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Unformatted text preview: Tools for Dynamic Analysis Contents: General Overview Key Element of Dynamics: Interest Rate The Components of Interest Rates Discounting Uncertainty and Interest Rates Benefit-Cost Analysis General Overview Natural Resource Economics addresses the allocation of resources over time. Natural Resource Economics distinguishes between nonrenewable resources and renewable resources. Coal, gold, and oil are examples of nonrenewable resources. Fish and water are examples of renewable resources, since they can be self-replenishing. Natural Resource Economics suggests policy intervention in situations where markets fail to maximize social welfare over time, i.e., where market forces cause depletion of nonrenewable natural resources too quickly or too slowly, or cause renewable resource use to not be sustainable over time (such as when species extinction occurs). Natural Resource Economics also investigates how natural resources are allocated under alternative economic institutions. Key Element of Dynamics: Interest Rate One of the basic assumptions of Dynamic Analysis is that individuals are impatient. They would like to consume the goods and services that they own today, rather than saving for the future or lending to another individual. Individuals will lend their goods and services to others only if they are compensated for delaying their own consumption. The Interest Rate (often called the Discount Rate in resource contexts) is the fraction of the value of a borrowed resource paid by the borrower to the lender to induce the lender to delay her own consumption in order to make the loan. The interest rate is the result of negotiation between the lender and the borrower. The higher the desire of the lender to consume her resources today rather than to wait, and/or the higher the desire of the borrower to get the loan, the higher the resulting interest rate. In this sense, the interest rate is an equilibrium outcome, like the price level in a competitive market. Even an isolated individual must decide how much of his resources to consume today and how much to save for consumption in the future. In this situation, a single individual acts as both the lender and the borrower. The choices made by the individual reflect the individual's implicit interest rate used for trading off consumption today for consumption tomorrow. Lets consider the following example. Suppose Mary owns a resource. Mary would like to consume the resource today. John would like to borrow Mary's resource for one year. Mary agrees to loan John the resource for one year if John will pay Mary an amount to compensate her for the cost of delaying consumption for one year. (The amount loaned is called the Principal. The payment from John to Mary in compensation for Mary's delayed consumption is called the Interest on the loan.)-2- Suppose Mary's resource is $100 in cash. Suppose the interest amount agreed to by Mary and John is $10. Then, at the end of the year of the loan, John repays Mary the...
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- Fall '07
- Interest Rates