Published on 12 Jul 2016
Most borrowers borrow through banks. But established and reputable institutions can also borrow from a different intermediary: the bond market. That’s the topic of this video. We’ll discuss what a bond is, what it does, how it’s rated, and what those ratings ultimately mean.
First, though: what’s a bond? It’s essentially an IOU. A bond details who owes what, and when debt repayment will be made. Unlike stocks, bond ownership doesn’t mean owning part of a firm. It simply means being owed a specific sum, which will be paid back at a promised time. Some bonds also entitle holders to “coupon payments,” which are regular installments paid out on a schedule.
Now — what does a bond do? Like stocks, bonds help raise money. Companies and governments issue bonds to finance new ventures. The ROI from these ventures, can then be used to repay bond holders. Speaking of repayments, borrowing through the bond market may mean better terms than borrowing from banks. This is especially the case for highly-rated bonds.
But what determines a bond’s rating?
Bond ratings are issued by agencies like Standard and Poor’s. A rating reflects the default risk of the institution issuing a bond. “Default risk” is the risk that a bond issuer may be unable to make payments when they come due. The higher the issuer’s default risk, the lower the rating of a bond. A lower rating means lenders will demand higher interest before providing money. For lenders, higher ratings mean a safer investment. And for borrowers (the bond issuers), a higher rating means paying a lower interest on debt.
That said, there are other nuances to the bond market—things like the “crowding out” effect, as well as the effect of collateral on a bond’s interest rate. These are things we’ll leave you to discover in the video. Happy learning!
September 20, 2017
Intro to the Bond Market
August 23, 2017
Intro to Stock Markets
Published on 5 Jul 2016
Today, we’ll examine a new kind of financial intermediary: stock markets.
As an individual, you participate in the stock market when you buy a company’s shares. This turns you into a part-owner, entitled to some of the company’s profits. Sometimes, profits are paid out directly via dividends. Other times, profits are reinvested for company growth. In this case, you benefit by seeing the value of your shares rise in tandem with this growth.
Still, the buying and selling of stock doesn’t actually create any new investment. Buying and selling only transfers ownership between stockholders. What actually creates investment is when a company offers stock to the public for the first time (known as an Initial Public Offering or IPO), which is when it issues new shares to raise money for key ventures.
This process of turning savings into investment is what makes the stock market an intermediary.
A key caveat, though — buying stock essentially means betting on a company. As with all gambles, sometimes it pays off, sometimes, it doesn’t. For you as a saver, this means some of your stocks will win, and others, not so much.
This volatility makes stock markets more risky than banks. Bank savers typically don’t have to worry about fluctuations in the value of their deposits.
As for the entrepreneurial side, the stock market is a key institution encouraging new businesses. For a founder, the payoff typically comes during the IPO. An IPO allows founders to sell some of their ownership (in a now more-valuable company) so they can diversify their own holdings.
Next time, we’ll look at the third kind of intermediary: bond markets.
August 18, 2017
What Do Banks Do?
Published on 28 Jun 2016
This week: Dive deeper into one type of financial intermediary: Banks.
Next week: Sticking with macroeconomics, we’ll take a look at the next intermediary: Stock Markets.
Some people want to save and invest, others want to borrow. Sometimes, savers and borrowers link up directly. But most times, they don’t know each other. So they rely on institutions that bridge them together. These bridges are called financial intermediaries, and this video will show you one kind—banks.
How do banks operate?
On the savings side, they attract depositors by paying interest on deposits. On the borrowing side, banks make loans, for which they charge interest. The key to a bank’s profit is in charging a higher interest for loans than the interest paid out to depositors. Of course, to make sure that loans are as productive as possible, banks have specialized staff and systems for evaluating loan applications.
That sort of due diligence, and specialization is central to what a bank does. Not only does a bank coordinate the savings of many, but it also undertakes the task of studying borrowers in order to determine the most qualified. And then, to further minimize risk, a bank will spread its money out across a whole portfolio of loans. Thus, if one loan goes bad, the bank won’t go bankrupt.
In this way, you can see how banks provide valuable services—they allow you to earn interest on your savings, while also turning those savings into loans, which help economic growth.
