Chapter 11 Asset markets Assets are goods that provide a flow of services over time: consumption services (housing, durable goods), monetary flow (financial asset, for example, bond). Assume complete certainty about the future flow of services in this chapter. Two asset A: p 0 today and p 1 next year B: 1 dollar today and 1+r next year

In equilibrium for both assets to be held, it must be 1+r= p 1 / p 0. If 1+r>p 1 / p 0, A holder will sell asset A now and pushes p 0 to go down so that the return on asset A becomes higher. In equilibrium since the returns on A and B are equal, there is no chance to arbitrage. One adjustment regarding assets with consumption returns. A’: a house today costs P dollars, but next year, it can sell for P+a dollars.

a is the appreciation (depreciation) of the house. So should the return rate of a house be a/P? If you buy a house, you can rent the house to someone else. Suppose the rent is R a year. Then the rate of return should be (a+R)/P. By no arbitrage condition, r= (a+R)/P must hold in equilibrium. Assets like art objects have this similar property. R could be the dollar value of being able to enjoy the art for a year. So the return in financial terms can be lower.

Extracting oil Zero extracting cost, the demand for oil is constant at D barrels per year and there is a total supply of S barrels. So we have a total of T=S/D years of oil left. The perfect substitute of oil will come at T years after and it will cost C dollars per barrel. In equilibrium, it must be p t+1 =(1+r)p t for there to be a positive amount supplied every year.

At T years after, the price per barrel must be c. Hence p 0 (1+r) T =C Hence, unforeseen new discovery of oil will increase T and decrease p 0. On the other hand, a decrease of C will decrease p 0. Another application on when to cut a forest: the lumber that you get from a forest F(t), the price of lumber is constant, no cost of cutting, the growth rate of tree starts high and gradually declines.

When to cut the trees? The forest grows just like money in the bank grows. Hence we should cut at T: F(1)/F(0)>1+r, F(2)/F(1)>1+r, …, F(T)/F(T-1)≥1+r, F(T+1)/F(T)<1+r, so at any point of time, you save your money in the bank that pays the highest, either in a financial bank or in a “tree” bank. War profiteering? (A blockade on oil imports due to some war, price of oil immediately goes up.)

Opportunity cost (If you can sell at 1.5 per gallon 6 weeks from now, you would be foolish to sell at much less than 1.5 per gallon now.) (Moreover, it makes sense to start consume less today and try inventing alternatives. This is just like the stock market. Market reacts at the time the information about a future event is known. Won’t wait till the time the future event is realized.)

Asset markets allow people to change their pattern of consumption over time. Old people may have a lump sum and would like to have a stream of payments while young may have a stream of payments but want a lump sum now. bank Entrepreneurs need cash now to start off and will pay back in the future. Investors invest now and get paid back in the future. stock market