Financial Economics-A.R.Ahmad*Introduction: Capital Markets, Consumption and investmentObjective: to study consumption and investment decisions made by individuals and firms. Framework: one good and one person economy. Trade-off b/w consumption now and consumption in future is allowed.

Information: He needs to know the following two things (1) Subjective trade-offs b/w consumption now and consumption in future. (2) The feasible trade-offs b/w present and future consumption that are technically possible.

The optimal rate of exchange b/w consumption now and in the future is R-rate interest rate is price of deferred consumption or the rate of return on investment

Financial Economics-A.R.Ahmad

Financial Economics-A.R.Ahmad*Do capital markets benefit society? Assumptions: 1. All outcomes from investment are known with certainty. 2. There are no transactions costs. 3. There are no taxes.4. The decisions are made in one period context.5. The individual are endowed with income yo and y1.

Financial Economics-A.R.Ahmad

Financial Economics-A.R.Ahmad*6. Individual must decide how much to actually consume now, (Co) and how much to invest in productive opportunities in order to provide end-of-period consumption, (C1).

7. Every individual is assumed to prefer more consumption to less.

Financial Economics-A.R.Ahmad

Financial Economics-A.R.Ahmad*Intertemporal Consumption : Indifference Curves

Consumption in period - oneI1Consumption in period-zeroI0HDEFABGy1x0x0y0

Financial Economics-A.R.Ahmad

Financial Economics-A.R.Ahmad*Productive Investment OpportunityAssumptions: (1) All investment are assumed independent of one another, and (2) Are perfectly divisibleMarginal rate of returnTotal InvestmentSlope = -(1+ r) = MRTIoriMRT is the rate at whichA rupee of consumption forgone Today is transformed by productiveInvestment into a rupee of consumptionTomorrow. A

Financial Economics-A.R.Ahmad

Financial Economics-A.R.Ahmad*Production Possibility Curve

Consumption in period-zeroConsumption in period - oneC1(1)C0(1)W0I0AA1st investment project2nd investment projectBB10th investment project

Financial Economics-A.R.Ahmad

Financial Economics-A.R.Ahmad*Consumers MaximisationU2U1Consumption in period-zeroConsumption in period - oneC0**C1**YMRS = MRT

Financial Economics-A.R.Ahmad

Financial Economics-A.R.Ahmad*Money Market LineConsumption in period-zeroConsumption in period - oneC1*C0*W0AMoney Market Line : (slope = MRT = -(1+r)I0*

Financial Economics-A.R.Ahmad

Financial Economics-A.R.Ahmad*The Production and Consumption without Capital MarketP1 = C1Consumption in period-zeroU1Consumption in period - oneU2BPo = Coyoy1 A

Financial Economics-A.R.Ahmad*Individual with different indifference curves choose different production/consumption patterns Consumption in period-zeroIndividual 1Consumption in period - one

Individual 2yoy1 AB

Financial Economics-A.R.Ahmad*Maximisation with Capital Market

Consumption in period - oneC1*C0*W0AMoney Market Line : (slope = -(1+r))I0*C1**YConsumption in period-zeroLC0**

Financial Economics-A.R.Ahmad

Financial Economics-A.R.Ahmad*Individual with different indifference curves choose different production/consumption patterns CoU1 (initial endowment)C1Poyoy1 U2 (production alone)U3 (production and exchangeACBDP1Co*C1*Wo*W1*