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ECON10A_12 - 1 Discounting Consumption in future is not as...

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1/4/2008 1 Review – Supply of Capital
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1/4/2008 2 Discounting Consumption in future is not as valuable as consumption today Interest rate r is one way to capture this $1 today→$(1+r) next period $1 next period→$1/(1+r) today
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1/4/2008 3 Budget Constraint - Algebraically I 1 income in period 1 I 2 income in period 2 Express total income in present dollars: I 1 + I 2 /(1+r) Budget line: c 1 + c 2 /(1+r)= I 1 + I 2 /(1+r) p 1 x 1 +p 2 x 2 = I 1 + I 2 /(1+r) p 1 =1, p 2 =1/(1+r) “Price” of $1 now is $1 now “Price” of a future dollar of consumption is 1/(1+r) dollars now. Give up 1 units present consumption→ Can consume (1+r) in future Budget line: c 1 + c 2 /(1+r)= I 1 + I 2 /(1+r) C 1 C 2 I 1 I 2 Slope= -(1+r)
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1/4/2008 4 Indifference Curves U(c 1 , c 2 ) MRS=mu 1 /mu 2 Diminishing MRS C 1 C 2 I 1 I 2
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1/4/2008 5 Putting It All Together - graphically Max U(c 1 ,c 2 ) s.t. c 1 +c 2 /(1+r) = I 1 +I 2 /(1+r) Tangency Condition Optimum occurs where: Slope of indif cuirve = Slope of budget line Budget condition Optimum must be on budget line c 1 +c 2 /(1+r) = I 1 +I 2 /(1+r) C 1 C 2 I 1 I 2 r c c mu c c mu + = 1 ) , ( ) , ( 2 1 2 2 1 1 C 1 * C 2 *
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Question 1 If interest rate is 5%, what is c 2 *? A. 79 B. 80 C. 85 D. 100 E. Can’t Tell 1/4/2008 6 c 1 c 2 100 100 120 c 2 *
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Question 1 If interest rate falls, c 2 * will A. Rise B. Fall C. Can’t tell 1/4/2008 7 c 1 c 2 100 100 120 c 2 *
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1/4/2008 8 Supply of Goods and Services
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1/4/2008 9 Overview We learned how households choose quantity of a given commodity they will consume, given prices and income. (Quantity demanded) But goods must be produced (i.e., supplied). We have yet to see how firms choose the quantity of goods they will produce, given prices and costs.
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