and maximize

profits is to keep costs at a minimum by adopting the most efficient methods of production.• The distribution of income is determined by ownership of factors of

production and by their prices.–Communism• State controls the resources, a central plan sets out what will be

produced and how. Labor is the only factor of production owned by households, available jobs are decided and wages are set by planners.

–Socialism• Transition from capitalism to communism• Market economy with bureaucratic decisions

– Welfare state capitalism: combines the private ownership of capital with state intervention in markets.


Mixed economy Classic roles of the government

• Protective function of the government–The most fundamental function of government is the

protection of individuals and their property against acts of aggression.–The protective function of the government also involves the

maintenance of a legal structure for the enforcement of contracts and a mechanism for the settlement of disputes.–Three main branches of power: legislative, executive, and

judiciary.• Productive function of the government–Allocation of goods and services the market fails to provide

efficiently.• Public goods and services• Externalities



• Public goods and services are jointly consumed and non-excludable.–If a public good is made available to one it is simultaneously

made available to others, consumption of the good is not be able to restricted to the costumers who pay for it.–Because those who do not pay can not be excluded no one has

much of an incentive to pay for such goods, each has an incentive to become free riders.–Public goods cannot be privately and profitably marketed to

efficiently service the collective demand for them, so the government should step in to provide these goods.



• Externalities occur when firms or people impose costs or benefits on others without those others receiving the proper payment or paying the proper costs.–While the optimal scope of government intervention never be

resolved most people will agree that government is needed to prevent some of the worst spillovers created by the market mechanism.–Government regulations operate with varying degrees of

effectiveness to control externalities.• Proponents of market economics believe that governments should not

diminish market freedom because they disagree over what is a market externality and what are government created externalities, and disagree over what appropriate level of intervention is necessary against the market created externalities. These failures can be solved through information disclosure, not through government regulation.• Others believe that government should intervene to prevent market

failure while preserving the general character of the market economy.


Mixed economy Alleviation of social inequality (equality conceptions)

• Equality of opportunity–All people should start out in life from the same platform

and have equal opportunities in life, regardless of where they were born or who their parents were. • public education, public healthcare system etc.

–People with similar abilities reach similar results after doing a similar amount of work.• without regard to the gender, race, religion…• freedom

• Equality of outcomes–Seeks to reduce or eliminate differences of wealth between

individuals or households in a society.–Equality comes sharply into conflict with freedom.• Taking from some to give to others on grounds of justice.


12. Government regulations Expenses and revenues of the budget

•Expenses

–Central government budget–Local government budget–Social security funds–Extrabudgetary funds

–Distribution by government departments

–Distribution by function•Economic•Social securities and welfare•Healthcare•Education•Defense•Government operation•Debt service

•Revenues

–Taxes and duties–Capital income–Other revenues

•Fees•Duties, service fees•Fines•Unrequited transfers from abroad


Government regulations Desirable tax system, horizontal and vertical equity

•Characteristics of a desirable tax system–Economic efficiency• The tax should not prevent efficient allocation of resources.

–Administrative simplicity• The tax should be easy and inexpensive to administer.

–Flexibility• The tax system should respond easily to changes in economic conditions.

–Transparency• A tax should be visible with a clear link between the taxing unit and the

services provided. Individuals should be able to ascertain their tax burdens so that burdens can be politically tailored to what society considers desirable.

–Fairness• The tax system should be fair in its treatment of different individuals.

– Individuals with equal income should have equivalent tax burdens. (Horizontal equity)

– People with different level of welfare should be treated differently. Individuals who are better able to pay higher taxes should bear a higher share of total taxes. (Vertical equity)


Government regulations Protection of the poor, domestic producers, consumers and workers

•The proper role for government in a market economy is controversial.–Most supporters of a market economy believe that

government has a legitimate role in defining and enforcing the basic rules of the market.–More controversial is the question of how strong a role the

government should have in both guiding the economy and addressing the inequalities the market produces.–There is no universal agreement on issues such as

protectional tariffs and welfare programs.