Notice though, that as a depositor, your savings won’t just rest in a vault. But then, what happens when you decide to make a withdrawal? Banks account for that by having reserves. Banks keep an eye on their reserves so they can cover the withdrawals of various depositors. Predictably, problems arise, when there aren’t enough reserves to cover withdrawals. In the words of our previous video, that’s one kind of failed intermediation.
In the next video, we’ll look at a different kind of intermediary — stock markets.
There, we’ll show you how stock markets turn savings into investment. Hang tight, and see you then!
August 13, 2017
Saving and Borrowing
Published on 21 Jun 2016
On September 15, 2008, Lehman Brothers filed for bankruptcy, and signaled the start of the Great Recession. One key cause of that recession was a failure of financial intermediaries, or, the institutions that link different kinds of savers to borrowers.
We’ll get to intermediaries in the next video, but for now, we’ll first look at the market intermediaries are involved in.
This market is the combination of savers and borrowers — what we call the “market for loanable funds.”
To start, we’ll represent the market, using two curves you know well—supply and demand. The quantity supplied in the market comes from savings, and the quantity demanded comes from loans. But as you know, we have to factor in price. In the case of the market for loanable funds, the price is the current interest rate.
What happens to the supply of savings when the interest rate goes up? When are borrowers compelled to borrow more? Or less? We’ll cover these scenarios in this video.
One quick note: there’s not really one unified market for loanable funds. Instead, there are many small markets, with different sorts of lenders, lending to different sorts of borrowers. As we said in the beginning, it’s financial intermediaries, like banks, bond markets, and stock markets, which link these different sides of the market.
We’ll get a better understanding of these intermediaries in our next video, so stay tuned!
August 7, 2017
The Idea Equation
Published on 31 May 2016
Alex Tabarrok’s TED talk showed you that ideas can trump nearly every crisis. Now, since ideas are so important, we have to ask: is the future of ideas a bright one?
To answer that, we’ll look at something we call the Idea Equation.
It goes like this: Ideas = Population x Incentives x Ideas/per hour.
This equation is a useful way to lay out the factors affecting idea production. When we understand the factors behind production, then we can better predict how the future will go.
Now, the first factor in the equation, is population.
Population determines how many possible idea creators we can have. The good news is, not only is world population growing, but a larger percentage of that population is becoming part of the researcher pool. For instance, China now has 1 researcher per thousand people. This seems low, until you remember they had about half a researcher per thousand in the year 2000. This means they’ve doubled their researcher pool, in just about 10 years.
So, on the population front, we’re seeing progress.
But how about the incentives that encourage idea creation? What’s the state of those?
That’s factor 2 in the equation, and again, we have good news here.
See, for the most part, countries are now choosing better institutions. On balance, the world now has more dependable legal systems, and more honest governments. Previously closed-off nations are now opening their markets to competition and trade. Aside from that, the world is generally becoming more politically stable, and property rights are strengthening as well.
As a result of these better institutions, there are now more incentives to produce ideas. Not to mention, we’re still continuing to globalize world markets. Remember what the TED talk said? Larger markets incentivize more R&D, and we’re certainly seeing higher activity in this area.
For example, in 1990, only seven nations accounted for 92% of world research spending. Today, those same 7 countries only account for 56%. Countries like China, Korea, and Brazil have already joined the fray, sharing the burden of idea creation, which benefits us all.
That said, we do still have the third part of the Idea Equation. This is where things get hairy.
You see, the factor “ideas/per hour” is the most mysterious one. Yes, it measures the productivity of idea creators, but we’re still unsure how productive the future will be. For one, there’s evidence that idea creation is becoming more expensive in certain fields. But on the other hand, we’re also seeing new technology that makes idea creation easier—things like the Internet, AI, and online education.
As long as we continue to globalize markets, provide better incentives for idea production, and keep developing technology that makes idea creation easier, then there’s no reason to think that the future can’t be bright. The brightness may not be guaranteed, but at least there’s hope, which is what matters.
July 31, 2017
Patents, Prizes, and Subsidies
Published on 17 May 2016
Growth on the cutting edge is all about the creation of new ideas.
