R
squared
An
indicator of the reliability of a relationship identified by regression
analysis. An r2 of 0.8 indicates that 80% of the change in one variable is
explained by a change in the related variable.
Random
walk
Impossible
to predict the next step. Efficient market theory says that the prices of many
financial assets, such as shares, follow a random walk. In other words, there
is no way of knowing whether the next change in the price will be up or down,
or by how much it will rise or fall. The reason is that in an efficient market,
all the information that would allow an investor to predict the next price move
is already reflected in the current price. This belief has led some economists
to argue that investors cannot consistently outperform the market. But some
economists argue that asset prices are predictable (they follow a non-random
walk) and that markets are not efficient.
Rate
of return
A
way to measure economic success, albeit one that can be manipulated quite
easily. It is calculated by expressing the economic gain (usually profit) as a
percentage of the capital used to produce it. Deciding what number to use for
profit is rarely simple. Likewise, totaling up how much capital was used can be
tricky, especially if it is expanded to include intangible assets and human
capital. When firms are evaluating a project to decide whether to go ahead with
it, they estimate the project's expected rate of return and compare it with
their cost of capital.
Rate
of return regulation
An
approach to regulation often used for a public utility to stop it exploiting
monopoly power. A public utility is forbidden to earn above a certain rate of
return decided by the regulator. In practice, this often encourages the utility
to be inefficient, slow to innovate and quick to spend money on such things as
big offices and executive jets, to keep down its profit and thus the rate of
return. Contrast with price regulation.
Ratings
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 cozy oligopoly and that encouraging more competition was the way
to improve ratings.
Rational
expectations
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.
Rationing
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. 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.
Real
exchange rate
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.
Real
options theory
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.
Real
terms
A
measure of the value of money that removes the effect of inflation. Contrast
with nominal value.
Recession
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.
Reciprocity
Doing
as you are done by. A grants b certain privileges on the condition that b
grants the same privileges to a. Most international economic agreements, for
example, on trade, include binding reciprocity requirements.
Redlining
Not
lending to people in certain poor or troubled neighborhoods – drawn with a red
line on a map – simply because they live there, regardless of their
credit-worthiness judged by other criteria.
Reflation
Policies
to pump up demand and thus boost the level of economic activity. Monetarists
fear that such policies may simply result in higher inflation.
Regional
policy
A
policy intended to boost economic activity in a specific geographical area that
is not an entire country and, typically, is in worse economic shape than nearby
areas. It can include offering firms incentives to provide jobs in the region,
such as soft loans, grants, lower taxes, cheap land and buildings, subsidized
labour and worker training. Is it necessary? A region's problems should be
somewhat self-correcting. After all, simple theories of supply and demand would
suggest that firms will move to areas of low wages and high unemployment to
take advantage of cheaper labour and surplus workers, or those workers will
move away from such areas to where more and better-paid jobs exist. But some
economic theories suggest that rather than moving to areas where wages are
lowest, firms often cluster together with other successful businesses. Regional
policy may need to be extremely generous to tempt firms to give up the
advantages of being in a cluster.
Regression
analysis
Number-crunching
to discover the relationship between different economic variables. The findings
of this statistical technique should always be taken with a pinch of salt. How
big a pinch can vary considerably and is indicated by the degree of statistical
significance and r squared. The relationship between a dependent variable (gdp,
say) and a set of explanatory variables (demand, interest rates, capital,
unemployment, and so on) is expressed as a regression equation.
Regressive
tax
A
tax that takes a smaller proportion of income as the taxpayer’s income rises,
for example, a fixed-rate vehicle tax that eats up a much larger slice of a
poor person’s income than a rich person’s income. This goes against the
principle of vertical equity, which many people think should be at the heart of
any fair tax system.
Regulation
Rules
governing the activities of private-sector enterprises. Regulation is often
imposed by government, either directly or through an appointed regulator.
However, some industries and professions impose rules on their members through
self-regulation.
Regulation
is often introduced to tackle market failure. Externalities such as pollution
have inspired rules limiting factory emissions. Regulations on the selling of
financial products to individuals have been introduced as protection against
unscrupulous financial firms with better information than their customers. Rate
of return regulation and price regulation have been used to combat natural
monopoly, sometimes instead of nationalization. Some regulation has been
motivated by politics rather than economics, for instance, restrictions on the
number of hours people can work or the circumstances in which an employer can
dismiss employees.
Even
when introduced for sound economic reasons, regulation can generate more costs
than benefits. Regulated firms or individuals may face substantial compliance
costs. Firms may devote substantial resources to regulatory arbitrage, which
would leave consumers no better off. Regulation may lead to moral hazard if
people believe that the government is keeping an eye on the behavior of the
regulated business and so do less monitoring of their own. Regulation may be
badly designed and thus lock an industry into an inefficient equilibrium. Rigid
regulation may hold back innovation. There is also the danger of regulatory
capture. In short, then, regulatory failure may be even worse for an economy
than market failure.
