Econ 123: Week 2

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Questions and Answers

What was a significant change made at Carnegie Tech's Graduate School of Industrial Administration (GSIA)?

Focused solely on engineering without business courses.

Reduced the number of economists on staff.

Prioritized rule of thumb methods over rigorous techniques.

Emphasized a scientific and mathematical approach to education. (correct)

According to Modigliani and Miller, what primarily determines a firm's value?

Market perceptions and investor sentiment.

The firm’s operating income and underlying asset risk. (correct)

The capital structure used by the firm.

The dividend policy of the firm.

What does the Capital Structure Irrelevance Proposition imply?

All firms must have an optimal capital structure.

Firms should always prefer debt financing.

Higher dividends always lead to higher firm value.

The source of financing does not affect the total value of the firm. (correct)

What theory did Modigliani and Miller propose regarding dividends?

Dividend policy does not influence the firm’s overall value. Signup and view all the answers

What challenge did Modigliani and Miller face regarding the cost of capital?

They were unsure how to measure it despite its usage in business schools. Signup and view all the answers

What was the traditional view that Modigliani and Miller challenged?

Optimal capital structure does not exist. Signup and view all the answers

What humorous analogy did Miller use to explain dividend policy?

A pizza delivery man discussing pizza slices with Yogi Berra. Signup and view all the answers

How did Modigliani and Miller view the relationship between dividend payment and firm value?

The payment of dividends has no bearing on the value of the firm. Signup and view all the answers

What key finding did the Chicago study conclude about random investment strategies?

Random investments are profitable most of the time. Signup and view all the answers

What was the average return from 1926 to 1960 for stocks when dividends were reinvested?

9% Signup and view all the answers

What conclusion did Michael Jensen draw about mutual fund managers' performance?

Their performance trails the market when adjusted for risk. Signup and view all the answers

What evidence supports the efficient market hypothesis according to the studies discussed?

Even skilled analysts cannot forecast returns accurately enough to cover costs. Signup and view all the answers

What did the article from Business Week comment on the Chicago study?

It stated that random investments can be profitable. Signup and view all the answers

What main concept is being debated in the context of investment funds in the content provided?

The struggle between active and passive management strategies. Signup and view all the answers

Which institution played a role in compiling long-term stock data for the studies referenced?

Center for Research on Security Prices (CRSP). Signup and view all the answers

What does the efficient market hypothesis (EMH) imply about stock prices?

Stock prices reflect all available information. Signup and view all the answers

What theory did John Muth develop that has significantly impacted macroeconomics?

Rational Expectations Signup and view all the answers

What was a major challenge posed by Muth's rational expectations theory?

It contradicted the Keynesian view of economic expectations. Signup and view all the answers

What does Muth believe about people's expectations in relation to new information?

They adjust their expectations based on new information. Signup and view all the answers

How did the rational expectations theory influence the understanding of policy interventions?

It indicated that interventions may lack intended effects if anticipated. Signup and view all the answers

What was a common misconception about people's expectations prior to Muth's work?

People's expectations can be systematically biased. Signup and view all the answers

Who popularized the rational expectations hypothesis after Muth introduced it?

Robert Lucas Signup and view all the answers

What was a consequence of the rational expectations theory in the context of inflation and unemployment?

It complicated the relationship between inflation and unemployment. Signup and view all the answers

In what year did John Muth publish his significant paper on rational expectations?

1961 Signup and view all the answers

What does the theory of random walks suggest about stock price movements?

Future stock price movements are random and do not reflect past patterns. Signup and view all the answers

What is a key advantage of the indexing strategy in investing?

It avoids transaction costs associated with frequent trading. Signup and view all the answers

According to Bogle, what does indexing guarantee for investors?

Investors will receive their fair share of market returns. Signup and view all the answers

What did Paul Samuelson endorse in 1974?

The creation of the first index fund. Signup and view all the answers

What is a major point of contention regarding corporate managers and shareholders?