So, we want institutions that incentivize such creation. How do we do this? The answer is somewhat tricky.
The first goal for good ideas is for them to spread as freely as possible. The further the reach, the greater the gains. The problem is, if just anyone can use ideas, then why would we ever pay for them? And without the right incentives, why would innovators create new ideas at all?
Imagine yourself as the creator of a new drug. Typically, it costs about a billion dollars to do this, not counting the time and effort needed to get the drug FDA-approved.
Now, if there were no protections in place, then theoretically, once the formula’s known, everyone could just copy the make-up of your new drug. See, the thing about pharmaceuticals is, once the formula’s known, production is relatively cheap. Given that, let’s assume imitations start flooding the market.
Predictably, the price of your new drug will plummet.
Once prices hit rock-bottom, you’ll have no way to recoup the $1 billion you spent on R&D.
Given that kind of result, we reckon you probably won’t want to develop more good ideas.
The US founding fathers anticipated this problem. Knowing that innovators needed incentives to have good ideas, the founders wrote a protection mechanism into the Constitution.
They gave Congress the ability to grant exclusive rights to inventors — rights to use and sell their inventions, for a limited period of time. This exclusive right, is what we call a patent. Patents grant inventors a temporary monopoly over the use and sale of their intellectual property.
Now, as nice as this is, patents are a thorny subject.
For one, how long should patents last? Also, how much innovation is considered enough to merit a patent grant? Not to mention, are patents the only way to reward good ideas?
The answer is no.
There are two more incentive options here: prizes, and subsidies.
Let’s start with subsidies. University and research subsidies are particularly effective in the basic sciences. Since innovations in this space are rather abstract, subsidies incentivize research without requiring the applications of the research to be explicitly named. The problem is, when we’re incentivizing just research, then researchers might pick directions that are interesting, but not particularly useful.
This is why the third incentive option — prizes — exists.
Prizes reward the output of solving a certain problem. Another plus, is that prizes leave solutions unspecified. They provide a problem to work on, but give quite a lot of leeway as to how the problem is solved.
Now, knowing the complexity inherent in patents, you might think that prizes and subsidies are good enough alternatives. But none of these incentives for ideas, are inherently better than any of the others. Patents, prizes, and subsidies all involve their own tradeoffs and questions.
For example, who decides what gets subsidized? Who decides which goals merit a prize?
It’s hard to determine what mix of institutions, will best incentivize the production of good ideas. Patents, prizes, and subsidies all navigate these conflicting goals, in their own way.
And yes, all this talk of incentives and conflicting goals and tradeoffs might be like walking a tightrope. But, it’s a tightrope we can’t opt out of. Certainly not if we want the economy to keep growing.
In our next release, you’ll watch a TED talk from a certain economist that elaborates further on ideas. And then, we’ll wrap up this course segment with the Idea Equation. Stay tuned!
July 24, 2017
The Economics of Ideas
Published on 10 May 2016
At the end of our last video, we asked, “What spurs the growth of new ideas?”
To answer that, we’ll tell you two stories.
The first is about a man named John Kay.
He created the flying shuttle, one of the key inventions of the Industrial Revolution. His shuttle improved looms, and made it possible to produce clothes quicker and more cheaply. This allowed larger numbers of people to have new, clean clothes, and it made fashion something that was no longer just for the rich. But what did he get for his efforts?
Well, the weavers who were threatened by his invention broke the improved looms and his house was burned down. He eventually fled to France, fearing for his life, and eventually died there, a poor man.
Our second story paints a completely different picture.
It’s about a man almost everyone knows: Steve Jobs.
Like Kay, Steve Jobs was also an innovator, pioneering products like the iPod, iTunes, iPhone, and the iPad. For his efforts, he earned not only money but recognition as well. Unlike John Kay, Steve Jobs became an icon, celebrated for his achievements in the world.
Why such a stark difference between these two men?
When we examine the differences between John Kay and Steve Jobs, we’re also looking at the thing that either dooms an idea or allows it to prosper. This vital factor is institutions, which serve as the soil where ideas are planted.
Depending on the quality of said soil, the ideas either take root, or they shrivel into nothingness.
