10.5 End-of-Chapter Material

In Conclusion

The performance of the stock market is one of the most closely watched of all economic statistics. This chapter provided some clues as to why people care so much about the value of stocks and other assets.

One reason is that people save by purchasing stocks and other assets. Thus savers want to know what determines the value of assets in the economy. Having read this chapter, you should now understand that the value of any asset is closely linked to the flow of benefits that the asset provides. Indeed, if markets are efficient, then the value of any asset should equal the discounted present value of the flow of benefits.

There are two other reasons why we pay so much attention to the stock market. (1) If the value of a stock reflects the discounted present value of expected dividends, then the market capitalization of a firm represents the best guess as to the value of that firm—which depends ultimately on the profits that it will generate in the future. In that case, a stock market index represents our best guess of the overall value of all firms. It truly is a measure of an economy as a whole. (2) The stock market plays a key role in allocating an economy’s saving to those firms that can make the most profitable use of those funds.

Exercises

  1. List the factors you think would make stock prices increase and decrease in the Shanghai stock exchange.
  2. An October 2007 article in the Economist magazine discusses land prices and office rents. According to the article, rents have recently increased, and land prices have been increasing in the past few years as well. Why would land prices and rents move together?
  3. Following from Question 2, what do you think has happened to the price of office buildings as rental rates have increased?
  4. Suppose an orange tree yields a crop of one orange after the first year and then two oranges in the second year. As before, let the price of an orange be $1 in both years. What is the value to you of buying the tree today and then selling it next year, after you have harvested the first orange? (Hint: first find the value of the tree tomorrow and then use that as the price for selling the tree.)
  5. Suppose an orange tree lives for two years, with a crop of five oranges in the first year and three in the second year. The price is $2 in the first year and $5 in the second year. If the interest rate is 20 percent, what is the price of the orange tree?
  6. (Advanced) The table titled Discounted Present Value Exercise provides information about the crop from an orange tree as well as the interest rate for a tree that lives four years. Assume that the price of oranges is $1 in the first year and then increases at 10 percent per year. What is the discounted present value of this tree?
  7. Suppose prospective buyers of houses become very optimistic about the future prices of houses. Existing owners, on the other hand, become very pessimistic about the future value of houses. What happens to the price of houses today?
  8. Suppose housing markets are efficient. If you see rapidly increasing prices in a market, do you think that rental rates are increasing as well?
  9. Explain how contractionary monetary policy can reduce housing prices.

  10. (Advanced) In the first row of Table 10.2 "Discounted Present Value of Dividends in Dollars", we considered a stock that pays a dividend of $1 this year and that will have a price of $2 next year. Suppose the inflation rate from this year to next year is 5 percent. There are two ways that you can correct for this inflation.

    1. You can leave next year’s price in nominal terms and deflate by the nominal interest rate, as we did in the table.

    2. You can adjust next year’s price and put it in terms of today’s dollars, so next year’s price is a “real price.” Then you can discount using the real interest rate, which you can get from the Fisher equation.

      Show that you get the same answer for the discounted present value using the second method as using the first method. (Note: when the interest rate is 10 percent, you should get exactly the same answer; when the interest rate is 5 percent, there will be a very small difference because the Fisher equation is an approximation.)

  11. Can you think of an exogenous event that would cause the demand curve but not the supply curve for an asset to shift?
  12. (Advanced) Explain why the DJIA and other stock market indices are more useful after they have been adjusted for inflation.

Economics Detective

  1. Find data from a stock exchange in another country. Create a version of Figure 10.3 "The DJIA: October 1928 to July 2007" for that stock exchange.
  2. What is the current annual return on US government bonds? What is the current annual return on government bonds issued by Argentina? How would you explain the differences in returns?
  3. Find recent data on the yields on the debt of Ireland, Spain, and Portugal. What happened to these yields, relative to the yield on German debt, in both October 2010 and November 2010? How might you explain the patterns you find? (Hint: think about our discussion of the riskiness of bonds.)
  4. The chapter opened with a discussion of the stock market in Shanghai. Suppose you wanted to buy shares of a company trading on that exchange. How would you go about doing that?
  5. Look at data on housing prices in your area. Do they fluctuate as much as stock prices?

Spreadsheet Exercise

  1. Suppose an orange tree lives for three years, with a crop of 5 oranges in the first year, 3 in the second year, and 10 in the third year. The price is $2 in the first year and $5 in the second and third years. If the interest rate is 20 percent the first year and then 10 percent the next two years, what is the price of the orange tree?

Table 10.4 Discounted Present Value Exercise

Year Number of Oranges Price of Orange Revenue Interest Rate
1 5 1.00 0.05
2 6 0.10
3 4 0.075
4 10 0.20