422fisher1_ez - FINANCE THEORY: Intertemporal...

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1 FINANCE THEORY: Inter- temporal Consumption-Saving and Optimal Firm Investment Decisions ECON 422:Fisher 1 © R.W.Parks/E. Zivot Eric Zivot Econ 422 Summer 2010 Reading z PCBR Chapter 1 (general overview of PCBR, Chapter 1 (general overview of financial decision making) z Varian, Intermediate Microeconomics: A Modern Approach . Chapter 10, Intertemporal Choice. ECON 422:Fisher 2 z Hirshleifer and Hirshleifer, Price Theory and Applications, Chapter 14, The Economics of Time. © R.W.Parks/E. Zivot
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2 Goals of this Section z Understand the economic principles behind Understand the economic principles behind inter-temporal consumption-savings decisions z Introduce present value concepts z Understand the roll of financial markets for the efficient allocation of savings and capital investmen ECON 422:Fisher 3 © R.W.Parks/E. Zivot investment z Understand what determines the level of interest rates The Fisher Model z Model of intertemporal choice involving consumption and investment decisions. (Named after Yale economist Irving Fisher) z Key Assumptions: » Two periods (generalizing to many future ECON 422:Fisher 4 © R.W.Parks/E. Zivot » Two periods (generalizing to many future periods is straightforward). » Perfect capital markets » the absence of uncertainty
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3 I. Intertemporal Exchange Model: Outline A Objects of choice endowments and A. Objects of choice, endowments and trade opportunities, preferences B. Individual optima and comparative statics C. Market exchange equilibrium and the ECON 422:Fisher 5 © R.W.Parks/E. Zivot determination of interest rates. Objects of choice z What is the consumer choosing? z One of the many possible “Consumption Streams” z A consumption stream is a sequence of time dated consumption, for the present and for the future; e.g. (C 0 ,C 1 ) ECON 422:Fisher 6 © R.W.Parks/E. Zivot »C 0 is the standard of living or consumption level for period 0 (the present) 1 is the standard of living or consumption level for period 1 (the future)
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4 Representing a Consumption Stream ECON 422:Fisher 7 © R.W.Parks/E. Zivot Consumer Preferences: Basic Assumptions z Consumers are able to choose between Consumers are able to choose between alternative consumption streams. z Choices are consistent (transitive) z They prefer more consumption to less; i.e., they prefer higher standards of living to lower. Ch t h t f d ECON 422:Fisher 8 © R.W.Parks/E. Zivot z Consumers choose the most preferred consumption stream among those attainable.
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5 Ways to Represent Consumer Preferences z Simple ranking of consumption choices z Utility function, U(C 0 , C 1 ) z Indifference curves: level sets of utility function » Combinations of C 0 and C 1 such that utility ECON 422:Fisher 9 © R.W.Parks/E. Zivot such that utility is constant (doesn’t change) » downward sloping, non intersecting, and convex shape Utility Function, U(C 0 ,C 1 ) z The utility function gives an index value for each consumption stream.
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This note was uploaded on 12/21/2011 for the course ECON 422 taught by Professor Staff during the Fall '08 term at University of Washington.

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422fisher1_ez - FINANCE THEORY: Intertemporal...

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