To understand how this is, think of the institutions in the United States today.
The US has institutions that encourage the germination and growth of ideas. If you’re an entrepreneur, America has incubators and investors, ready to fund your idea if it’s a good one. In the US, you also have recourse to laws that protect your idea, not to mention a culture that celebrates innovators. And, if your idea’s a good one, the market will handsomely reward you.
To tell you the truth, John Kay could only have dreamed of institutions like the ones we have today.
As you can see, good institutions can mean the difference between an idea withering and an idea thriving.
While it may seem like ideas grow at random, the truth is you need a set of key ingredients, or what we call “institutions.”
In the next video, we’ll see how patents affect the growth of ideas, and we’ll examine the trade-offs between protecting and sharing ideas. Last, we’ll also look at the role the government can play, in providing a stable environment where ideas can flourish.
July 18, 2017
The Solow Model and Ideas
Published on 3 May 2016
More Solow Model from MRU’s Macro course: the power of ideas in driving economic growth.
A deeper dive into what helps spur the creation of ideas.
According to our previous videos in this section, the Solow model seems to predict that we’ll always end up in a steady state with no economic growth.
But, the Solow model still has one variable unaccounted for: ideas.
So, can ideas keep us growing?
Ideas do one thing really well: they give us more bang for our buck.
This means we get more output for the same inputs of capital and labor. Ideas are a way of upping our productivity, increasing output per worker across different industries.
Just how much extra output are we talking about?
Well, imagine changing the A variable of the Solow model from 1 to 2. This means a doubling of our productivity.
This shifts the entire output curve upward. When output doubles, so does investment. Once investment comes in faster than depreciation, we end up accumulating capital once again.Thus, the economy keeps growing, which further boosts output.
Now, think of what would happen, if ideas continually improved. With each improvement, ideas would keep shifting the output curve upward, which will continually increase investment as well, and allow us to keep to the left of the steady state.
And when we stay to the left, that means we keep growing.
What all this means is, growth at the cutting edge is determined by two things.
First, it’s determined by how fast new ideas are formed, and second, by how much those ideas increase productivity.
You now have a complete picture of our simple Solow model. It’s a model that accounts for catching up growth, due to capital accumulation, and cutting edge growth, due to the buildup of ideas.
Now, since ideas foster growth at the cutting edge, we’re left with the question that naturally follows: what factors help spur the accumulation of ideas?
That’s what we’ll discuss in the next video, so hang tight!
July 15, 2017
Office Hours: The Solow Model: Investments vs. Ideas
Published on 7 Jun 2016
Ideas are a major factor in economic growth. But so are saving and investing. If you were given the choice between living in an inventive (more ideas) or a thrifty (more savings) country, which would you choose?
The Solow model of economic growth, which we recently covered in Principles of Macroeconomics, can help you make the choice. In this Office Hours video, Mary Clare Peate will use our simplified version of the Solow model to show you an easy way to work out each country’s economic prospects, and then compare them to see where you’d rather be.
June 26, 2017
Human Capital & Conditional Convergence
Published on 26 Apr 2016
In our previous macroeconomics video, we said that the accumulation of physical capital only provides a temporary boost to economic growth. Does the same apply to human capital?
To answer that, consider this: what happens to all new graduates, in the end?
For a while, they’re productive members of the economy. Then age takes its toll, retirement rolls around, and eventually, the old workforce is replaced with a new infusion of people. But then, the cycle restarts. You get a new workforce, everyone’s productive for a while, and then they too retire.
Does this ring a bell?
It should, because this is similar to the depreciation faced by physical capital.
Similarly, are there diminishing returns to education? It likely wouldn’t pay off for everyone to have a PhD, or for everyone to master Einstein’s great theories.
That means the logic of diminishing returns, and the idea of a steady state, also applies to human capital.
So, now we can revise our earlier statement.
Now we can say that the accumulation of any kind of capital, only provides a temporary boost in economic growth. This is because all kinds of capital rust. So, one way or another, we’ll reach a point where new investments can only offset depreciation.
It’s the steady state, all over again.
However, what does the journey to steady state look like?
