Introduction: Capital Markets,

Consumption, and Investment

Chapter 1
Objective
• consumption and investment decisions made by individuals and firms
• the role of interest rates in making consumption/investment
decisions
Consumption and Investment without Capital
Markets
• Assumptions:
- all outcomes from investment are known with certainty
- there are no transaction costs or taxes
- decisions are made in a one-period context
- every individual prefers more consumption to less (i.e. the marginal utility
of consumption is always positive)
- the marginal utility of consumption is decreasing
• Individuals are endowed with income at the beginning of the period, y0,
and at the end of the period, y1 → decide how much to consume now, C0,
and how much to invest in productive opportunities in order to provide
end-of-period consumption, C1.
Consumption and Investment without Capital
Markets
Consumption and Investment without Capital
Markets

Indifference curves
Consumption and Investment without Capital
Markets

Slope = Marginal rate

of substitution (MRS)
between C0 and C1
Consumption and Investment without Capital
Markets
• Marginal rate of substitution (MRS) between consumption today and
consumption tomorrow reveals how many extra units of consumption
tomorrow must be received in order to give up one unit of
consumption today and still have the same total utility.

• The marginal rate of substitution between consumption today and

!
end-of period consumption, 𝑀𝑅𝑆!!" , is equal to the slope of a line
tangent to an indifference curve given constant total utility
𝜕𝐶"/𝜕𝐶# |$%&'()* . This in turn is equal to the individual’s subjective
rate of time preference, −(1 + ri).
Consumption and Investment without Capital
Markets
• Assumptions
- each individual in the economy has a schedule of productive
investment opportunities that can be arranged from the highest rate
of return down to the lowest (i.e. diminishing marginal returns to
investment).
- all investments are independent of one another and perfectly
divisible.
Consumption and Investment without Capital
Markets
Consumption and Investment without Capital
Markets

= Marginal rate of
transformation (MRT)

• Marginal rate of transformation (MRT) offered by the production/investment opportunity set is the rate at
which a dollar of consumption foregone today is transformed by productive investment into a dollar of
consumption tomorrow.
Consumption and Investment without Capital
Markets

• An individual endowed with a resource bundle (y0, y1) that has utility U1 can move along the production
opportunity set to point B, where the indifference curve is tangent to it and receives the maximum
attainable utility, U2.
• Because C0 < y0 → invest y0 − C0. If C0 > y0 → disinvest.
Consumption and Investment without Capital
Markets

At point B:
-the investor’s subjective marginal rate of substitution is equal to the marginal rate of transformation
offered by the production opportunity set (i.e. MRS = MRT)
-the individual’s consumption in each time period is exactly equal to the output from production (i.e., P0 = C0
and P1 = C1).
Consumption and Investment without Capital
Markets
• Without the existence of capital markets, individuals with the same endowment and the same
investment opportunity set may choose completely different investments because they have
different indifference curves.
Problem 6
Suppose your production opportunity set in a world of perfect certainty consists of
the following possibilities:

(a) Graph the production opportunity set in a C0, C1 framework.

(b) If the market rate of return is 10%, draw in the capital market line for the
optimal investment decision.
C. Consumption and Investment with Capital
Markets
Capital markets facilitate the exchange of funds between lenders and
borrowers at the market rate of interest. Assuming that interest rates
are positive, any amount of funds lent today will return interest plus
principal at the end of the period.
X1 =X0 +rX0
X1=(1+r)X0

• Ignore production
• Combine production possibilities with market exchange possibilities
C. Consumption and Investment with Capital
Markets (Ignore production)
• At initial endowment
of (y0, y1) (point A),
subjective time
preference < market
rate of return →
lend.
• Maximize utility by
moving along the
market line to the
point where
subjective time
preference = market
interest rate (point
B).
U2 > U1
C. Consumption and Investment with Capital
Markets (Ignore production)
• The present value, W0, of our initial endowment, (y0, y1), is the sum of current income, y0, and the
present value of our end-of-period income, y1(1 + r)−1:

• The present value of the consumption bundle at point B is also equal to our current wealth, W0:

→ The equation for the capital market line:

→ Moving along the capital market line does not change one’s wealth, but it does offer a pattern of
consumption that has higher utility.
C. Consumption and Investment with Capital
Markets (Combine production possibilities with
market exchange possibilities )
• At point A, rate of
return > subjective
time preference →
invest and move along
the production
opportunity set.
• At point D, marginal
rate of return on
productive investment
= subjective time
preference,
U2 > U1.
Borrowing rate < rate of
return on the marginal
investment → continue to
invest.
C. Consumption and Investment with Capital
Markets (Combine production possibilities with
market exchange possibilities )
• At point B, marginal
return on investment =
borrowing rate, receive
output from
production (P0, P1),
and the present value
of wealth is W0∗.
Subjective time
preference > market rate
of return → borrow and
consume more than P0.
• At point C, subjective
time preference =
market rate of return,
optimal consumption
(C0∗, C1∗) is found,
U3 > U2.
C. Consumption and Investment with Capital
Markets (Combine production possibilities with
market exchange possibilities )
• Step 1: choose the optimal production decision by taking on projects
until the marginal rate of return on investment equals the objective
market rate;
• Step 2: choose the optimal consumption pattern by borrowing or
lending along the capital market line to equate your subjective time
preference with the market rate of return.
C. Consumption and Investment with Capital
Markets (Combine production possibilities with
market exchange possibilities )
• Fisher separation theorem Given perfect and complete capital
markets, the production decision is governed solely by an objective
market criterion (represented by maximizing attained wealth) without
regard to individuals’ subjective preferences that enter into their
consumption decisions.
C. Consumption and Investment with Capital
Markets (Combine production possibilities with
market exchange possibilities )
• Given the same opportunity
set, every investor will make the
same production decision (P0,
P1) regardless of the shape of
his or her indifference curves.
→ Investment decision can be
delegated to managers.
• In equilibrium, MRSi =MRSj
=−(1+r)=MRT
→ All individuals use the same
time value of money (i.e., the
same market-determined objective
interest rate) in making their
production/investment decisions.
Problem 1
Graphically demonstrate the Fisher separation theorem for the case
where an individual ends up lending in financial markets. Label the
following points on the graph: initial wealth, W0; optimal
production/investment (P0,P1); optimal consumption (C0∗, C1∗); present
value of final wealth, W0∗.
D. Marketplaces and Transaction Costs
• Assume that we have a primitive economy with N producers, each making a
specialized product and consuming a bundle of all N consumption goods.
• Without a marketplace, for N individuals making two-way exchanges, there are
[N(N-1)]/2 trips. The cost of each leg of a trip is T dollars.
D. Marketplaces and Transaction Costs
• If an entrepreneur establishes a central marketplace and carries an inventory of
each of the N products, the number of trips is reduced to N. The savings is [N (N −
1)/2 − N ]T. à the operational efficiency of capital markets
E. Transaction Costs and the Breakdown of
Separation
• Different borrowing and
lending rates will have the
effect of invalidating the
Fisher separation principle.
• Individuals with different
indifference curves will
now choose different
levels of investment.