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
iClicker questions
Efficient Markets Theory says
A. It is nearly impossible to choose stocks that will
B.
C.
D.
E.
outperform the market with any degree of
consistency.
Investors who understand the theory will
consistently outperform the average investor.
Current interest rates are an accurate reflection of
how markets assess future risks.
None of the above
All of the above
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)
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!
3. Insuring against risk
 Insurance  The price of certainty
 Diversification  Spreading risk
4. Speculation
 Betting on short-term price movements
Efficient Market Theory
 “The problem is that everyone else has access to the
same information.”
Warren Buffet
“I’d be a bum on the street
with a tin cup if markets
were always efficient.”
 “… the most important economic post in a democratic
government is appointed, not elected.”
Money
 Means of exchange
 Unit of account
 Portable and durable
 Relatively scarce
 “… the value of modern currency: It has purchasing
power.”
Roles of the Federal Reserve
 Regulation of commercial banks
 Supporting banking infrastructure
 E.g., clearing checks and other financial transactions
 Monetary policy
Monetary policy
 “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
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
iClicker questions
Which is worse?
A. Inflation
B. Deflation
C. Both about the same
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
Inflation
 How is inflation caused by government policy an
indirect tax on citizens?
Inflation: Higher prices for the
same product or service
U.S. Consumer Price Index: 1913-2011
240
220
200
180
160
140
120
100
80
60
40
20
0
Changing prices
Inflation Rate: 1913-2011
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
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
Currency exchange issues
 “Basic economic logic suggests that exchange rates
should roughly align with purchasing power parity”
 What is the “Big Mac PPP” index?
 “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.”
Euros per US Dollar
 “In general a weak currency is good for exporters and
punishing for importers.”
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
What happened in Iceland?
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
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
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
Why can’t Greece use other tools?
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
Financial Times, 9/28/2010
Not just Ireland
Will China save the world?
iClicker questions
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
International Institutions
 What do these organizations do?
 World Bank
 International Monetary Fund
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
Example from the mortgage market:
A payment of $733.76/month
Higher cost of borrowing
Lower cost of borrowing
 Interest rate: 8%/year
 Interest rate: 5%/year
 Amount that can be
 Amount that can be
borrowed:
$100,000
 Payment: $733.76
borrowed:
$136,686
 Payment: $733.76
Supply response

If prices fall, suppliers are less willing to produce
Investors seek the highest return they can get



Holding risk constant
Adjusting for inflation expectations
Mortgage debt outstanding
Mortgage Debt held by major
financial institutions ($Billions)
5,200
5,100
5,000
4,900
4,800
4,700
4,600
4,500
4,400
4,300
4,200
4,100
2007
2008
2009
2010
2011Q1