Economic Concepts Worksheet: Economics Concepts Review

Economic Concepts Worksheeteconomics Conceptsreview Your Week 1 Learni

Review your Week 1 Learning Activities, especially Chapter 1 of Focus on Personal Finance, Khan Academy Resources and Video Reflection, and Investopedia Resources located in the “Additional Reading and Video Resources” link on your course page. Respond to each of the following questions in your own words. Each response should be at least 50 words.

1. A nominal interest rate is defined as “the opportunity cost of holding or using money.” Explain what you understand this definition to mean.

   The nominal interest rate represents the percentage cost of borrowing money or the return on savings before accounting for inflation. It reflects the opportunity cost because when money is invested or saved, the potential gains from alternative uses of that money are foregone. Essentially, it is the cost or benefit of choosing to hold or use money in a particular way, ignoring inflation effects.

2. When the economy is in a recession, the Federal Reserve usually cuts interest rates. Why would the federal government do this?

   The Federal Reserve lowers interest rates during a recession to stimulate economic activity. Reduced rates make borrowing cheaper for consumers and businesses, encouraging spending and investment. This increased spending can help boost economic growth, reduce unemployment, and prevent the economy from contracting further. Lower rates aim to revive economic confidence and activity.

3. How does your saving and spending profile change depending on the state of the economy, i.e., whether the economy is in a recession versus expansion? Do interest rates play a role in your decisions? Why or why not?

   In a recession, I tend to save more due to economic uncertainty and job security concerns, while spending decreases. During economic expansion, I might feel more confident to spend on larger purchases. Interest rates influence my decisions because low rates make borrowing cheaper, incentivizing spending and borrowing, whereas high rates encourage saving.

4. If interest rates are at a level of 1% and expected inflation is 2%, would you prefer saving or spending your money? Justify your answer.

   With interest rates at 1% and expected inflation at 2%, my real return on savings would be negative, meaning the purchasing power of saved money would decrease over time. Therefore, I would prefer to spend or invest the money rather than save it, as saving would result in a loss of value.

Behavioral Economics Concepts Review

From the Week 1 Learning Activities and Investopedia Resources, I have chosen the concepts of Herd Behavior and Prospect Theory. Herd behavior refers to individuals following the actions of a larger group, often leading to conformity or market bubbles. For example, during a stock market rally, I might be inclined to buy stocks simply because many others are doing so, potentially ignoring my own analysis. Prospect theory describes how people evaluate potential gains and losses differently, often being more motivated to avoid losses than to seek equivalent gains. This can influence my decisions, such as holding onto losing investments longer than rationally advised or taking on excessive risk to avoid perceived losses. Both concepts highlight how psychological factors can impact personal financial and credit decisions, leading to behaviors that deviate from traditional economic rationality.

References

• Best, R. (2013). Behaviorial Finance: Psychology, Decision-Making, and Markets. Routledge.
• Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291.
• Investopedia. (2023). Herding Behavior. https://www.investopedia.com/terms/h/herdingbehavior.asp
• Investopedia. (2023). Mental Accounting. https://www.investopedia.com/terms/m/mentalaccounting.asp
• Federal Reserve. (2023). Monetary Policy. https://www.federalreserve.gov/monetarypolicy.htm
• Mankiw, N. G. (2021). Principles of Economics (9th ed.). Cengage Learning.
• Thaler, R. H. (2016). Misbehaving: The Making of Behavioral Economics. W. W. Norton & Company.
• Shiller, R. J. (2015). Irrational Exuberance (3rd ed.). Princeton University Press.
• Khan Academy. (2023). Introduction to Macroeconomics and Monetary Policy. https://www.khanacademy.org/economics-finance-domain/macroeconomics
• Investopedia. (2023). Behavioral Finance. https://www.investopedia.com/terms/b/behavioralfinance.asp