Ch 6 Intertemporal Consumption

Eco 204 s ajaz hussain do not distribute at start of

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Unformatted text preview: nsumption (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. At start of each individual “endowed” with (individual specific) units of corn At start of each individual “endowed” with (individual specific) units of corn “Young” Agent chooses corn consumption level If If “Old” Agent chooses corn consumption level “save” corn at RBC If then “live off” savings + interest “borrow” corn from RBC If then “pay back” loan + interest In this inter-temporal UMP model agents do not save in both periods nor do they borrow in both periods. If you save when you’re young then you “un-save” when you are old and if you borrow when you’re young then you “save” when you are old. Why can’t agents save in both periods? For one, it’s because there’s no uncertainty in this economy because agents have perfect foresight. Secondly, it’s because there’s no sexy time in this ecornomy: no romance, no chocolates, no walks on moonlit beaches, no fireplaces, no inky-binky action. Without sexy time, agents can’t have children which means that they won’t die with savings to be bequeathed to their children. On the other hand, why can’t agents borrow in both periods? Because RBC has gangsters who will make debtors pay back loans or else .. ! Recall that agents can save corn at, or borrow corn from, RBC (Royal Bank of Corn). We assume that RBC offers savers and charges borrowers a nominal interest rate . From ECO 100 recall that “nominal” variables are in terms of currency whereas “real” variables are in terms of real (actual) goods. For example, suppose you earn $100/day. Your nominal wage is: The nominal wage tells us how much money you earn but not how many goods you can buy (earning power). Suppose that the price of a unit of corn is In this case, your real wage is: 4 ECO 204 Chapter 6: Inter-temporal Consumption (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. The real wage tells us how much you earn in terms of a real good (in this corn). In the same way, the nominal interest rate is the interest rate on the dollar value of savings/borrowings as opposed to the real interest rate which is the interest rate on the real value of savings/borrowings. Take a look at this scenario: Scenario # 1: No Inflation Suppose you borrow $100 In real terms, you’ve borrowed 100 units ( ) ( ) Pay back In real terms, you’re paying back 110 units Suppose at you borrow $100. Since the nominal interest rate is 10%, in you will pay back $110. Now look at this problem in real terms (in terms of corn). Observe there is no inflation here ( ). When you took out a loan of $100, you really borrowed 100 units of corn. When you pay back the loan, you do so in dollars ($110). In terms of corn however you’re paying back $110/$1 = 110 units of corn. That is, you borrowed 100 units of corn and are paying back 110 units of corn: the “real”...
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This note was uploaded on 03/20/2014 for the course ECON 204 taught by Professor Ajazhussain during the Fall '09 term at University of Toronto- Toronto.

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