There are concerns that corporate managers may not act in the best interests of shareholders. Signup and view all the answers

Which statement best reflects Bogle's view on market efficiency?

Market prices are the best estimate of fair value and are difficult to outsmart. Signup and view all the answers

What is the primary focus of the Efficient Market Hypothesis (EMH)?

The efficiency of markets in reflecting information in stock prices. Signup and view all the answers

What is meant by passive investing as described in indexing?

Investing in a diversified portfolio without regular adjustments. Signup and view all the answers

What central weakness of large public corporations is addressed by Jensenism?

Conflict between owners and managers Signup and view all the answers

According to Kahneman and Tversky, what is the impact of cognitive biases on decision-making?

They may result in irrational decisions. Signup and view all the answers

Which heuristic involves judging the likelihood of an event based on recent memories?

Availability heuristic Signup and view all the answers

What does the framing effect illustrate about decision-making?

It highlights that presentation can influence choices significantly. Signup and view all the answers

What is loss aversion, as described in the content?

The preference to acquire gains rather than avoid losses. Signup and view all the answers

What is a common result of using heuristics in decision-making?

They simplify complex tasks, leading to faster decisions. Signup and view all the answers

What aspect of Jensenism does Doug Henwood criticize?

Its belief in the capability of financial markets to optimize investments. Signup and view all the answers

Which principle describes how initial information can heavily influence later decisions?

Anchoring bias Signup and view all the answers

Study Notes

Rational Expectations Theory

Developed by John Muth in 1961, emphasizing that individuals make decisions using all available information.
Individuals adjust their expectations based on new information, leading to correct average expectations over time.
Contrasts with the Keynesian view that assumed people often had systematic biases in their expectations.
Influences macroeconomic principles, including reactions to monetary and fiscal policies.
Integral in the formation of the New Classical Economics and Real Business Cycle Theory.

Modigliani-Miller Theorem

Proposes that capital structure irrelevance means a firm's value is unaffected by whether it is financed through debt or equity.
Argues the dividend policy is irrelevant to a firm's value; value is determined by earning power and investment decisions instead.
Challenges traditional beliefs about optimal capital structure and dividend relevance.
Highlights the importance of evaluating the cost of capital, which remains complex to calculate.

Efficient Market Hypothesis (EMH)

Suggests that stock prices reflect all available information, making it difficult to outperform the market consistently.
Supported by studies from UChicago showing that random selections of stocks yield similar returns to expert-driven portfolios.
Michael Jensen's work indicates that mutual fund managers often fail to achieve risk-adjusted returns that surpass market performance.

Active vs Passive Investing

Bogle's indexing strategy emphasizes that market returns are driven by economic fundamentals, making it hard to beat the market.
Stresses the advantages of passive investing to minimize transaction costs.
Paul Samuelson advocated for index funds, arguing they would outperform actively managed funds for small investors.

Corporate Governance and Regulation

Questions whether corporate managers prioritize shareholder interests, given that they're managing other people's funds.
Introduction of efficient markets theory suggests financial markets will optimize investment decisions and guide corporate behavior effectively.
Jensen noted that strong incentives can align the interests of owners and managers in large public corporations.

Psychology in Economics

Daniel Kahneman and Amos Tversky explored cognitive biases affecting decision-making.
Common biases include:
- Availability heuristic: Judging likelihood based on recall of similar events.
- Representativeness heuristic: Assessing probabilities based on stereotypes.
- Anchoring bias: Overreliance on initial information received.
- Framing effect: Decisions influenced by how information is presented.
- Loss aversion: Preference for avoiding losses over acquiring gains.
Their research implies that while heuristics simplify decision-making, they can lead to significant, systematic errors.

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Description

This quiz explores the concepts of rational expectations as presented by John Muth. It discusses how individual and corporate predictions about the future converge with the predictions made by sophisticated economic models. Test your understanding of these theories in the context of Financial Economics.