The Basic Tools of Finance (Chapter 14 of Mankiw)

N. Gregory Mankiw, “Principles of Macroeconomics,” 8th Edition, Cengage Learning.

IBE201 Principles of Macroeconomics, Sophia University FLA

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Introduction

Finance:
Studies how people make decisions:
Allocation of resources over time
Handling of risk
Present value
Amount of money today that would be
needed, using prevailing interest rates, to
produce a given future amount of money

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Introduction

Future value
Amount of money in the future that an amount of
money today will yield, given prevailing interest
rates
Compounding
The accumulation of sum of money in, say, a bank
account, where the interest earned remains in the
account to earn additional interest in the future

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Present value

If you put $100 in a bank account today, how much will it

be worth in N years?
Present value:
Interest rate = r
Future value =

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Present value

How much would you have to deposit in a bank right now

to yield $200 in N years?
Future value:
Interest rate = r
Present value=

Discounting:
Find present value for a future sum of money

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Present value

General formula for discounting:

r: interest rate
X: amount to be received in N years (future value)
Then,

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Managing risk

Risk aversion
Dislike of uncertainty
Utility
A person’s subjective measure of
well-being/satisfaction

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Managing risk

Utility function
Every level of wealth provides a certain amount of
utility
Exhibits diminishing marginal utility
The more wealth a person has, the less utility
the person gets from an additional dollar

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The Utility Function

Figure 1 The Utility Function

Utility

Utility gain from

winning $1,000

Utility loss from

losing $1,000

0 Wealth
$1,000 loss Current $1,000 gain
wealth

This utility function shows how utility, a subjective measure of satisfaction, depends on wealth.
As wealth rises, the utility function becomes flatter, reflecting the property of diminishing marginal
utility. Because of diminishing marginal utility, a $1,000 loss decreases utility by more than a
$1,000 gain increases it.

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