Buying and Selling: Applications

Three Applications Model with real endowments 1. Labor Supply (Labor-Leisure Choice) 2. Intertemporal Choice (Consumption-Savings Choice) 3. Uncertainty (Insurance) (Consumption across states of the world)

Intertemporal Choice Two periods: Today and Tomorrow Goods: consumtion today and tomorrow Endowment: income today and income tomorrow Possibility of borrowing and lending

Intertemporal Choice

Many Periods Cashflows

Many Periods Cashflow E: T=3, r=100%. Choose: $1 in each of the three period or $8 in the third

Important cashflow: Perpetuity Gives constant payment x forever Cashflow

Perpetuity (Example) You can rent an apartment for $1000 each month (r=0.5%=0.005) You can buy it P=300.000 Renting vs buying?

Perpetuity (Example) Valuate a consol that pays $10,000 per year. (r=5%=0.05) You inherit $1000,000. How much monthly interest are you going to get ? (r=5%=0.05)

Important cashflow: Annuity “Tree” that gives constant payment in T following periods Cashflow

Leasing or Buying A Car Leasing or buying a car? Lease T=3, x=$800, r=100% or buy P=750 Take a loan (how much do you pay monthly) Loan=1000, T=3, r=100% and x=?

Asset Valuation: Bonds Treasury bill: Face, Coupon, Maturity PV of T-bills (F, c, T) and r

Asset Valuation: Example T-bond (F=100, c=10, T=6) and r=5%

Life cycle problems Consumption – savings problem Pension: How much to put aside? How much am I going to get?

Consumption Smoothing Income: m=100 in the first 60 years Consumption C during 80 years, Constant consumption! Find C if r=5%

Pension Plan You want C=100 when retired (61-80) How much do you have to save if r=5%,

Pension Plan You save S=100 (21-60) How much will you get (per year) if r=5%,