Econ 185 - Summer 2006

The Simple IS-MP Model

We capped the week with an introduction of the Simple IS-MP Model.

Monetary Economics

The transactions demand for money and fractional reserve banking (with open market operations) anchor the demand and supply of money.

Risk - III

We extended our discussion of the mean-variance analysis diagram.

We then discussed hedging and speculating using options.

Risk - II

We reviewed the concepts of expected value, variance, and standard deviation.

We then went through page 3 in the handout, showing that the utility-based valuation of risk and the statistical view are similar.

We concluded by introducing the mean-variance analysis diagram.

Risk - I

We began to consider how to analyze asset markets when the outcomes are uncertain.

Midterm Answers

Getting Ready for the Midterm

We are spending Tuesday and Wednesday getting ready for the midterm on Thursday.

The Expectations Hypothesis

The Expectations Hypothesis is one possible linkage between short-term interest rates and long-term interest rates. If future interest rates are largely determined by future inflation, then the long-term bond market is going to be sensitive to forecasts of future inflation.
A handout from today's WSJ illustrated this concern.

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Calculating the forward rate is another view of this issue.

The equations for the expectations hypothesis and the forward rate are very closely related. The forward rate is not necessarily equal to the expected future rate because an unobservable risk premium is also a component of the long-term rate.

Exchange Rates - II

We looked at a more equation-oriented view of the linkages, showing how interest rates, inflation rates, and changes in the exchange rate might be related for two countries.

Exchange Rates - I

We discussed the Purchasing Power Parity and Interest Rate Parity views of linkages between countries.

PPF - Optimal Investment in Education

By letting the horizontal axis be young (age < 30) we extended the production possibility frontier diagram to an analysis of the optimal investment in education.

PPF - Optimal Saving for Retirement

Introducing a Production Possibility Frontier allows us to extend the Intertemporal Substitution framework to study the optimial saving for retirement. We also demonstrate that people benefit from the existence of financial markets in that they attain higher utilities than would otherwise be possible.

As a bonus, we considered the effects of making the interest on retirement savings tax free.

Intertemporal Substitution

We modified the Two Goods - Two Prices diagram to have one good in two time periods. The budget constraint then incorporates the interest rate.

Investment in Education

We used the decision to go to college as an example of a typical investment decision. The costs are in the near future, and the benefits are spread over a much longer period. The decision to make the investment depends on the interest rate. (We did not do those calculations, but it is true.)

We focused on the effects of a growing benefit, assuming in this case that income will grow over time. We then discounted at a real interest rate, which made a large difference in the investment decision.

Mortgages

We studied the market values of fixed rate mortgages.