–Friedman: Governments have a role in fixing market failures but only if the government is helping to solve information transmission problems not masking current information.



•One of the major complaints of markets is a belief that they create exploitation of labor and poverty.–Free market economists make compelling arguments on how

poverty is often created and sustained by government interference and regulation of the economy.• unequal property rights, high transaction costs to property rights,

tariffs and other trade barriers, labor laws•Market economies are criticized for their income inequality–There is nothing unfair about income inequality in a positive

sum relationship where people are engaging in voluntary transactions.–The market economists argue that planned economies and

welfare will not solve poverty problems but only make them worse. Poverty can be reduced by low levels of government regulation and interference, free trade, equal property rights, tax reform and reduction.



•Protection of the poor–Private charity• Reflects the opinion of the society• Private charitable activities declined because of the extension of

governmental welfare activities•Protection of domestic producers–Price supports, tariffs, quotas distort the market mechanism–Social aid paid by consumers of foreign goods

•Protection of consumers•Protection of workers–Minimum-wage laws protects the insiders from the

competition


13. Macroeconomic measures Measures of the value of economic activity (GDP, GNP)

• Gross domestic product measures both the income of everyone in the economy and the total expenditure on the economy’s output of goods and services.

Nominal and real GDPGDP is the sum of four categories of expenditure: C+I+G±NX

• Gross national product measures the total income earned by residents of the nation.

GNP=GDP±factor payment from and to abroad


Macroeconomic measuresInflation, measurement of inflation

Inflation is the increase in overall level of pricesMeasurement of inflation–Consumer Price Index

Measures changes in the cost of living through the changes of the price of a basket of goods and services purchased by a typical consumer.–GDP deflator

The ratio of nominal GDP and real GDP


Macroeconomic measures Inflation, measurement of inflation

Inflation does not make people poorer. Accumulation of capital and technological progress lead to higher consumption.

Problems result from inflation:–Unproductive activities because of the inflation–Destroys the information function of the price system, which leads to inefficiencies in the allocation of resources.–The costs of expected inflation• shoe-leather costs• menu costs• the cost of relative price variability• tax distortions• inconvenience of making inflation corrections

–Unexpected inflation has an effect that is more pernicious than any of the costs of steady, anticipated inflation: it arbitrarily redistributes wealth among individuals.


Macroeconomic measures Types and natural rate of unemployment

UnemploymentThe natural rate of unemployment is the average rate around which the economy fluctuates.Frictional unemployment is caused by the time it takes workers to search for a job.

Some frictional unemployment is inevitable in a changing economy.Unemployment insurance inadvertently increase it.

Structural unemployment results from wage rigidity and job rationing.The real wage is stuck above the equilibrium level, and the supply of labor exceeds the demand.Causes of wage rigidity:

– Minimum-wage laws– Unions and collective bargaining– Efficiency wages


14. Fiscal policy Equilibrium in the long run

Equilibrium in the market for goods in the long runComponents of the demand for the economy’s output

Closed economy–households, firms, government

Consumption–Households divide their disposable income between

consumption and saving.–Income after the payment of all taxes is disposable income.–We assume that the level of consumption depends directly on

the level of disposable income. The higher the disposable income, the greater the consumption is.–Consumption function:–Marginal propensity to consume (MPC)• the amount by which the consumption changes when disposable

income increases by one dollar.

