Week 9: Consumption and Savings II

Question 1

Diagram for Different Interest Rates for Borrowers and Lenders

Answer 1

Question 2

Interest Rates for Borrowers Increases Diagram

Answer 2

Question 3

4 consequences of an increase of borrowing rate?

Answer 3

1. increased cost of borrowing - less likely to borrow
2. more likely to save as improved returns
3. higher mortgage repayments
4. economic growth will slow

Question 4

Increased Borrowing Rate Diagram with Intertemporal Preferences

Answer 4

Question 5

Why does Ricardian Equivalence not hold when the borrowing rate changes? 3 reasons

Answer 5

• tax changes change the endowment point
• tax changes with imperfect credit market modify the bundles that can be reached by consumers
• consumers choose another allocation

Question 6

Collateral Definition

Answer 6

an item of value that a lender can seize from a borrower if he or she fails to repay a loan according to the agreed terms

Question 7

How does a collateral work with a lender?

Answer 7

Lender may not trust the borrower - borrower promises to pay the debt in second period but don’t pay
Lender asks borrower to post a collateral (asset - house, car, gov bond etc.) and if borrower does not pay lender keeps the asset

Question 8

What are the simplifying assumptions for collaterals and credit markets? (2)

Answer 8

1. interest rates is the same for borrowers and lenders

2. collateral cannot be sold in first period

Question 9

Consumption equation with house (price per square metre) as collateral

Answer 9

Question 10

Consumption diagram with house (price per square metre) as collateral

Answer 10

Question 11

What do lenders request with a collateral?

Answer 11

Repayment from borrower must be lower than or equal to the value of the house

Question 12

Diagram for how much someone can borrow using a collateral

Answer 12

Question 13

What happens if the price of a collateral decreases? Diagram

Answer 13

Question 14

What happens if the price of a collateral decreases?

Answer 14

Reduces the amount and maturity of firm debt

Question 15

Precautionary Saving

Answer 15

Saving just in the case of an uncertain and unpredictable event

Question 16

3 main findings from evidence from household consumption

Answer 16

1. low income - behave as if borrowing is constrained, engage in precautionary saving, MPC from income boost is high 2. above avg income - consumption smoothing effective, MPC from temp income shocks is low 3. many departures from classical model in data

Question 17

Marginal Propensity to Consume (MPC)

Answer 17

the proportion of an aggregate raise in pay that a consumer spends on the consumption of good and services

Question 18

Consumption Smoothing

Answer 18

creating a balance between spending and saving during the different phases of our lives to achieve a higher overall standard of living

Question 19

Investment

Answer 19

an asset or item acquired with the goal of generating income or appreciation - todays investment influences future opportunities

Question 20

How do firm’s make investment decisions?

Answer 20

Keep investing in capital until MPK = difference between real interest rate and growth rate of the price of capital

Question 21

Marginal Product of Capital (MPK)

Answer 21

the amount of extra output the firm get from an extra unit of capital, holding the amount of labour constant

Question 22

Two ways to invest

Answer 22

1. save money in the bank

2. buy new capital

Question 23

Arbitrage Equation

Answer 23

Question 24

Arbitrage Equation Rearranges with P(k,t) = 1

Answer 24

Question 25

User Cost of Capital

Answer 25

the unit cost for the use of a capital asset for one period – the price of employing or obtaining one unit of capital services

Question 26

Arbitrage Equation/Arbitrage Pricing Theory

Answer 26

multi-factor asset pricing model based on the idea that an asset’s returns can be predicted using the linear relationship between the assets’ expected return and several macroeconomic variables that capture systematic risk

Question 27

Growth Rate in Price Equation

Answer 27

Question 28

What does it mean if growth rate is positive or negative?

Answer 28

Positive - 'capital gain' | Negative - 'capital loss'

Question 29

Why does price of capital change? (3 reasons)

Answer 29

Depreciation Technological change in electronics Scarce resources

Question 30

Arbitrage Equation that Includes Depreciation

Answer 30

Question 31

User cost of capital

Answer 31

total cost to the firm of using one more unit of capital

Question 32

How much should a firm invest? Diagram

Answer 32

Question 33

Add a Tax Component (τ) to Investment Equation

Answer 33

Question 34

Rearrange the Investment Equation with Tax Component for MPK (when MPK = user cost of capital)

Answer 34

Question 35

Increase in Corporate Income Tax Diagram

Answer 35

Question 36

Method to calculate investment rate from desired capital

Answer 36

1. using production function, MPK and standard accumulation formula 2. rearrange MPK equation to Y/K = 3.uc 3. Rewrite capital accumulation equation: △K(t+1) = I(t) - dK(t) 4. divide both sides by K(t) 5. Sub in 3uc for Y/K 6. Investment rate

Question 37

Investment Rate Equation

Answer 37

Question 38

What 3 terms does the investment rate depend on?

Answer 38

1. desired growth rate of capital 2. depreciation 3. user cost of capital

Question 39

Arbitrage Equation and the Price of a Stock

Answer 39

Question 40

How to solve arbitrage equation for the price of the stock?

Answer 40

1. divide both sides by price of stock | 2. solve for price of stock

Question 41

Arbitrage Equation solved for price of stock

Answer 41

Question 42

Price-Earnings (P/E) Ratios

Answer 42

ratio for valuing a company that measures its current share price relative to its earnings per share (EPS)

Question 43

P/E Ratio Equation

Answer 43

Question 44

Characteristics of Informationally Efficient Markets (3)

Answer 44

- financial prices fully and correctly reflect all available info - impossible to make economic profits by trading on basis of info - theory states that only unexpected news moves stock prices

Question 45

Mutual Funds Definition

Answer 45

a type of financial vehicle made up of a pool of money collected from many investors to invest in securities such as stocks, bonds, and other assets

Question 46

Types of Mutual Funds

Answer 46

Actively managed: constant buying and selling, deliver high returns with low risk, higher fees Index funds: managed by a single computer program, designed to imitate major stock index

Question 47

What is Tobin's model?

Answer 47

the only asset a firm has is its capital - stock value of firm is the value of the capital stock

Question 48

Tobin' Equation

Answer 48

Question 49

What does it mean if q > 1 and q < 1 in Tobin's Equation

Answer 49

q < 1 - value of firm is greater than the value of capital - firms should invest in more capital q > 1 - value of firm is less than value of capital - firms should disinvest

Question 50

2 basic predictions in Tobin's equation

Answer 50

1. value of q should be close to 1 | 2. value of q should be a useful predictor of firm investment