determinants of the level of real interest rates · 2010. 7. 20. · 1 determinants of the level of...
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Determinants of the Level of Real Interest Rates
Societal PreferencesSocietal Preferences» The more present oriented are societal
preferences, the higher the market r– Shifts borrowing curve out
Societal Endowments» The more present oriented are societal
endowments the lower the market r
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endowments, the lower the market r– Shifts lending curve out
Productive Opportunities [see later]
II. Intertemporal Production (Real Investment) and
Exchange: OutlineExchange: Outline
A. Individual optimaB. The Fisher Separation TheoremC. Market equilibrium
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C. Market equilibrium
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An Intertemporal Production Function Shows the Relationship Between Inputs Today and
Outputs in the Future
IOutputOutput
Q0
Q1F(I)
Note: slope of F(I) is called the marginal
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0 Io I1 Input
grate of transformation(MRT)
From Production Function to Fisher Diagram
Reverse the production function aroundReverse the production function around the vertical axisDrag the origin to the endowment point of the Fisher diagram
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Production Function to Fisher Diagram
OutputOutput
Production Function Reversed
Inputs
Output
C1
0 0Inputs
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0 Co
Endowment point
Consumer-Investor Optimum with No Borrowing or Lending
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Optimal Real Investment with Borrowing and Lending Opportunities
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Optimal Real Investment with Borrowing and Lending Opportunities
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Optimal consumption and investment
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The Fisher Separation Theorem
The consumer - investor’s two-fold problem ofThe consumer - investor s two-fold problem of determining the optimal level of investment and the optimal consumption stream can be separated into two steps:» First choose the investment level that
maximizes wealth. This choice does not
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maximizes wealth. This choice does notdepend on preferences.
» Next determine the optimum consumption stream, based on the maximized wealth.
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The Fisher Separation Theorem (continued)
The choice of optimal investment can beThe choice of optimal investment can be separated from the choice of optimal consumption. i.e it does not depend on investor preferences.A necessary condition for utility maximization is wealth maximization.
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is wealth maximization.Note: The separation result depends on the existence of a perfect capital market. Investors can borrow or lend at the market rate r.
Optimal Investment and NPV
Optimal investment maximizes currentOptimal investment maximizes current wealthEquivalently, optimal investment maximizes Net Present Value (NPV)» NPV = PV of investment cash flows – initial
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investment cost
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Example: Fisher Separation
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Example: Fisher Separation
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Determinants of the Level of Real Interest Rates Revisited
Societal Preferences» The more present oriented are societal preferences, the» The more present oriented are societal preferences, the
higher the market r– Shifts Borrowing curve out
Societal Endowments» The more present oriented are societal endowments, the
lower the market rS f
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– Shifts lending curve outProductive Opportunities» The more productive are the opportunities for converting
present into future resources through real investment (i.e. production), the higher the market r.
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