ECO1016 Contemporary Issues in Economics Notes PDF

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1Lecture Notes – Microeconomics Education More education is usually associated with higher personal incomes à more qualifications means higher Marginal Revenue Productivity Education is an investment in human capital which contributes to economic growth Reforms to the higher education system in the ...

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ECO1016:(Contemporary(Issues(in(Economics( ( Miguel(Flores(&(Panos(Arsenis( ( Lecture'Notes'–'Microeconomics' ( Education' • More(education(is(usually(associated(with(higher(personal(incomes(à(more(qualifications(means( higher(Marginal(Revenue(Productivity' • Education(is(an(investment(in(human(capital(which(contributes(to(economic(growth' • Reforms(to(the(higher(education(system(in(the(UK(introduced(in(2012' o Increase(in(tuition(fees' Key(Concepts:(Production( • To(make(any(product,(we(have(both(fixed(and(variable(inputs( o Fixed(inputs(–(not(easily(changed,(plant(&(equipment( o Variable(inputs(–(workers,(can(be(hired(and(fired(more(easily(and(quickly(than(replacing(a( machine( • Diminishing(returns(–(there(exists(a(point(where,(because(there(are(some(fixed(inputs,(the( additional(resources(like(workers(!(production,(but(does(so(at(a(¯(rate( Key(Concepts:(Investments(in(Human(Capital( • Tangible(Capital(–(Assets(that(yield(income(and(other(useful(outputs(over(long(periods(of(time( o Bank(account,(shares(of(IBM(stock(or(steel(plants( • Physical(capital(–(machines(which(are(part(of(production(or(services(process( o Computers(provide(financial(services( • Human(capital(–(skills,(knowledge(and(experience(possessed(by(an(individual(or(population,(viewed( in(terms(of(their(value(or(cost(to(an(organisation/country( o People(cannot(be(separated(from(their(knowledge(or(skills(in(the(way(they(can(be(separated( from(their(financial(and(physical(assets( Key(Concepts:(Present(Value(and(Investment(Decision( • Suppose(you(need(to(incur(a(cost(C(this(year(to(get(a(future(payment(P(after(t(years.(The(interest( rate(is(r( • Net(Present(Value((NPV)(–(of(the(investment(is(the(difference(between(the(cost(and(the(interestadjusted(value(of(future(payment( NPV(=(-C(+((((P( (((((((( ( ( ( ( ( ( ( ((((((((((1+r)t(((( • You(should(invest(if(NPV(>(0,(otherwise(it’s(not(worthy( • Determining(the(right(amount(of(investment(depends(on(the(difference(between(the(present(value( of(benefits(and(the(present(value(of(costs( Key(Concepts:(Education(Investment(decision( • Private(benefits(of(studying(exceed(the( private(costs( • OC:(opportunity(cost( o DC:(direct(cost( o DB:(direct(benefit( o YE:(earnings(of(educated(worker( o YN:(earnings(of(uneducated( worker( ( ( ( ( ( (

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ECO1016:(Contemporary(Issues(in(Economics( ( Miguel(Flores(&(Panos(Arsenis( ( Elementary(and(Secondary(School(–(Reasons(to(support(public(education( • Individuals(invest(in(education(because(of(the(private(benefits(of(higher(lifetime(earnings( • Other(benefits(of(education(are:( o Educated(people(are(less(likely(to(be(on(welfare(and(commit(crimes( o Educated(people(are(more(likely(to(be(productive(and(pay(more(taxes( o People(with(greater(human(capital(may(!