)( TYCC


)(rII

Fiscal policy Equilibrium in the long run

Investment–Investment goods are purchased by firms but households

spend their income indirectly through firms–The motivation behind investment is to increase future

income and future consumption–The quantity of investment goods demanded depends on the

real interest rate, which measures the cost of the funds used to finance investment.• Profitability of investments depend on the real interest rate• Net Present Value

–Investment functionR

eal i

nte

rest

rat

e, r

Investment, I

Investment function, I=I(r)R

eal i

nte

rest

rat

e, r

Investment, I

Rea

l in

tere

st r

ate,

r

Investment, I

Investment function, I=I(r)Investment function, I=I(r)



Government purchases–Transfer payments to households are not included.• Transfer payments are not made in exchange for some of the

economy’s output, or rather do affect the demand for goods only indirectly. • Disposable income (Y-T) includes both the negative impact of taxes

and the positive impact of transfer payments.–Motivated by political reasons–Government purchases and taxes are exogenous variables

–We assume a balanced budget (G=T)

,G G T T


Fiscal Policy Equilibrium in the long run

Equilibrium in the market for goods in the long runFactors of production and the production function

determine the quantity of output supplied to the economy (Economy's natural rate of output)

What ensures that the sum of consumption, investment and government purchases equals the amount of output produced?

YLKFY ),(



National income accounts identity

Summarizing our discussion about the market for goods

Real interest rate (r) is the only variable not determined, so it must adjust to ensure that the demand for goods equals the supply. Real interest rate is the factor responsible for the equilibrium.

Y C I G

( ) ( )Y C Y T I r G


I, S

r

I=I(r)

Equilibrium interest rate

S

S



Fiscal policy Equilibrium in the long run, Say’s law

• Say’s law– If saving above consumption is transformed totally into investment

(interest rate mechanism) and prices and wages (and interest rates) are flexible then all produced goods can be sold, there is no unemployment– Supply always creates its demand, wages and interest rates are always

ample to facilitate the selling of all goods.– Say’s law spectacularly failed in 1930s.

• In the long run prices are flexible, in the short run prices are sticky

• We can model the economy – in the long run – without the existence of money.– Real and nominal variables can be separated (classical dichotomy)– The money supply does not effect real variables, money is neutral.– Consequently the output (standard of living) is not affected by any

monetary factors.• (In the short run prices are sticky, therefore changes in the money supply can influence

the level of output, and the standard of living.)


Fiscal Policy Determination of output in the short run (Keynesian cross)

Keynesian crossPlanned expenditure

The amount households, firms, and the government would like to spend on goods and services.

Pla

nned

exp

endi

ture

, E

Income, output, Y

GICE

MPC

1$

G

I


Fiscal policy The Keynesian cross

Economy equilibrium:Actual Expenditure = Planned Expenditure

EY

E

Income, output, Y

GICE

45º

EY

Equilibrium income


Fiscal policy The Keynesian cross

The adjustment to equilibrium in the Keynesian crossIf the economy is not in equilibrium, firms will experience unplanned changes in inventories, and this induces them to change production levels. Changes in production in turn influence total income and expenditure moving the economy toward equilibrium.

Unplanned inventory accumulation

Unplanned drop in inventory45º

E

Income, output, Y

GICE

EY

Equilibrium income


Fiscal policy Stabilization options according to the Keynesian cross

• Government purchases• Decrease in taxes

E

Income, output, Y

45º

EY

1. An increase in government

purchases, or a tax cut shifts planned

expenditure upward…

G

Y 2. …which increases equilibrium income.

MPC TBoth increase in G and decrease in T have a multiplied effect on income

• Crowding-out hypothesis: government spending or government debt reduces the amount of business investment.– Government spending may crowd-out investment because of resource limitations– Deficit may lead to rising interest rates thereby lowering investment.


Fiscal policyMacroeconomic policy: Active – passive

• How should government policymakers respond to the business cycle?• Should monetary and fiscal policy take an active role in trying to stabilize the economy, or should remain passive?–Shocks to the economy can cause recessions. –Monetary and fiscal policy can prevent recessions by responding to these shocks.–Some economists consider it wasteful not to use these policy instruments to stabilize the economy.–Others are critical to the government’s attempt to stabilize the economy.


Fiscal policyMacroeconomic policy: Active – passive

Why do some critics want the government to refrain from using monetary and fiscal policy for economic stabilization?The effects of economic policy are not immediate.– Inside lag is the time between a shock to the economy and the policy action responding to that shock. –Outside lag is the time between a policy action and its influence on the economy.Fiscal policy has long inside lag, monetary policy has substantial outside lag.