Regulatory
arbitrage
Exploiting
loopholes in regulation, and perhaps making the regulation useless in the
process. This is often done by international investors that use derivatives to
find ways around a country’s financial regulations.
Regulatory
capture
Gamekeeper
turns poacher or, at least, helps poacher. The theory of regulatory capture was
set out by Richard Posner, an economist and lawyer at the university of Chicago,
who argued that “regulation is not about the public interest at all, but is a
process, by which interest groups seek to promote their private interest ...
Over time, regulatory agencies come to be dominated by the industries
regulated.” Most economists are less extreme, arguing that regulation often
does well but is always at risk of being captured by the regulated firms.
Regulatory
failure
When
regulation generates more economic costs than benefits.
Regulatory
risk
A
risk faced by private-sector firms that regulatory changes will hurt their
business. In competitive markets, regulatory risk is usually small. But in
natural monopoly industries, such as electricity distribution, it may be huge.
To ensure that regulatory risk does not deter private firms from offering their
services, a government wishing to change its regulations may have good reason
to compensate private firms that suffer losses as a result of the change.
Relative
income hypothesis
People
often care more about their relative well being than their absolute well being.
Someone who prefers a $100 a week pay rise when a colleague gets $50 to both of
them gets a $200 increase, for example. Poor people may consume more of their
income than rich people do because they want to reduce the gap in their
consumption levels. The relative income hypothesis, set out by James
duesenberry, says that a household's consumption depends partly on its income
relative to other families. Contrast with permanent income hypothesis.
Rent
Confusingly,
rent has two different meanings for economists. The first is the commonplace
definition: the income from hiring out land or other durable goods. The second,
also known as economic rent, is a measure of market power: the difference
between what a factor of production is paid and how much it would need to be
paid to remain in its current use. A soccer star may be paid $50,000 a week to
play for his team when he would be willing to turn out for only $10,000, so his
economic rent is $40,000 a week. In perfect competition, there are no economic
rents, as new firms enter a market and compete until prices fall and all rent
is eliminated. Reducing rent does not change production decisions, so economic
rent can be taxed without any adverse impact on the real economy, assuming that
it really is rent.
Rent-seeking
Cutting
yourself a bigger slice of the cake rather than making the cake bigger. Trying
to make more money without producing more for customers. Classic examples of
rent-seeking, a phrase coined by an economist, Gordon bullock, include:
A
protection racket, in which the gang takes a cut from the shopkeeper's profit;
A
cartel of firms agreeing to raise prices;
A
union demanding higher wages without offering any increase in productivity;
Lobbying
the government for tax, spending or regulatory policies that benefit the
lobbyists at the expense of taxpayers or consumers or some other rivals.
Whether
legal or illegal, as they do not create any value, rent-seeking activities can
impose large costs on an economy.
Replacement
cost
What
it would cost today to replace a firm's existing assets.
Replacement
rate
The
fertility rate required in a country to keep its population steady. In rich
countries, this is usually reckoned to be 2.1 children per woman, the extra 0.1
reflecting the likelihood that some children will die before their parents. In
poorer countries with higher infant mortality, the replacement rate may be much
higher. In many countries, since the early 1990s the fertility rate has fallen
below the replacement rate. There has been much debate about why, and much
agreement that, if this trend continues, those countries may face long-term
problems such as a relatively growing proportion of retired older people having
to be supported by a relatively shrinking proportion of younger people.
Repo
Agreements
in which one party sells a security to another party and agrees to buy it back
on a specified date for a specified price. Central banks deal in short-term
repos to provide liquidity to the financial system, buying securities from
banks with cash on the condition that the banks will repurchase them a few weeks
later.
Required
return
The
minimum expected return you require from an investment to be willing to go
ahead with it.
Rescheduling
Changing
the payment schedule for a debt by agreement between borrower and lender. This
is usually done when the borrower is struggling to make payments under the
original schedule. Rescheduling can involve reducing interest payments but
extending the period over which they are collected; putting back the date of
repayment of the loan; reducing interest payments but increasing the amount
that has to be repaid eventually; and so on. The rescheduling may or may not
require the lender to bear some financial loss. The rescheduling may or may not
require the lender to bear some financial loss. The rescheduling of loans to countries
usually takes place through the Paris club and London club.
Reservation
wage
The
lowest wage for which a person will work.
Reserve
currency
A
foreign currency held by a government or central bank as part of a country’s
reserves. Outside the United States the dollar is the most widely used reserve
currency. Everywhere the euro is increasingly widely used.
Reserve
ratio
The
fraction of its deposits that a bank holds as reserves.