(the(productivity(of(others(with(whom(they( interact( o Education(people(tend(to(have(more(stable(employment,(which(reduces(life(stressors(and( risk(factors(that(negatively(affect(health( • Education(may(also(have(external(returns(if(its(benefits( spill(over(to(other(individuals( • Can(use(the(supply-demand(diagram(to(illustrate(the( inefficiency(of(having(unsubsidised(private(education( o The(unsubsidised(market(would(yield(T*(and(S*( o The(optimum(level(with(an(external(benefit(would( be(S’((all(students)(pay(zero(tuition(fees(and( taxpayers(will(pay(T’(per(student( o NB:(without(school(subsidies((coming(from( taxpayers)(S*(mortgage(payment(+(property(taxes(+( insurance)(à(no(guarantee(that(you(would(get(the(mortgage(even(if(you(have(the(funds(to( make(the(initial(payment( o If(the(borrower(defaulted(on(the(mortgage,(the(local(bank(would(take(the(loss( Mortgage(market(has(changed(a(lot(since(then:( • In(1968,(Congress(introduced(the(Federal(National(Mortgage(Association((Fannie(Mae)(and( authorised(it(as(a(govt-sponsored(enterprise(to(buy(mortgages(from(banks(and(other(financial( institutions( o Fannie(Mae(would(securities(mortgages:(bundle(them(together(and(sell(them(to(investors( o Benefit(of(this(process?(à(banks(sold(the(mortgages(à(the(mortgages(which(formed(the( bundles(were(geographically(diversified(à(risk(was(low(à(investors(bought(them(à( mortgage(rates(¯( • Later(on,(Federal(Home(Loan(Mortgage(Corporation((Freddie(Mac)(would(sell(mortgage-backed( securities((MBS)(to(investors( • With(reduced(rates,(mortgages(became(more(affordable;(in(the(late(1980s,(the(down(payment( would(be(only(5%-10%(of(the(home(value( • As(if(all(these(developments(were(not(enough(to(inflate(the(housing(market,(interest-only(and( negative-amortization(mortgages(cropped(up( o Interest-only(mortgage(–(allow(the(buyer(to(pay(only(the(interest(for(the(first(few(years(and( then(the(scheme(would(rests(to(a(traditional(mortgage(but(the(payment(would(be(higher( o Negative-amortization(mortgage(–(the(same(but(the(buyer(would(pay(less(than(the(interest( portion(of(the(payment( § Fraction(of(interest(not(paid(goes(towards(end(balance(of(debt( • Table(below(shows(this:( ( ( (

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ECO1016:(Contemporary(Issues(in(Economics( ( Miguel(Flores(&(Panos(Arsenis( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( • Assume(a($250,000(loan,(for(30yrs(at(5%(interest( • Comment(–(point(where(you(start(paying(of(your(debt,(hence(payments(are(higher( o Problem(is(that(you(might(be(disillusioned( • Paying(only(the(interest(rate(of(the(payment((or(worse,(a(portion(of(it)(for(the(first(few(years(means( that(once(the(mortgage(resets(to(the(traditional(scheme(the(payment(will(!(substantially( • These(mortgages(allowed(many(buyers(to(acquire(houses(that,(otherwise,(would(not(have(been( affordable( • However,(it’s(still(unclear(whether(buyers(understood(the(terms(of(these(mortgages:( o Have(they(read(all(the(documentation?( o Maybe,(they(were(confident(that(even(if(the(payments(!,(they(could(take(out(a(2nd( mortgage(with(a(home'equity'line(of(credit,(since(the(house(prices(were(!( § House(prices(double,(hence(automatically(eligible(for(more(credit(–(then(means(you( can(take(2nd(mortgage(on(top(of(the(1st(mortgage( • The(outcome(of(the(above(developments(is(that(US(households(and(firms(continually(!(their( borrowing(since(the(1970s:( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( (