Automatic stabilizers are policies that stimulate or depress the economy when necessary without any deliberate policy change.– The system of income taxes– Unemployment insurance

Difficulties associated with active policy– Economic forecasting is difficult.– People’s expectations are not predictable– History does not settle the debate over stabilization policy


Fiscal policyMacroeconomic policy: conducted by rule – by discretion

• Policy is conducted by rule if policymakers announce in advance how policy will respond to various situations and commit themselves to following through on this announcement.• Policy is conducted by discretion if policymakers are free to size up events as they occur and choose whatever policy seems appropriate at the time.

–Distrust in (incompetent and opportunistic) politicians is against discretionary policy.– If we can trust policymakers, discretionary policy is better, because it is more flexible.–The time inconsistency of discretionary policy• In some situations policymakers may want to announce in advance the policy they will follow in order to influence the expectations of private decisionmakers. But later after the private decisionmakers acted on the basis of their expectations, those policymakers may be tempted to renege on their announcement.


15. Economic growth Steady state

Solow growth modelThe accumulation of capital–Determined by the supply and demand for goods

Ou

tpu

t p

er w

ork

er, y

Capital per worker, k

c

i

s f(k)

f(k)

MPK

1

y

( )y f k

y c i i sy 1c s y


Economic growth Steady state

Capital stock is a key determinant of the economy’s output, is influenced by investment and depreciation

s f(k)

f(k)

δk

There is a single capital stock at which investment equals depreciation: steady-state level of capital

It represents the long-run equilibrium of the economy

k1 k2k*

i*=δk*

δk1

δk2

k

y

s1 f(k)

k1*

s2 f(k)

k2*


Economic growth The golden rule level of capital

We assume that policymakers can set the economy’s saving rate at any level.–What steady state should the policymakers choose?– The goal is to maximize the well-being of society which is described by the highest level of consumption.

Steady state consumption:Increase in steady state capital has two opposing effects• more output • more output must be used to replace capital that is wearing out

Where is the optimum?There is only one level of stock that maximizes consumption.

s f(k)

f(k)

δk

k

y

k1 k2k*

i*=δk*δk1

δk2

kopt*

sopt f(k)iopt*

copt*

MPK δ

* ( *) *c f k δk

Golden Rule level of capital


Economic growth The golden rule level of capital

Economy will not move to the Golden Rule level of capital, there is only one saving rate that produces it.Supposing that the economy has reached a steady state other than the Golden Rule, policymakers face two different problems:

1. The economy begins at a steady state with more capital than it would have in the Golden Rule steady state.The rate of saving should be reduced, and consumption should be increased in order to reduce the capital stock.

2. The economy begins with less capital than in the Golden Rule steady state.The saving rate must be raised. This causes an immediate fall in consumption and a rise in investment.

Output, y

Timet0

Consumption, c

Investment, i

Output, y

Timet0

Consumption, c

Investment, i

“Generation problem”


Economic growth Population growth

The basic Solow model shows that capital accumulation, by itself, cannot explain sustained economic growth.The economy eventually approaches a steady state.

We add population growth to the model.We assume that the population and the labor force grow at a constant rate: nThe growth in the number of workers causes capital per worker and output per worker to fall

Population growth has the same affect as depreciation

Δ ( )k i δ n k

Δ ( ) ( )k s f k δ n k


Economic growth Population growth

k

k (δ+n1)

k1*

f(k)

s f(k)

y

k2*

k(δ+n2)


Economic growth Technological progress

As the efficiency of labor rises, the output per worker increases Technological progress can lead to sustained growth.

k (δ+n)

f(k)

s f(k)

k

y

k*

g

g

Financialsummary

Economy & Finance

mixed economy market

communism market economy

command economy market

mixed economymarket

communism state

market coordination

economic growth steady

economic control