Week 9: Consumption and Savings II Flashcards
Diagram for Different Interest Rates for Borrowers and Lenders
Interest Rates for Borrowers Increases Diagram
4 consequences of an increase of borrowing rate?
- increased cost of borrowing - less likely to borrow
- more likely to save as improved returns
- higher mortgage repayments
- economic growth will slow
Increased Borrowing Rate Diagram with Intertemporal Preferences
Why does Ricardian Equivalence not hold when the borrowing rate changes? 3 reasons
- 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
Collateral Definition
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
How does a collateral work with a lender?
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
What are the simplifying assumptions for collaterals and credit markets? (2)
- interest rates is the same for borrowers and lenders
2. collateral cannot be sold in first period
Consumption equation with house (price per square metre) as collateral
Consumption diagram with house (price per square metre) as collateral
What do lenders request with a collateral?
Repayment from borrower must be lower than or equal to the value of the house
Diagram for how much someone can borrow using a collateral
What happens if the price of a collateral decreases? Diagram
What happens if the price of a collateral decreases?
Reduces the amount and maturity of firm debt
Precautionary Saving
Saving just in the case of an uncertain and unpredictable event
3 main findings from evidence from household consumption
- 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
Marginal Propensity to Consume (MPC)
the proportion of an aggregate raise in pay that a consumer spends on the consumption of good and services
Consumption Smoothing
creating a balance between spending and saving during the different phases of our lives to achieve a higher overall standard of living
Investment
an asset or item acquired with the goal of generating income or appreciation - todays investment influences future opportunities
How do firm’s make investment decisions?
Keep investing in capital until MPK = difference between real interest rate and growth rate of the price of capital
Marginal Product of Capital (MPK)
the amount of extra output the firm get from an extra unit of capital, holding the amount of labour constant
Two ways to invest
- save money in the bank
2. buy new capital
Arbitrage Equation
Arbitrage Equation Rearranges with P(k,t) = 1
User Cost of Capital
the unit cost for the use of a capital asset for one period – the price of employing or obtaining one unit of capital services
Arbitrage Equation/Arbitrage Pricing Theory
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
Growth Rate in Price Equation
What does it mean if growth rate is positive or negative?
Positive - ‘capital gain’
Negative - ‘capital loss’
Why does price of capital change? (3 reasons)
Depreciation
Technological change in electronics
Scarce resources
Arbitrage Equation that Includes Depreciation
User cost of capital
total cost to the firm of using one more unit of capital
How much should a firm invest? Diagram
Add a Tax Component (τ) to Investment Equation
Rearrange the Investment Equation with Tax Component for MPK (when MPK = user cost of capital)
Increase in Corporate Income Tax Diagram
Method to calculate investment rate from desired capital
- using production function, MPK and standard accumulation formula
- rearrange MPK equation to Y/K = 3.uc
- Rewrite capital accumulation equation: △K(t+1) = I(t) - dK(t)
- divide both sides by K(t)
- Sub in 3uc for Y/K
- Investment rate
Investment Rate Equation
What 3 terms does the investment rate depend on?
- desired growth rate of capital
- depreciation
- user cost of capital
Arbitrage Equation and the Price of a Stock
How to solve arbitrage equation for the price of the stock?
- divide both sides by price of stock
2. solve for price of stock
Arbitrage Equation solved for price of stock
Price-Earnings (P/E) Ratios
ratio for valuing a company that measures its current share price relative to its earnings per share (EPS)
P/E Ratio Equation
Characteristics of Informationally Efficient Markets (3)
- 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
Mutual Funds Definition
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
Types of Mutual Funds
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
What is Tobin’s model?
the only asset a firm has is its capital - stock value of firm is the value of the capital stock
Tobin’ Equation
What does it mean if q > 1 and q < 1 in Tobin’s Equation
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
2 basic predictions in Tobin’s equation
- value of q should be close to 1
2. value of q should be a useful predictor of firm investment