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ECO1016:(Contemporary(Issues(in(Economics( ( Miguel(Flores(&(Panos(Arsenis( ( How(to(make(a(housing(bubble( • The(implication(from(the(previous(discussion(is(that(bubbles(are(all(about(expectations;(bubbles(are( created(by(the(expectation(of(higher(prices(causing(people(to(buy(assets(based(on(that(expectation( rather(than(fundamentals( • People(fuel(the(bubble(when(they(adopt(the(paradigm(of(‘buy(now(before(the(price(goes(up’( • Think(of(a(buyer(of(a(negative-amortization(mortgage:( o Say,(the(initial(price(is($250,000(and(the(buyer(pays(only(half(of(the(interest( o After(the(1st(five(years,(the(mortgage(resets(to(the(traditional(version(and(the(payments(!( significantly;( o If(after(5yrs(the(house(is(worth($500,000,(who(cares(about(the(payments?(à(Why(is(that?( o Because(the(buyer(has(much(more(equity((=(what(the(house(is(worth(–(what(is(owed)(and( he(can(use(that(to(take(a(second(mortgage(to(pay(the(payments!( • Above(mechanism(can(explain(the(demand(side(of(the(housing(bubble( • Why(were(the(banks(so(willing(to(supply(mortgages?( o The(banks(didn’t(own(the(mortgages(–(they(would(sell(the(mortgage(within(days(of(writing( it;(even(if(the(buyer(could(not(afford(the(mortgage,(it(wasn’t(the(banker’s(job(to(counsel(the( homebuyer( o ‘Liar(loans’(–(a(substantial(amount(of(negative-amortization(mortgages(were(provided( without(the(bankers(verifying(the(borrowers’(income(or(assets;(they(only(consulted(the( credit(rating(agencies((Moody’s)( • These(were(not(the(only(reasons(that(contributed(to(the(proliferation(of(mortgages:( o Nowadays,(the(application(for(a(mortgage(is(a(much(more(automated(process(–(a(few(clicks( and/or(phone(calls(and(no((or(minimum)(interaction(with(a(banker( o Credit(Default(Swaps((CDS)(–(fears(of(foreclosures(led(to(the(emergence(of(the(CDS,(which(is( an(insurance(on(MBS(in(case(borrowers(fail(to(pay(their(debts( o The(CDS(eased(investors’(concerns(and(kept(the(bubble(going( o CDS(were(not(regulated(as(insurance(policies(even(though(they(are((typically,(sufficient( capital(is(required(and(reinsurance)( o Everyone(was(too(happy(to(be(concerned(with(the(CDS(–(homeowner(wealth(and( homeownership(flourished(and(the(insurers(had(a(very(profitable(line(of(business( Pop(goes(the(bubble( • The(people(who(used(the(negative-amortization(mortgages(believed(that((a)(their(income(will(!(and( they(will(be(able(to(cover(the(increased(payments(and/or((b)(the(housing(prices(will(keep(rising( • Imagine(the(price(of(a(house(falls(from($250,000(to($200,000(because(the(fundamentals(are(now( starting(to(take(over( o Becomes(apparent(that($250,000(for(a(house(that(is(not(that(big(and/or(not(in(the(best( neighbourhood(might(be(too(much( o Owner(must(still(pay($1656(per(month,(because(they(owe($283,250( • What(are(the(owner’s(options?( o 1)(Sell(the(house(–(but(this(probably(wouldn’t(be(enough(to(pay(off(the(debt(since(the(value( of(the(house(has(¯,(à(might(need(another(non-collateralised(loan( o 2)(Go(bankrupt(–(this(will(eliminate(the(ability(to(get(credit( • One(of(the(consequences(of(the(bubble(then(was(the(!(of(foreclosures(since(2006:( o In(2007(and(2008,(foreclosures(!(by(51%(and(81%,(respectively;( o In(Nevada(in(early(2009,(1(in(14(homes(were(in(some(sort(of(foreclosure( o Hardest(hit(states(were(California,(Nevada(and(Florida:(the(total(housing(costs(far(exceeded( the(30%(of(family(income(threshold((about(81%(in(Los(Angeles)( o In(2008,(1(in(6(households(in(the(US(were(above(the(30%(guideline( ( (

