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Intertermporal Choice II
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Intertemporal Choice Two periods: Consumption smoothing
Today: Many periods
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3 Periods Cash flows
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Many Periods Cash flow E: T=3, r=100%. Choose:
$1 in each of the three period or $8 in the third
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Translation Cashflow
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Important cashflow: Perpetuity
Gives constant payment x forever Cashflow
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Perpetuity (Example) You can rent an apartment for $1000 each month (r=0.5%=0.005) You can buy it P= Renting vs buying?
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Quiz Consider consol that pays $10,000 per year. (r=5%=0.05)
Q: In terms of todays dollars consol is worth A) $ 10,000 B) $100,000 C) $ 200,000 D) $1000,000
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Important cashflow: Annuity
“Tree” that gives constant payment in T following periods Cashflow
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Quiz: Leasing or Buying A Car
Lease T=3, x=$800, r=100% or buy P=750 You should Buy a car Lease a car Both options are equally attractive
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Loan Payment Take a loan (how much do you pay monthly)
Loan=1000, T=3, r=100% and x=?
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Asset Valuation: Bonds
Treasury bill: Face, Coupon, Maturity PV of T-bills (F, c, T) and r
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Asset Valuation: Example
T-bond (F=100, c=10, T=6) and r=5%
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Life cycle problems Consumption – savings problem Pension:
How much to put aside? How much am I going to get?
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Consumption Smoothing
Income: in the first 40 years Consumption C during 60 years, Constant consumption! Find C if r=5%
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Pension Plan You want C=100 when retired (61-80)
How much do you have to save if r=5%,
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Pension Plan You save S=100 (21-60)
How much will you get (per year) if r=5%,
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