PAM_2000_Fall_2008_Chapter_16 - Title: Glamorous Artist:...

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1 • Title: Glamorous • Artist: Fergie • Economic concept: income-consumption path; Engel curve • Representative lyrics: To support your shoe fetish Lifestyles so rich and famous Robin Leach will get jealous Half a million for the stones Taking trips from here to Rome So If you ain't got no money take yo broke ass home PAM 200: Intermediate Microeconomics Prof. John Cawley Chapter 16: Interest Rates, Investments, and Capital Markets
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2 Where We Are Consumer Theory Individual Demand Market Demand Theory of Production Costs of Production Perfect Competition Imperfect Competition: Monopoly Monopolistic Competition Oligopoly Prices General Equilibrium Market Imperfections Factor Markets Strategy Game Theory Outline • Comparing money at different points in time – Interest rates and discount rates – Present value of money invested in the past – Present value of money to be received in the future – Future value of money invested today • Choices over time; investment decisions – Net present value – Internal rate of return
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3 Interest Rate • Interest rate : how the market values money today versus money tomorrow; if interest rate is i , – If you borrow $1 today you will owe $1*(1+ i ) next period – If you lend $1 today you will be owed $1*(1+ i ) next period – $1 that you’ll receive next period is worth today 1 $1* (1 ) i + Discount Rate • Discount rate : how a person values money today versus money tomorrow – $1 tomorrow is worth today – Myopic : high discount rate • Person on death row has high discount rate; assigns little value to future events – Farsighted : low discount rate • A person will want to borrow money if her discount rate exceeds the market interest rate 1 $1* ) d +
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4 Compounding Interest • Legend: Einstein, asked what is the most powerful force in the universe, answered: “compounding interest” • Interest is compounding when your interest earns interest. Example: – Year 0: deposit $100 in bank account – Year 1: balance is $100*(1+ i ) – Year 2: balance is $100*(1+ i )*(1+ i ) – Year 3: balance is $100*(1+ i )*(1+ i )*(1+ i ) – Year t: balance is $100*(1+ i ) t Frequency of Compounding • Earn more interest the more often interest is compounded (calculated and paid) • Example: Suppose interest rate is i =.04 (4%) – If bank compounds annually: • At end of 1 year will have for each dollar deposited: – If bank compounds semiannually: • Will have after six months: • At end of year will have for each dollar deposited: .04 (1 ) 1.02 2 += .04 .04 )*(1 ) 1.0404 22 ++ = (1 .04) +
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5 Frequency of Compounding • If invest A 0 dollars at interest rate i , with interest compounded k times per year, then after t years will have: • As compounding becomes continuous (as k approaches infinity), this equals: where 0 (1 ) kt t i AA k =+ 0 it t A Ae = 1 lim 1 2.718 k k e k →∞ ⎛⎞ = ⎝⎠ Interest and the Frequency of Compounding
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6 Truth in Lending • Because the actual amount of interest paid depends on how often interest is compounded as well as the interest rate, it used to be hard to compare offers by lenders
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This note was uploaded on 05/30/2009 for the course PAM 2000 taught by Professor Evans,t. during the Spring '07 term at Cornell University (Engineering School).

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PAM_2000_Fall_2008_Chapter_16 - Title: Glamorous Artist:...

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