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ECO1016:(Contemporary(Issues(in(Economics( ( Miguel(Flores(&(Panos(Arsenis( ( Effect(on(the(overall(economy( • Impact(of(the(housing(bubble(was(modest(in(2006(and(most(of(2007(à(late(2007(it(snowballed( (securitised(mortgages’(value(was(in(doubt)(à(became(apparent(in(the(fall(of(2008((Lehman( Brothers(collapse)( • The(US(govt(took(measures(to(prevent(a(massive(financial(meltdown((similar(reactions(occurred(in( the(UK):( o Take(ownership(in(lenders/banks(–(the(US(govt(took(equity(stakes(in(US(financial(institutions( such(Bank(of(America(and(Citigroup(in(exchange(for(capital( o Nationalisation(–(the(US(Treasury(Dept.(took(ownership(of(both(Fannie(Mae(and(Freddie( Mac(and(the(Federal(Reserve(took(a(stake(in(AIG((American(International(Group(–( multinational(insurance(corporation)( o Toxic(asset(purchases(–(the(Federal(Reserve(removed(some(of(the(toxic(assets((securities( mortgages)(from(banks’(balance(sheets( • From(September(2008(until(the(end(of(the(year(capital(markets(were(almost(frozen(à(consumer( spending(¯( • Automakers(like(GM(and(Chrysler(experienced(sharp(declines(in(car(purchases(and(required(govt( assistance( • Decline(in(economic(activity(was(the(steepest(since(the(Great(Depression(in(the(1930s( • One(interesting(feature(of(the(housing(bubble,(that(delayed(the(housing(market(finding(its( ‘bottom’,(was(the(difficulty(in(selling(homes(whose(debt(was(greater(than(their(value( • Specifically,(the(securitisation(makes(the(process(of(short(selling(even(more(involved( • The(process(of(short(selling(involves(a(buyer(and(a(seller(of(a(home(agreeing(to(a(price(and(the( mortgage(company(agreeing(to(write(off(the(difference(between(the(price(of(the(home(and(what(is( owed(to(the(mortgage( • Until(this(process(is(completed,(many(homes(will(remain(unoccupied(in(places(like(Nevada( ( The'recession'of'2007-2009' Before(it(began( • Recession(of(that(period(was(one(of(the(most(severe(recessions(in(post-WWII(history( • Housing(was(providing(the(steam(behind(this(growth(–(the(price(of(homes(was(!(at(a(remarkable( rate( • Under(normal(circumstances,(!(house(prices(may(deter(many(individuals(from(buying(a(home(but( banks(were(very(eager(to(provide(loans(because(the(expectation(was(the(prices(will(keep(!(à(even( if(the(borrower(defaulted(on(the(loan,(the(bank(would(unload(the(house(for(more(than(the(loan( value(à(no(money(loss( • Rising(housing(prices(then(fuelled(two(distinct(housing(booms:( o Home(building( o Home(equity(lines(of(credit( • Moreover,(the(financial(crisis(of(the(1990s((Asia(in(1997-98(&(Russia(in(1998)(prompted(several( developing(countries(to(change(their(macroeconomic(stance( • Until(then,(many(of(these(countries(had(modest(trade(and(current(account(deficits(–(X-Z(=(balance( of(payments( • The(crises(led(to(a(sharp(declines(in(foreign(borrowing,(¯(in(currency(and(stock(market(value(and( recessions( • As(a(result,(these(countries(started(saving(and(lending(to(the(rest(of(the(world((especially(to(the(US)( o Countries(started(spending(a(lot(of(money(abroad(but(then(later(started(saving( o These(countries(then(channelled(their(savings(into(the(US(market(and(hence(invested(in(it(–( US(market(is(safe(due(to(political(stability(at(the(time(and(is(an(economy(that(is(likely(to( grow( (

