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The extent to which the value and impact of a tax, tax relief or subsidy is reduced because of its side-effects. For instance, increasing the amount of tax levied on workers’ pay will lead some workers to stop working or work less, so reducing the amount of extra tax to be collected. However, creating a tax relief or subsidy to encourage people to buy life insurance would have a deadweight cost because people who would have bought insurance anyway would benefit.
Industry:Economy
Broadly speaking, a period of slow or negative economic growth, usually accompanied by rising unemployment. Economists have two more precise definitions of a recession. The first, which can be hard to prove, is when an economy is growing at less than its long-term trend rate of growth and has spare capacity. The second is two consecutive quarters of falling GDP.
Industry:Economy
A measure of the value of money that removes the effect of inflation. Contrast with nominal value.
Industry:Economy
A newish theory of how to take investment decisions when the future is uncertain, which draws parallels between the real economy and the use and valuation of financial options. It is becoming increasingly fashionable at business schools and even in the boardroom. Traditional investment theory says that when a firm evaluates a proposed project, it should calculate the project’s net present value (NPV) and if it is positive, go ahead. Real options theory assumes that firms also have some choice in when to invest. In other words, the project is like an option: there is an opportunity, but not an obligation, to go ahead with it. As with financial options, the interesting question is when to exercise the option: certainly not when it is out of the money (the cost of investing exceeds the benefit). Financial options should not necessarily be exercised as soon as they are in the money (the benefit from exercising exceeds the cost). It may be better to wait until it is deep in the money (the benefit is far above the cost). Likewise, companies should not necessarily invest as soon as a project has a positive NPV. It may pay to wait. Most firms’ investment opportunities have embedded in them many managerial options. For instance, consider an oil company whose bosses think they have discovered an oil field, but they are uncertain about how much oil it contains and what the price of oil will be once they start to pump. Option one: to buy or lease the land and explore? Option two: if they find oil, to start to pump? Whether to exercise these options will depend on the oil price and what it is likely to do in future. Because oil prices are highly volatile, it might not make sense to go ahead with production until the oil price is far above the price at which traditional investment theory would say that the NPV is positive and give the investment the green light. Options on real assets behave rather like financial options (a share option, say). The similarities are such that they can, at least in theory, be valued according to the same methodology. In the case of the oil company, for instance, the cost of land corresponds to the down-payment on a call (right to buy) option, and the extra investment needed to start production to its strike price (the money that must be paid if the option is exercised). As with financial options, the longer the option lasts before it expires and the more volatile is the price of the underlying asset (in this case, oil) the more the option is worth. This is the theory. In practice, pricing financial options is often tricky, and valuing real options is harder still.
Industry:Economy
An exchange rate that has been adjusted to take account of any difference in the rate of inflation in the two countries whose currency is being exchanged.
Industry:Economy
Falling inflation and interest rates lead to higher spending (see wealth effect).
Industry:Economy
Although economists say that rationing is what the price mechanism does, what most people think of as rationing is an alternative to letting prices determine how scarce economic resources, goods and services are distributed (see also queuing). Non-price rationing is often used when the distribution decided by market forces is perceived to be unfair. Rationing may lead to the creation of a black market, as people sell their rations to those willing to pay a high price (see black economy).
Industry:Economy
How some economists believe that people think about the future. Nobody can predict the future perfectly; but rational expectations theory assumes that, over time, unexpected events (shocks) will cancel out each other and that on average people’s expectations about the future will be accurate. This is because they form their expectations on a rational basis, using all the information available to them optimally, and learn from their mistakes. This is in contrast to other theories of how people look ahead, such as adaptive expectations, in which people base their predictions on past trends and changes in trends, and behavioral economics, which assumes that expectations are somewhat irrational as a result of psychological biases. The theory of rational expectations, for which Robert Lucas won the Nobel prize for economics, initially became popular with monetarists because it seemed to prove that Keynesian policies of demand management would fail. With rational expectations, people learn to anticipate government policy changes and act accordingly; since macroeconomic fine tuning requires that governments be able to fool people, this implies that it is usually futile. Subsequently, this conclusion has been challenged. However, rational and near-rational expectations have become part of the mainstream of economic thought.
Industry:Economy
A guide to the riskiness of a financial instrument provided by a ratings agency, such as Moody’s, Standard and Poor’s and Fitch IBCA. These measures of credit quality are mostly offered on marketable government and corporate debt. A triple-A or A++ rating represents a low risk of default; a C or D rating an extreme risk of, or actual, default. Debt prices and yields often (but not always) reflect these ratings. A triple-A bond has a low yield. High-yielding bonds, also known as junk bonds, usually have a rating that suggests a high risk of default. A series of financial market crises from the mid-1990s onwards led to growing debate about the reliability of ratings, and whether they were slow to give warning of impending trouble. After the Enron debacle, which again the ratings agencies had failed to predict, some critics argued that the big three agencies had formed a cosy oligopoly and that encouraging more competition was the way to improve ratings.
Industry:Economy
