Introduction: Capital Markets,

Consumption and investment

Objective: to study consumption and investment decisions made by

individuals and firms.
Framework: one good and one person economy. Trade-off b/w
consumption now and consumption in future is allowed.
Information: He needs to know the following two things
(1) Subjective trade-offs b/w consumption now and
consumption in future.
(2) The feasible trade-offs b/w present and future consumption
that are technically possible.
The optimal rate of exchange b/w consumption now and in the
future is R-rate interestFinancial
rate Economics-A.R.Ahmad
is price of deferred consumption or1the
rate of return on investment

Do capital markets benefit society?

Assumptions:
1. All outcomes from investment are known with
certainty.
2. There are no transactions costs.
3. There are no taxes.
4. The decisions are made in one period context.
5. The individual are endowed with income y o and
y1.
Financial Economics-A.R.Ahmad

6. Individual must decide how much to actually

consume now, (Co) and how much to invest in
productive opportunities in order to provide
end-of-period consumption, (C1).
7. Every individual is assumed to prefer more
consumption to less.

Financial Economics-A.R.Ahmad

Intertemporal Consumption : Indifference

Curves
Consumption
in period - one

MRSCCo1
B

C1
Co

U con tan t

(1 ri )

y1
F
G

I1

x0
y0

E
D

Financial Economics-A.R.Ahmad

x0

I0
Consumption
in period-zero
4

Productive Investment Opportunity

Assumptions: (1) All investment are assumed independent
of one another, and (2) Are perfectly divisible
Marginal
rate of
return

Slope = -(1+ r) = MRT

ri

Io

MRT is the rate at which

A rupee of consumption forgone
Today is transformed by productive
Investment into a rupee of consumption
Tomorrow.

Financial Economics-A.R.Ahmad

Total Investment
5

Production Possibility Curve

Consumption
in period - one

10th investment project

B
B

C1(1)

2nd investment
project
A

1st investment
project

I0
C0(1) W0
Financial Economics-A.R.Ahmad

Consumption
in period-zero
6

Consumers Maximisation
Consumption
in period - one

C1

MRS = MRT

**

U2
U1
C0**
Financial Economics-A.R.Ahmad

Consumption
in period-zero
7

Money Market Line

Consumption
in period - one

Money Market Line :

(slope = MRT = -(1+r)

C1*

I0*

C0*
Financial Economics-A.R.Ahmad

W0

Consumption
in period-zero
8

The Production and Consumption without

Capital Market
Consumption
in period - one

MRS MRT
B

P1 = C1

y1

A
yo

U2

U1

Consumption
Financial Economics-A.R.Ahmad in period-zero

Po = Co

Individual with different indifference curves

choose different production/consumption patterns
Consumption
in period - one

Individual 2

A
Individual 1

y1

Financial Economics-A.R.Ahmad
o

Consumption
in period-zero

10

Maximisation with Capital Market

Consumption
in period - one
C1

**

C1*

I0 *

C0**

Money Market Line :

(slope = -(1+r))

C0*

Financial Economics-A.R.Ahmad

W0

Consumption
in period-zero
11

Individual with different indifference curves

choose
different production/consumption patterns
y1
C
W0 y0

W1*

(1 r )

*
C
1
W0 C0*
(1 r )

C1* W0 (1 r ) (1 r )C0* ,
since W 0(1 r ) W 1

B
P1

C1*

C1* W1 (1 r )C0*
U3 (production and exchange
U2 (production alone)

D
A

y1

U1 (initial endowment)
Po

Co* y

o
Financial Economics-A.R.Ahmad

Wo*

Co
12