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ECO1016:(Contemporary(Issues(in(Economics( ( Miguel(Flores(&(Panos(Arsenis( ( o This(fuelled(the(price(of(assets,(especially(houses,(due(to(investment(from(other(countries( • The(capital(markets(in(advanced(economies(were(flooded(with(these(savings(and(demand(for( investment(!,(which(contributed(to(rising(US(asset(markets((incl.(stock(and(housing(market)( • At(the(same(time,(European(global(banks(were(borrowing(from(the(US(money(markets(and(they( were(using(funds(to(buy(securitised(assets(à(they(helped(inflate(the(US(bubble(by(indirectly( providing(credit(to(US(borrowers( o Essentially(trading(mortgage-backed(securities( o Higher(demand(for(securities(lead(to(!(in(prices(à(hence(inflation(in(US(bubble( o Securities(were(resold(as(it(is(profitable(due(to(high(demand(for(it( A(bit(of(a(background(in(monetary(policy( • Nowadays,(central(banks(of(developed(economies(set(inflation(targets(that(they(try(to(meet(using( monetary(tools( o Used(by(govts(to(mitigate(the(adverse(effect(of(the(housing(market( o Largely(independent,(not(controlled(by(the(govt(–(UK(inflation(target(set(to(be(low(and( stable(à(2%((+/-(1%)( o UK(inflation(rate(21st(Dec(–(1.2%( • Typically,(central(banks(use(open-market(operations(to(control(inflation(–(buying(and(selling(of( bonds(that(!(and(¯,(respectively,(the(money(supply( o Bonds(are(agreements(between(two(parties((borrower(and(lender)(–(lender(will(provide( some(funds(to(borrower,(then(borrower(will(have(to(pay(back(with(interest( o Relatively(safe,(but(because(it’s(issued(by(the(govt(it’s(unlikely(that(it(will(fail,(always(funds( to(repay(their(creditors( o Compared(to(stocks(in(the(markets(which(are(much(more(volatile( • How(does(this(channel(work?( o Firstly,(interest(rate(is(the(‘price’(at(which(people(lend(or(borrow(money( o Central(bank(will(control(money(supply(by(buying(and(selling(bonds,(by(buying(bonds(it(will( !(money(supply(wince(the(central(bank(offers(money(in(return( § Shift(to(the(right(of(the(money(supply(which(leads(to(lower(interest(rates(–(larger( amount(of(loanable(funds(available( o Imagine(the(central(bank(buys(bonds((debt)(à(money(supply(!(à(interest(rate(¯(à( borrowing(costs(for(firms(and(households(¯(à(AD(!( § All(other(banks(then(have(lower(interest(rate(alongside(central(bank(rate(à(as(a( result,(economy(can(grow(through(economic(growth(etc.( § Commercial(banks(have(different(rates(for(different(products(–(i.e.(credit,(mortgage,( loan(etc.( • NB:(There(are(several(different(rates(in(the(markets( o Bank(of(England(sets(the(Official(Bank(Rate,(which(is(different((lower)(to(the(interest(rate(for( home(loans(or(credit(cards( • Apart(from(the(open-market(operations,(another(monetary(tool(is(the(reserve(ratio:(the(percentage( of(every(deposit(made(in(a(checking(account(that(a(bank(must(maintain(at(the(central(bank( o Amount(of(deposit(that(is(held(at(the(central(bank(and(this(is(a(financial(regulation(that( every(commercial(bank(must(meet( o For(US(&(UK(there(is(a(certain(lower(minimum(rate( o Every(bank(has(the(obligation(to(give(you(back(the(money(that(you(put(in(your(account( through(ATMs(etc.( • If(the(central(bank(lowers(the(ratio,(how(would(the(money(supply(change?( o Ratio(may(change,(say(!,(if(central(bank(asks(for(a(higher(deposit,(money(supply(would(¯( o Savings(rate(is(low( ( (

