Econ 102 Fall 2006

1
Econ 102 Fall 2006

• Lecture 2.1
• The Theory of Interest

2
Main Questions

• What determines investment?
• What determines saving?
• What determines the interest rate?

3
Main concepts

• Investment is determined by profit maximizing
  firms
• Saving is determined by utility maximizing
  households
• The interest rate equates the two

4
Irving Fishers theory of interest

• Irving Fisher 1867-1947
• Developed theory of interest
• His work was based on previous Austrian theories

5
Key Concepts

• Production Income is a flow derived from a stock
  of capital
• By waiting and building capital more can be
  produced in the future
• Consumption people prefer to consume early
  rather than late
• Interest is the price of not waiting

6
Production possibilities

• Society has a stock of resources, physical plus
  human capital
• These resources yield a flow of income
• The income (and the resources themselves) can be
  consumed or invested (used to produce capital
  goods)
• Tomorrows stock of resources is whats left
  after consumption

7
Income and capital
is physical capital
Production function
is income

• There are diminishing returns to capital
• This is why the slope of the production function
  is decreasing

8
Resource constraint

• Income can be consumed or invested (this is an
  identity)
• Consumption goods are purchased by both private
  and government sectors
• Investment goods are also purchased by private
  and government sectors

9
Investment and Capital
10
Production possibilities
11
Firms and investment
12
Firms and investment
13
Profit maximizing
Sales are constrained by the ppf
The firm seeks the highest feasible iso-profitline
14
Investment demand and profit maximization
This is the investment demand schedule
15
Indifference curves represent intertemporal
preferences
16
The budget set
17
Time preference
18
Utility maximization
The household divides income between consumption
and saving to maximize utility
19
Measuring saving instead of consumption
Income tomorrow
Income tomorrow
Income
Income
Saving
Consumption
Consumption
Saving
20
Saving and the interest rate
Consumption tomorrow
The interest rate
The saving schedule
S1
Slope (1r1)
S1
Interest rate r1
Interest rate r2
Slope (1r2)
S2
Y
Saving
S2
Consumption today
21
Interest and Production Sets
The slope of this line is the real interest rate
The budget set
Income tomorrow
Any individual household could have this much
income tomorrow if it saved zero
r
The pf
This much could be produced tomorrow if
investment is zero
SI
Saving and investment
22
Saving and Investment
The real interest rate
Saving and investment are equated by movements in
the real interest rate
Saving and Investment
23
Summary of Lecture

• Commodities can be classed as consumption or
  investment goods
• Income can be consumed or saved
• Firms weigh the benefit of investment against the
  cost of borrowing
• Households weight the benefit of more consumption
  tomorrow (interest) against the psychic cost of
  waiting

24
Reading and study questions

• Reading Chapter 6
• Page 168 2, 3 ,7