Econ II - Session 11 Flashcards
What is meant by ‘discounting’?
Valuation of future payments in today’s terms. In other words: Attaching less value to 1$ in the future than to 1$ today.
Once discounted, payments are in ‘present value terms’.
Undiscounted payments are in ‘current value terms’.
Reasons for people prefering consuming now over consuming later.
1) Impatience
2) Declining marginal utility (cause you might become richer in the future)
3) Risk: The future payment might not realize.
Current Value
future’s value of a future payment.
Present Value
Today’s value of a future payment (=discounted).
What’s the discount factor (definition)
The “exchange rate between present and the future”:
Value of a payment in the future in present value terms.
Climate damages of climate change occur to a large degree in the long-term future, because…
- stock-flow nature of emissions
- slow feedbacks and inertia (=Trägheit) in the climate system
- non-linear impacts
The costs of climate policy occur today in the nearer-term future, because many of the costs are upfront investments in …?
- In physical assets & infrastructure (wind turbines, housing isolation)
- in technology and knowledge (research and development, policy learning)
Static (one time period) discounting and cost-benefit analysis
Objective function:
net benefits NB = B-C
solution: B’ = C’
Dynamic (two or more time periods) discounting and cost-benefit analysis
Objective function: Net present benefits NB(pv) = B(pv) - C(pv)
Solution: B’(pv) = C’(pv)
Discounting in the Ramsey framework, 1st interpretation:
How to estimate the (monetary) discount rate 𝑟 ?
𝑟 = 𝛿 + 𝜂 ⋅ 𝑔
Monetary discount rate 𝑟 is the sum of the pure rate of time preference (𝛿) plus growth discounting (𝜂⋅𝑔)
Discounting in the Ramsey framework, 2nd interpretation:
What effects do growth accounting have?
Return on investment pulls towards more savings.
Impatience and declining marginal returns pull towards consuming now.
Both must be in balance.
𝑟 = 𝛿 + 𝜂 ⋅ 𝑔
How to determine 𝑟 & 𝑔 ?
𝑟 : monetary discount rate is defined by the other three factors
𝑔 : future rate of technology growth can be estimated by the use of 1) long-term historical average of frontier Economics (about 2% p.a.) and 2) endogenous growth models
𝑟 = 𝛿 + 𝜂 ⋅ 𝑔
How to determine 𝛿 & 𝜂 ?
1) Through stated preferences
- stated pref. = ask people in surveys
- Respondents would need to understand the trade-offs implied in the Ramsey model
2) Treat as normative parameters
3) Through observation of public policy
4) Through observed behavior on financial markets and macroeconomic variables
What are fundamental problems with how 𝛿 & 𝜂 are defined?
- Stated and revealed preferences reflect the preferences of those living today
- Markets show how parameters are, not how they should be
- Markets represent the past, not the future
How can 𝜂 simply be defined?
Influence of 𝜂 on curve (high/low)
- Aversion against inequality between rich and poor
- The coefficient of relative risk aversion
- high 𝜂 : lower curve
- low 𝜂 : steeper curve
