8Financial Theory

8Financial Theory - Financial Theory

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Financial Theory: Lecture 8 Transcript September 29, 2009 << back Professor John Geanakoplos: So we're spending a couple classes these days learning basic facts and vocabulary about finance, and along the way we're trying to apply the simple lessons that Irving Fisher taught about turning a financial problem into a general equilibrium problem and making use in particular of the budget set. That very simple budget set we wrote down at the very beginning turns out to be quite useful and people often can get quite confused. So the last issue we ended with, I'm going to take up again. Suppose that you've got a very long-lived institution like Yale. How should Yale think of how much to spend every year? What is Yale's budget set? Almost every big institution like Yale creates a fiction of an annual budget and they talk about the deficit and having to bring the deficit under control and making cuts to close the deficit gap, but really there is no such thing as a one-year budget set. I mean, why one year? Why not one month? Why not one day? Nobody expects Yale to balance its budget every day. Some expenditure comes in one day. They have to hire an electrician to fix something unexpected. They're going to spend more money than they take in student tuition that day. So the fact that they're supposed to budget the balance every year is just a fiction. Irving Fisher taught us that Yale really has--if you can borrow and lend and you don't have to worry about risk there's one infinite-lived budget set. It's an infinite horizon budget set where you just take the present value of all the expenditures, that's the left hand side, and the present value of all the revenue, that's the right hand side, and make sure that the left hand side is smaller than the right hand side over the whole course of Yale's life. So that simple principle has a tremendous implication which was overlooked, to the chagrin of the last Yale president. So as I said, the issue was in 1997, I believe, it could have been '96 something like that, 1997, Benno Schmidt, who was then the Yale president, released a white paper, he called it, documenting the fact that Yale had deferred maintenance in the buildings, he called it, and a study that he commissioned, a very good study that he commissioned, argued that the deferred maintenance--Yale could be brought up to snuff and then go on afterwards as a normal running institution provided it spent 100 million dollars a year for ten years, and that included fixing every college--they're going to do more than one a year over a 10 year period. So Yale's total budget, as I told you, was about 1 billion dollars at the time, and then here all of a sudden was this 100 million dollar a year expense for 10 years. That's 10 percent of the Yale budget. And a lot of the costs you can't change. You have to have the lights on. You have to heat the buildings.
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This note was uploaded on 02/08/2012 for the course ECON 251 taught by Professor Geanakoplos,john during the Fall '09 term at Yale.

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8Financial Theory - Financial Theory

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