Financial Theory: Lecture 6 Transcript
September 22, 2009
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Professor John Geanakoplos:
All right, so we spent a long time reviewing general equilibrium and we've
now switched to finance, and you're hopefully going to see that the principles of finance emerge very quickly
from the principles of general equilibrium. So that although it seems it was a long interlude we've actually
learned a lot about the financial economy. So I'm going to continue with the example that we started with the
last time. So we have a financial economy. So in a financial economywhat is a financial economy?
On this top board the financial economy is defined by lots of people in the economy and their utilities. So
here we have for simplicity two kinds of people A and B with utilities given by the log X
1
+ 1 half log X
2
etcetera. It's also people know today what their endowments are and they have some idea of what they're
going to be tomorrow. They're labor powered today and they're going to be able to work again next year. So
the labor endowments are given by (1, 1) for A, and (1, 0) for B.
And then they also know that there are two stocks in the economy and they have to anticipate what the
dividends are going to be. And as Fisher said, the main value of assets is that they give you something, they
produce something. In this case they're going to be dividends and beta's producing dividends of 2, and alpha
is producing a dividend of 1 next period, and then the ownership of shares.
So that's the beginning of the economy and we want to define from that equilibrium which involves: what are
the contemporaneous prices going to be, that's Q for contemporaneous, what are the prices of the stocks
going to be, and who's going to hold which portfolio of assets of stocks, and who's going to consume what.
And so Fisher said that's a very complicated problem. You can simplify it by looking at a general equilibrium
problem which is much shorter to describe. And so the general equilibrium economy is going to be a much
simpler one.
It's going to consist of U
A
and U
B
the same as before, and Ehat
A
1
, the endowments, Ehat
A
2
and (Ehat
B
1
Ehat
B
2
). So we've left out half the variables up there and we define Ehat
A
1
= E
A
1
= 1 and Ehat
B
1
= E
B
1
=
1, but Ehat
A
2
(this is the Fisher insight) = E
A
2
+ what A owns of the payoffs of the future dividends, [theta
bar
A
alpha
times D
alpha
2
plus thetabar
A
beta
times] D
beta
2
. Since A owns half of the alpha stock, sorry, all of
the alpha stock and half of the beta stock, his endowment is 1, his original thing, plus what the stock is going
to produce, and after all he's the owner. So he's going to get all of 1 + a half of 2 which is = 3. I took more
space than I thought. And so similarly Ehat
B
2
is going to be 1 + a half of 2 which = 2. So here endowments
are this and also let's just write it here, Ehat
A
2
= 3, so this.
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 Fall '09
 GEANAKOPLOS,JOHN
 Inflation, Interest Rates, Interest Rate, Nominal Interest Rate, Fisher equation, Professor John Geanakoplos

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