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Time and the Discount Rate

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Presentation on theme: "Time and the Discount Rate"— Presentation transcript:

1 Time and the Discount Rate
Project flows of costs and benefits are not even over time.

2 Flow of Costs and Benefits
Consider 2 Investment Options Option1 Year Cost Benefit Net Sum Option 2 Year Cost Benefit Net Sum

3 Flow of Costs and Benefits
Net Benefits by Year

4 Flow of Costs and Benefits
These two options have very different flows of costs and benefits over time. Is there any difference between these two options? Which is preferred?

5 Flow of Costs and Benefits
In order to address this question, need to understand how the future is valued relative to the present: Intertemporal time preferences The interest rate

6 Time Preference of Consumers
Consider consumers have a stock of wealth today, and must choose to consume between today and tomorrow. Intertemporal indifference map Time indifference Intertemporal indifference curve

7 Intertemporal Consumption Choice
Consumption T1 S1 x S0 x I0 (Intertemporal Indifference Curve) C1 C0 Consumption T0

8 Intertemporal Consumption Choice
A Family of Indifference Curves Consumption T1 Consumption T0

9 Time Preference of Consumers
Expect consumers to have “positive time preference” : prefer consumption today rather than in the future Why? There is a chance that will not be able to consume in the future (in the long run we are all dead) Expectation that income will be higher in the future (economy will grow) (Goods and services will be more abundant in the future as a result of economic growth)

10 Intertemporal Consumption Choice
Consumption T1 “PPF” (Slope=-1) S0 = C0 Se < Ce Zero time preference 450 Positive time preference C0 Ce Consumption T0

11 The price of current consumption
Income or wealth that is consumed today is not available to be saved for consumption in the future. What is the price of consuming today? Interest rate: amount that savings today can be increased in the future, through investment.

12 Interest Rate The price (or opportunity cost) of consuming a dollar of income or wealth today rather than saving for consumption in the future Expressed as a percentage increase: (K1/K0)-1} * 100 K0 money invested in time 0 K1 money obtained from investment in time 1

13 Interest Rate Example: Invest $100 in time 0 Return = $112 in time 1
(112/100-1) * 100 = 12% A unit-free measure, expressed as a ratio

14 Interest Rate Consumption T1 150 112 100 i = 50% i = 12% i = 0% 100

15 Time Preference of Consumers
From consumers’ time preferences, derive the supply of savings. Determine amount of income and wealth that households will save for the future at different interest rates.

16 Response to change in interest rate
Consumption T1 i2 i1 S2 S1 i0 S0 Consumption T0

17 Response to change in interest rate
Ssavings i2 x i1 x i0 x S0 S1 S2 Savings ($)

18 Investment opportunities
Investment opportunities generate the demand for savings (capital) Intertemporal production possibility frontier

19 Intertemporal production possibility frontier
PPF I0 P1 P0 Production0

20 Demand for Investment Rank potential investments according to the rate of return, from highest to lowest. This will give the derived demand schedule for savings

21 Demand for Investment Production1 i2 i2 I1 i1 I0 PPF i0 Production0

22 Response to change in Interest Rate
x i1 x i2 x Demand for Invesment I0 I1 I2 Investment Demand ($)

23 Capital Market Supply i of Savings ieq Demand for Investment Qeq
Quantity ($)

24 Interest rate In market equilibrium interest rate (r) = MRS = MRT
In reality: transactions costs associated with matching up suppliers and demanders of savings: Financial intermediation (banks) Spread between savings and borrowing rate Risk premia

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