Discounting_new_

Discounting_new_ - Outline lecture on discounting 2010...

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Outline lecture on discounting 2010 16:01 A5/P5 Outline Discounting lecture for Econ 3022 Nov. 2010 Why do people discount the future? Abstracting from changes in the general price level, people discount the future because there is an interest rate on the market. Given this interest rate a £ in the future must be less valuable than a £ today – irrespective of inflation. For example, assume a market interest rate of 5%. Then a promise of repayment of £100 next year is only worth £100/1.05 this year – i.e. 95.238, for that is all that one needs to invest in order to obtain £100 next year. In other words the value this year – i.e. the present value – of a return next year is ‘discounted’ by the interest rate. But why is there an interest rate in the economy and what determines it? Various ways of looking at this, [e.g. John Broome’s emphasis on role of technological progress]. But for our purposes can follow traditional way of looking at it, namely to regard the underlying interest rate as simply another price, being the price that brings into balance the demand and supply of loanable funds. On the one hand the scope for profitable investment opportunities means that there is a demand for funds to finance investment. On the other hand, people have various reasons why they would be reluctant to lend money unless they get some reward for it. These two forces of demand and supply then determine the equilibrium price of loanable funds, namely ‘the’ interest rate. [In practice, of course, there are innumerable different interests rate on the
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Discounting_new_ - Outline lecture on discounting 2010...

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