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Chapter 5 Intertemporal Decision Making and Capital Values

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Intertemporal Decision Making


Intertemporal

resource allocation relates to allocation of resources to present and future uses. The rate of interest paid to borrow money is the borrowing rate (ib). The rate of interest earned on savings is the deposit rate (id).

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Intertemporal Value Comparisons


Future

value (FV) is the value that a sum of money invested today will turn into at a point in the future. Suppose $1000 is invested for one year at an interest rate (id) of 10%. The FV = $1000 (1+id) = $1100. $1000 invested for 1 year at a interest rate of 10% will turn into $1100 in one year.
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Future Value Rule

1.

2.

3.

From the example: Choose $1000 received today if id exceeds 10%. Choose $1100 received 1 year from now if id is less than 10%. Choose either if id equals 10%.

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Present Value
The

present value (PV) is the value today of a sum of money received in the future. The PV of $1100 received in one year is the sum of money you could exchange today for a payment of $1100 one year from now (ib=10%). PV = $1100/(1+ib) = $1000
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Present Value Rule


From the previous example:
1.

2.

3.

Choose $1000 payable today if ib exceeds 10%. Choose $1100 payable 1 year from now if ib is less than 10%. Choose either if ib equals 10%.
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Separation Theorem
1.

2.

Individuals will choose among different income streams by choosing the largest present value. They will choose consumption expenditures over time to maximize utility, given the constraint that the PV of income does not exceed the PV of consumption expenditures.
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Present Values
Mt

is the present value of an income stream (M0, M1, M2, Mt,). If you deposit PV, at the end of t periods you will have PV(1+i)t. This must equal Mt since PV is the present value of Mt (PV(1+i)t = Mt). Therefore: PV = Mt /(1+i)t.
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Present Values
The

PV of an income stream:

PV=M0/(1+i)+M1/(1+i)2++MT/(1+i)T

An income stream with equal payments forever is a perpetuity. The present value of a perpetuity can be approximated as: PV = M/i

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Rates of Return
R = (p1-p0)/p0 Where: R = rate of return p0= current selling price p1= future selling price

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The Demand for Consumer Capital and Complimentary Goods


Capital

goods are anything that yields service over time. Human capital is human endowments (skills) that yield service over time. Consumer capital - goods valued not for themselves but for the services they provide over time. Reservation price is the maximum price a person is willing to pay.
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Figure 5.1 The demand for film

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Figure 5.2 The demand for a camera

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Figure 5.3 Reservation prices

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Intertemporal Allocation of Nonrenewable Resources


Bagwells

decisions are how much of his 10 000 barrels of oil to pump (sell) in period zero (z0) and period one (z1). His goal is to maximize the present value of his oil income where w0 and w1 are the price of oil in period zero and period one respectively.
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Intertemporal Allocation of Nonrenwable Resources


The present value of oil income is: PV = w0z0+ w1z1/(1+i)
Given that z1=10 000-z0 (oil sold in one period reduces oil sold in the other period).

Substituting gives: PV = 10 000w1/(1+i)+z0(w0-w1/(1+i))


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PV = 10 000w1/(1+i)+z0(w0-w1/(1+i))
Where:
10 000w1/(1+i) is wealth if all oil sold in period 1. z0(w0-w1/(1+i)) is the rate of change in wealth as one more unit of oil is sold in period 0 and one less in period 1.

If w0>w1/(1+i), all oil sold in period 0. If w0<w1/(1+i), all oil sold in period 1. If w0=w1/(1+i), oil may be sold in each.

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Hotellings Law
Assuming

that each of a great number of people own a small portion of total oil supply: PV=w0z0+ w1z1/(1+i) If z0 & z1 are positive: w0= w1/(1+i) Rewriting gives w1= w0/(1+i) The price of oil rises from one period to the next at the rate of interest.
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Figure 5.4 The optimal time to harvest

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The Life-Cycle Model


The

total available for consumption in period 1 is: C1=M1+(1+i)(M0-C0). Rearranging gives the budget line: C0(1+i)+C1=M0(1+i)+M0 Note that -(1+i) is the slope showing that the opportunity cost of a dollar consumed in period 0 is (1+i) dollars in period 1.
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Figure 5.5 An intertemporal budget line

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Figure 5.6 The rate of interest and the intertemporal budget line

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Figure 5.7 Choosing an intertemporal consumption bundle

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Figure 5.8 Comparative statics of a change in income

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Initial Savings and a Rise in the Interest Rate (Figure 5.9)


In

this case there is savings in period one and initial equilibrium of E. When i rises, the budget lines swivels around the initial endowment at A. The new equilibrium is at E (consumption in both periods increases).
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Figure 5.9 Comparative statics of an increase in i part 1

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Initial Savings and a Rise in the Interest Rate (Figure 5.9)


For

consumption in period 1 the income and substitution effect are complementary and C1 increases. For consumption in period 0 the income effect leads to an increase in C0, while the substitution effect leads to a decrease. So C0 may rise or fall.
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Initial Borrowing and a Rise in the Interest Rate (Figure 5.10)


Here

there is borrowing in period one and initial equilibrium of E. When i rises, the budget lines swivels around the initial endowment at A. The new equilibrium is at E (consumption in period 0 rises and consumption in period 1 falls).
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Figure 5.10 Comparative statics of an increase in i part 2

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Initial Borrowing and a Rise in the Interest Rate (Figure 5.10)


For

consumption in period 0 the income and substitution effect are complementary and C0 increases. For consumption in period 1 the income effect leads to a decrease in C1, while the substitution effect leads to a decrease. So C1 may rise or fall.
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