Reserve
requirements
Regulations
governing the minimum amount of reserves that a bank must hold against
deposits.
Reserves
Money
in the hand, available to be used to meet planned future payments or if some
other need arises. Firms may put their reserves in a bank, as a deposit. For a
bank, reserves are those deposits it retains rather than lending them out.
Residual
risk
When
you buy an asset you become exposed to a bundle of different risks. Many of
these risks are not unique to the asset you own but reflect broader
possibilities, such as that the stock market average will rise or fall, that
interest rates will be cut or increased, or that the growth rate will change in
an entire economy or industry. Residual risk, also known as alpha, is what is
left after you take out all the other shared risk exposures. Exposure to this
risk can be reduced by diversification. Contrast with systematic risk.
Restrictive
practice
A
general term for anything done by a firm, or firms, to inhibit competition.
Generally against the law.
Returns
The
rewards for doing business. Returns usually refer to profit and can be measured
in various ways.
Revealed
preference
An
example of a popular joke among economists: two economists see a Ferrari. 'I
want one of those,' says the first. 'Obviously not,' replies the other. To get
a smile out of this it is necessary (but not, alas, sufficient) to know about
revealed preference. This is the notion that what you want is revealed by what
you do, not by what you say. Actions speak louder than words. If the economist
had really wanted a Ferrari he would have tried to buy one, if he did not own
one already.
Economists
have three main approaches to modeling demand and how it will change if prices
or incomes change.
The
cardinal approach involves asking consumers to say how much utility they get
from consuming a particular good, aggregating this across all goods and
services, and calculating how demand would change on the assumption that people
will consume the combination of things that maximizes their total utility.
The
ordinal approach does not require consumers to say how much utility they get in
absolute terms from consuming a particular good. Instead, it asks them to
indicate the relative utility they get from consuming one item compared with another
that is, to say if they prefer one basket of goods to another, or are
indifferent between them.
The
third approach is revealed preference. To model demand it is only necessary to
be able to compare an individual's consumption decisions in situations with
different prices and/or incomes and to assume that consumers are consistent in
their decisions over time (that is, if they prefer wine to beer in one period
they will still prefer wine in the next).
Ricardian
equivalence
The
controversial idea, suggested by David Ricardo, that government deficits do not
affect the overall level of demand in an economy. This is because taxpayers
know that any deficit has to be repaid later, and so increase their savings in
anticipation of a tax bill. Thus government attempts to stimulate an economy by
increasing public spending and/or cutting taxes will be rendered impotent by
the private-sector reaction.
Risk
The
chance of things not turning out as expected. Risk taking lies at the heart of
capitalism and is responsible for a large part of the growth of an economy. In
general, economists assume that people are willing to be exposed to increased
risks only if, on average, they can expect to earn higher returns than if they
had less exposure to risk. How much higher these expected returns need to be
depends partly on the probability of an undesirable outcome and partly on
whether the risk taker is risk averse, risk neutral or risk seeking.
During
the second half of the 20th century, economists greatly improved their
understanding of risk and developed theories of risk management, which suggest
when it makes sense to use insurance, diversification or hedging to change risk
exposures.
In
financial markets the most commonly used measure of risk is the volatility (or
standard deviation) of the price of, or more appropriately the total returns
on, an asset. Often added to the risk profile are other statistical measures
such as skewness and the possibility of extreme changes on rare occasions.
Risk averse
Someone
who thinks risk is a four-letter word. Risk-averse investors are those who,
when faced with two investments with the same expected return but two different
risks, prefer the one with the lower risk.
Risk
management
The
process of bearing the risk you want to bear, and minimising your exposure to
the risk you do not want. This can be done in several ways: not doing things
that carry a particular risk; hedging; diversification; and buying insurance.
Risk
neutral
Someone
who is insensitive to risk. Risk-neutral investors are indifferent between an
investment with a certain outcome and a risky investment with the same expected
returns but an uncertain outcome. Such people are few and far between.
Risk
premium
The
extra return that investors require to hold a risky asset instead of a
risk-free one; the difference between the expected returns from a risky
investment and the risk-free rate.
Risk
seeking
Someone
who cannot get enough risk. risk-seeking investors prefer an investment with
an uncertain outcome to one with the same expected returns and certainty that
it will deliver them.
Risk-free
rate
The
rate of return earned on a risk-free asset. This is a crucial component of
modern portfolio theory, which assumes the existence of both risky and
risk-free assets. The risk-free asset is usually assumed to be a government
bond, and the risk-free rate is the yield on that bond, although in fact even a
treasury is not entirely without risk. In modern portfolio theory, the
risk-free rate is lower than the expected return on the risky asset, because
the issuer of the risky asset has to offer risk averse investors the
expectation of a higher return to persuade them to forgo the risk-free asset.