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ECO1016:(Contemporary(Issues(in(Economics( ( Miguel(Flores(&(Panos(Arsenis( ( Balance(sheets(and(leverage( • Many(basic(issues(of(the(financial(crisis(can(be(better(understood(by(looking(at(balance(sheets(and( leverage( o Balance(sheets(help(to(gain(insights(as(to(how(a(bank(works(and(what(is(happening(in(the( bank(–(shows(why(banks(were(so(willing(to(lend(credit(in(the(run(up(to(the(recessions( o Shows(what(the(bank(loans(and(what(other(agents,(firms/households,(owe(to(the(bank( • Focus(on(the((hypothetical)(balance(sheet(of(a(large(commercial(bank((Bank(of(America):( ( ( ( ( ( ( ( ( ( ( ( • Assets(–(loans(are(what(a(bank(does(à(how(it(makes(money!((interest(etc.)( o Bank(may(buy(bonds/stocks/securities,(invest(in(MBS( o Part(of(the(investment(is(in(MBS(–(how(banks(are(exposed(to(the(housing(market( o Bonds(are(safer(than(securities(but(securities(are(more(profitable(despite(the(risk( o Reserves(are(the(money(that(is(kept(at(the(central(bank( o Loans(–(mortgages(&(loans(to(businesses( o Investments(–(Treasury(bonds(and(mortgage-backed(securities( o Cash(&(Reserves(–(includes(reserves(required(to(hold(on(deposit(with(the(Federal(Reserve( • Liabilities(–(deposits(are(the(money(that(you(put(in(the(bank,(hence(the(bank(is(‘indebted’(to(you( o In(order(for(a(bank(to(perform(on(a(day-to-day(basis,(needs(to(borrow(money(to(do( investments,(transactions(between(banks(etc.( o Short-term(debt(expires(within(a(few(weeks(or(a(month( o There(is(heavy(trading(between(banks( o Long-term(debt(expires(within(a(year(or(a(few(years( o All(banks(rely(on(each(other(in(order(to(function( o Deposits(–(made(by(households(&(businesses,(these(are(funds(owed(to(someone(else( o Short-term(debt(–(30-day(commercial(paper( o Long-term(debt(–(10-year(corporate(bonds( • Equity/Capital(–(Equity(are(assets(–(liabilities( o Can(be(positive(or(negative( o Equity(is(on(the(liability(side(because(the(banks(are(private(–(this(is(what(is(owed(to(the( shareholders(of(the(ban( • Balance(sheet(consist(of(assets((what(the(bank(owns)(and(liabilities((what(the(bank(owes(to(others)( o Balance(sheet(because(both(columns(must(balance(à(the(equity/net(worth/capital(makes( them(balance( o Equity(=(total(assets(–(total(liabilities( • Equity(is(the(value(of(the(institution((in(this(case,(the(bank)(to(its(shareholders/owners(–(it(is(owed( to(someone(else,(thus(it(is(a(liability( • Regulations(for(the(bank(not(to(perform(excessively(risky(investments(and(to(not(become(insolvent( • Banks(are(subject(to(financial(regulations:( o Reserve(requirement(–(already(mentioned(above(as(reserve(ratio((typical(value(is(3%(of( deposits).(Part(of(the(deposit(that(needs(to(be(in(the(central(bank( (

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ECO1016:(Contemporary(Issues(in(Economics( ( Miguel(Flores(&(Panos(Arsenis( ( o Capital(requirement(–(which(requires(the(bank’s(capital(to(be(at(least(a(certain(fraction(of( the(bank’s(total(assets((e.g.(6%)( • Example:(reserve(requirement(=>(100/1000(=(10%(and(capital(requirement(=>(200/2000(=(10%( • Leverage(was(at(the(heart(of(the(global(financial(crisis( o Assets(=(Equity(+(liabilities( o Equity((shareholders)( o From(leverage,(we(can(see(how(much(the(bank(relies(on(borrowing( o Higher(leverage(=(more(risk( • Leverage(is(given(by:( ( ( ( ( • For(the(bank(in(the(balance(sheet,(leverage(=(1800/200(=(9( o This(value(suggests(that(for(every($10(of(assets(the(bank(holds,($9(is(essentially(financed(by( borrowing(and(only($1(is(financed(by(money(from(shareholders( • \(leverage(magnifies(any(changes(in(the(value(of(assets(and(liabilities(in(terms(of(the(return(to( shareholders( • Insolvent(–(when(you’re(in(debt( o Solvent(–(not(in(debt( • The(last(statement(should(become(apparent(with(the(following(example:( o Assume(that(the(bank(had(a(good(year(and(i...