The Solow model predicts that poor countries should eventually catch up to rich countries, especially since they’re growing from a lower base. And given their quicker accumulation of capital, poorer nations should also grow faster, than their more developed neighbors.
And eventually, every country should reach similar steady states.
In other words, we would see growth tracks that all eventually converge.
So, why isn’t this always the case? Why, in some cases, are we seeing “Divergence, Big time,” as coined by economist Lant Pritchett?
The answer to these questions, lies in the institutions of different countries and the incentives they create.
Assuming that a certain set of countries do have similar institutions, that’s where we see the convergence predicted by the Solow model. We see that poorer countries do grow faster than their richer counterparts. And conditional on having similar institutions, eventually, even poorer countries will reach a similar steady state of output as more developed nations. We call this phenomenon conditional convergence.
You can think of it as a national game of catch-up, with catch-up only happening if institutions don’t differ.
What happens though, once all this catching up is done?
Let’s not forget that there’s still another variable in the Solow model. This is variable A: ideas — the subject of our next video.
There, we’ll show you how ideas can keep a country moving along the cutting edge of growth.
June 21, 2017
Physical Capital and Diminishing Returns
Published on 29 Mar 2016
Do you recall our question about Germany and Japan from our previous video?
How did they achieve record economic growth following World War II?
Today’s video will help answer that question. We’ll be digging into the K variable of our simplified Solow model: physical capital.
To help with our discussion, we’ll be exploring two specific concepts. The first is the iron logic of diminishing returns which states that, for each new input of capital, there is less and less output produced. Your first input of capital will likely be the most productive, because you’ll allocate this first unit to the most important, value-adding tasks.
The second concept we’ll cover is the marginal product of capital. This concept describes the output created by each new unit of invested capital.
Can you already see how these two forces of capital help answer our question about Germany and Japan?
For these two war-torn countries, the first few units of invested capital had a lot of bang for their buck. The first roads between destroyed cities, the first new steel mills, the first new businesses — these helped boost their growth rate tremendously.
Even more so, remember that Germany and Japan were growing from a low economic base after the war. It’s easy to grow a lot when the base is small. But all else being equal, you’d rather have a larger base, and grow slower.
Capital has some more nuances worth thinking about, which we’ll show in the next video. So get to watching, and in our next macroeconomics video, we’ll show you yet another problem surrounding physical capital.
June 19, 2017
Office Hours: The Solow Model
Published on 20 Apr 2016
In last week’s Principles of Macroeconomics video, you learned about the steady state level of capital and the Solow model of economic growth. Here are two of the practice questions from that video:
Country A has K=10,000 and produces GDP according to the following equation: GDP=5√K.
1) If the country devotes 25% of its GDP to making investment goods, how much is the country investing?
2) If 1% of all machines become worthless every year (they depreciate, in other words) in Country A, GDP is…?
June 4, 2017
Intro to the Solow Model of Economic Growth
Published on 28 Mar 2016
Here’s a quick growth conundrum, to get you thinking.
Consider two countries at the close of World War II — Germany and Japan. At that point, they’ve both suffered heavy population losses. Both countries have had their infrastructure devastated. So logically, the losing countries should’ve been in a post-war economic quagmire.
So why wasn’t that the case at all?
Following WWII, Germany and Japan were growing twice, sometimes three times, the rate of the winning countries, such as the United States.
Similarly, think of this quandary: in past videos, we explained to you that one of the keys to economic growth is a country’s institutions. With that in mind, think of China’s growth rate. China’s been growing at a breakneck pace — reported at 7 to 10% per year.
On the other hand, countries like the United States, Canada, and France have been growing at about 2% per year. Aside from their advantages in physical and human capital, there’s no question that the institutions in these countries are better than those in China.
So, just as we said about Germany and Japan — why the growth?
To answer that, we turn to today’s video on the Solow model of economic growth.
The Solow model was named after Robert Solow, the 1987 winner of the Nobel Prize in Economics. Among other things, the Solow model helps us understand the nuances and dynamics of growth. The model also lets us distinguish between two types of growth: catching up growth and cutting edge growth. As you’ll soon see, a country can grow much faster when it’s catching up, as opposed to when it’s already growing at the cutting edge.
