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448_03IntertempEcon - Lecture Notes 3 Intertemporal...

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14 Lecture Notes 3 Intertemporal Resource Allocation The demand and supply of “investment funds” • As we noted in the first set of lecture notes, investment is critical to providing consumers with the maximum possible level of welfare that can be obtained with an available supply of resources. Most consumers would prefer to spread their consumption over time. They would like to save in periods when their income is in excess of their current consumption needs and borrow, or liqui- date their savings, in periods when their desired consumption is in excess of their income. • Investment by firms provides one way consumers can spread their consumption through time. When a consumer foregoes consumption and provides funds to a firm, the firm can generate in- come to be paid back to the consumer in the future. These income payments from the firm then allow future consumption to exceed future labor income. • Consumers may also be able to lend to each other if the time profiles of their income streams do not match the time profiles of their desired consumption streams. Some consumers may have more income than they currently wish to spend. If so, they can lend to others who wish to spend more than they currently have. The borrowers, in return, spend less than their income in the fu- ture, thus enabling them to repay the loan with interest. • Consumers can also invest directly through accumulating their own human capital. This reduces their current consumption or income but enables them to increase their future income in return. • The government can also change the income or consumption profile of consumers by investing in public capital assets. These could be infrastructure, such as roads or ports, that help make workers more productive in the future, or public assets, such as theaters or sports stadiums, that contribute directly to future consumption. • Before consumers would be willing to give up current command over resources in exchange for a promise of future command over resources, they would need to be confident that the promise
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15 will be kept. A legal system that can be relied upon to enforce contracts is a necessary pre-con- dition for consumers to save. 1 • Financial intermediaries specialize in channeling net savings from the household sector to finance the net borrowing of firms and governments in the financial markets. 2 • It is usual to assume in economics (and it is almost always found to be true empirically 3 ) that sub- stitution effects dominate income effects (see the further discussion below). In the current appli- cation, the dominance of the substitution effect implies that the net supply of savings from the household sector will be upward sloping as a function of the interest rate.
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448_03IntertempEcon - Lecture Notes 3 Intertemporal...

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