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Econ434handout11 - Economic Scene Pentagon Shows That It...

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May 24, 2001 Economic Scene: Pentagon Shows That It Doesn't Always Pay to Take the Money and Run By ALAN B. KRUEGER uppose your employer hands you a pink slip and offers you a choice: an annual payment of $8,000 a year for 30 years or a lump sum of $50,000 today. Which would you choose? This is not just a hypothetical exercise. When it downsized in the early 1990's, the Defense Department offered many military personnel a similar choice. The military also provided pamphlets and counseling to explain how to make the choice wisely. To the surprise of most economists, the affected personnel rarely followed the military's sound advice. The decision should depend, of course, on how much one values money received today versus tomorrow. A bird in the hand is worth more today than tomorrow, but how much more? The difference between the value an individual places on a dollar received today as opposed to a year from now is called the discount rate. Standard economic theory says that if capital markets work perfectly, people will borrow or lend until their discount rate equals the market rate for borrowing or lending. Someone with a low discount rate will save money and accumulate interest; someone with a high discount rate will borrow and accumulate debt. This should continue to the point where their personal discount rates equal the market rate. Thus, with some justification, the military's pamphlet provided calculations of the present value of the annuity payment using a 7 percent discount rate, the interest rate on money market funds at the time. If the annuity's present value exceeds the value of the lump sum, the annual payment is a better deal.
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