That said, this video will allow you to see a simplified version of the model. It’ll describe growth as a function of a few specific variables: labor, education, physical capital, and ideas.
So watch this new installment, get your feet wet with the Solow model, and next time, we’ll drill down into one of its variables: physical capital.
Helpful links:
Puzzle of Growth: http://bit.ly/1T5yq18
Importance of Institutions: http://bit.ly/25kbzne
Rise and Fall of the Chinese Economy: http://bit.ly/1SfRpDL
June 1, 2017
QotD: Economics
Science may be the noblest endeavor of the human mind, but I believe (though I cannot prove) that the most crippling and dangerous kind of ignorance in the modern West is ignorance of economics, the way markets work, and the ways non-market allocation mechanisms are doomed to fail. Such economic ignorance is toxic, because it leads to insane politics and the empowerment of those whose rhetoric is altruist but whose true agenda is coercive control.
Eric S. Raymond, “What Do You Believe That You Cannot Prove?”, Armed and Dangerous, 2005-01-06.
May 26, 2017
Puzzle of Growth: Rich Countries and Poor Countries
Published on 16 Feb 2016
Throughout this section of the course, we’ve been trying to solve a complicated economic puzzle — why are some countries rich and others poor?
There are various factors at play, interacting in a dynamic, and changing environment. And the final answer to the puzzle differs depending on the perspective you’re looking from. In this video, you’ll examine different pieces of the wealth puzzle, and learn about how they fit.
The first piece of the puzzle, is about productivity.
You’ll learn how physical capital, human capital, technological knowledge, and entrepreneurs all fit together to spur higher productivity in a population. From this perspective, you’ll see economic growth as a function of a country’s factors of production. You’ll also learn what investments can be made to improve and increase these production factors.
Still, even that is too simplistic to explain everything.
So we’ll also introduce you to another piece of the puzzle: incentives.
In previous videos, you learned about the incentives presented by different economic, cultural, and political models. In this video, we’ll stay on that track, showing how different incentives produce different results.
As an example, you’ll learn why something as simple as agriculture isn’t nearly so simple at all. We’ll put you in the shoes of a hypothetical farmer, for a bit. In those shoes, you’ll see how incentives can mean the difference between getting to keep a whole bag of potatoes from your farm, or just a hundredth of a bag from a collective farm.
(Trust us, the potatoes explain a lot.)
Potatoes aside, you’re also going to see how different incentives shaped China’s economic landscape during the “Great Leap Forward” of the 1950s and 60s. With incentives as a lens, you’ll see why China’s supposed leap forward ended in starvation for tens of millions.
Hold on — incentives still aren’t the end of it. After all, incentives have to come from somewhere.
That “somewhere” is institutions.
As we showed you before, institutions dictate incentives. Things like property rights, cultural norms, honest governments, dependable laws, and political stability, all create incentives of different kinds. Remember our hypothetical farmer? Through that farmer, you’ll learn how different institutions affect all of us. You’ll see how institutions help dictate how hard a person works, and how likely he or she is to invest in the economy, beyond that work.
Then, once you understand the full effect of institutions, you’ll go beyond that, to the final piece of the wealth puzzle. And it’s the most mysterious piece, too.
Why?
Because the final piece of the puzzle is the amorphous combination of a country’s history, ideas, culture, geography, and even a little luck. These things aren’t as direct as the previous pieces, but they matter all the same.
You’ll see why the US constitution is the way it is, and you’ll learn about people like Adam Smith and John Locke, whose ideas helped inform it.
And if all this talk of pieces makes you think that the wealth puzzle is a complex one, you’d be right.
Because the truth is, the question of “what creates wealth?” really is complex. Even the puzzle pieces you’ll learn about don’t constitute every variable at play. And as we mentioned earlier, not only are the factors complex, but they’re also constantly changing as they bump against each other.
Luckily, while the quest to finish the wealth puzzle isn’t over, at least we have some of the pieces in hand.
So take the time to dive in and listen to this video and let us know if you have questions along the way. After that, we’ll soon head into a new section of the course: we’ll tackle the factors of production so we can further explore what leads to economic growth.
