February 12, 2004
Saving for Retirement
Retirement is a fundamental motivation for saving. We considered this by adding a production possibility frontier to our intertemporal substitution diagram.
The most important point of the discussion is that access to financial markets makes the agent better off. This explains the existence of financial markets.
The diagram also shows how taxing interest income causes people to work less when they are young. Conversely, cutting the tax rate on interest income would cause people to work more when they are young.
The production possibility frontier does not take on the shape below because there is an interaction between the amount you work when you are young and the amount you can work when you are old.
The agent can have any point on a budget constraint if he can get to some point on that budget constraint. Given a production possibility frontier, the agent solves the problem of getting to the best possible budget constraint.
Investing in Education
A production possibility frontier also provides a nice explanation of the decision to invest in education, particularly the decision to borrow money to finance an education.
Again, the most important point is that access to financial markets makes the agent better off. In this case, a government guarantee (or a parental signature) is often necessary to secure that access.
Subsidizing the student loan rate can make the student even happier. We analyzed the potential misallocation of society's investment resources to see if subsidizing student loans is a good idea.
It turned out that subsidzing student loans is a very good idea if education entails a large positive externality for society. That is, if everybody (not just the student) benefits from the student's education. An example might be a student who starts a company (using skills learned in school) that generates 1,000 new jobs.