Revision Notes.docx - Money Banking and Financial Markets...

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Money Banking and Financial Markets Agents acquire goods because they want to consume them, but money is acquired because it facilitates the acquisition of goods in the future. Money Medium of Exchange Liquidity premium Money is a bubble market value is disconnected from the fundamental value e.g. present discounted value of dividends or rent price for a house Lack of double coincidence of wants i.e. ‘friction’ preventing barter (trading without money) Imperfect commitment problem preventing use of credit (issuing loans) Essential characteristics for a monetary economy: A Model with money requires: - Existence of some ‘friction’ to trade: If agents can trade goods for any other good at no cost, there is no role for money - Agents acquire money in order to spend it in the future: There can be no last period! There are two possibilities to meet the second requirement: Agents live forever, or individuals die but their generations overlap Overlapping Generations Model (Introduced by Paul Samuelson in 1958) The Environment: Individuals live for two periods, we call people in their first period of life: young, and in their second period of life: old Economy starts in period 1. In each period t≥1 there are N t agents born the future generations In the first period there live N 0 initial old individuals In each period there are N t young people and N t-1 old people - One nonstorable consumption good - Each individual receives a single perishable good, endowment y, of the consumption good in the first period of life - In the second period of life no agent receives an endowment - Everyone wants to consume both when young and old Preferences: Future Generations - Agents want to consume in both periods - To receive another unit of consumption tomorrow, a person is willing to give up some quantity today - Utility of an individual depends on a combination of consumption when; young: c 1,t (first period of life, born in t), old: c 2,t+1 (second period of life, born in t) - Agents rank consumption bundles of the quantities c 1 and c 2 - There are always some bundles (c 1 , c 2 ) where individuals are indifferent which one to choose - An indifference curve connects all consumption bundles that yield equal utility to the individual - Curve has negative slope; agents are willing to give up c 2 for c 1 - Curve gets flatter as we move to the right. Agents are willing to give up less and less c 2 for one unit of c 1 : diminishing marginal rate of substitution - Transitivity: If an agent prefers, bundle B to A, bundle C to B, then this agent must prefer bundle C to A. Graphically this implies that indifference curves can never cross
Preferences: The Initial Old - The Initial Old live and consume only in the initial period - They want to maximize their consumption in that period Economic Problem: Each future generation has access to the nonstorable good only when young but wants to consume in both periods.

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