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The document discusses how equilibrium interest rates are determined in a simple model. It describes an investor who receives $10,000 income in years 1 and 2 and must decide how much to consume and save in a 5% savings account. Aggregating across all investors determines the demand and supply curves for borrowing and lending. The equilibrium interest rate is where these curves intersect, at the point where the total amount investors want to borrow equals the total amount they want to lend.

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Hugo Pagola
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38 views

Slides1 Lecture1 Subtopic6

The document discusses how equilibrium interest rates are determined in a simple model. It describes an investor who receives $10,000 income in years 1 and 2 and must decide how much to consume and save in a 5% savings account. Aggregating across all investors determines the demand and supply curves for borrowing and lending. The equilibrium interest rate is where these curves intersect, at the point where the total amount investors want to borrow equals the total amount they want to lend.

Uploaded by

Hugo Pagola
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Individual Choice Problem Solution Equilibrium Interest Rates

Lecture 1.6: Market Equilibrium


Investment Analysis
Fall 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 1, 2012
Individual Choice Problem Solution Equilibrium Interest Rates
A Simple Choice Problem
An investor will receive an income of $10, 000 at the end of
years 1 and 2 with certainty.
The only investment available is a savings account with
interest rate r=5%. The investor can also borrow money at
a 5% rate.
Question
How much should the investor save and how much should he
consume each year?
Individual Choice Problem Solution Equilibrium Interest Rates
A Simple Choice Problem
An investor will receive an income of $10, 000 at the end of
years 1 and 2 with certainty.
The only investment available is a savings account with
interest rate r=5%. The investor can also borrow money at
a 5% rate.
Question
How much should the investor save and how much should he
consume each year?
Individual Choice Problem Solution Equilibrium Interest Rates
A Simple Choice Problem
An investor will receive an income of $10, 000 at the end of
years 1 and 2 with certainty.
The only investment available is a savings account with
interest rate r=5%. The investor can also borrow money at
a 5% rate.
Question
How much should the investor save and how much should he
consume each year?
Individual Choice Problem Solution Equilibrium Interest Rates
The Solution
The optimum consumption pattern for the investor is determined by the point
at which an indifference curve is tangent to the opportunity set.
Individual Choice Problem Solution Equilibrium Interest Rates
Determining Equilibrium Interest Rates
In the above example, the investor wishes to consume $8, 000 in period
1 and lend the remainder of his income, namely $2, 000, at r=5%.
Summing across all investors who wish to lend when r=5% gives one
point on the supply curve.
Similarly, summing across all investors who wish to borrow when r=5%
gives one point on the demand curve.
By varying the interest rate, the supply and demand curves can be
traced out.
The equilibrium interest rate is rate at which the demand and supply
curves intersect the rate at which the amount investors wish to
borrow is equal to the amount investors wish to lend.
In this simple world, equilibrium interest rates are determined by investors
tastes and income.
Individual Choice Problem Solution Equilibrium Interest Rates
Determining Equilibrium Interest Rates
In the above example, the investor wishes to consume $8, 000 in period
1 and lend the remainder of his income, namely $2, 000, at r=5%.
Summing across all investors who wish to lend when r=5% gives one
point on the supply curve.
Similarly, summing across all investors who wish to borrow when r=5%
gives one point on the demand curve.
By varying the interest rate, the supply and demand curves can be
traced out.
The equilibrium interest rate is rate at which the demand and supply
curves intersect the rate at which the amount investors wish to
borrow is equal to the amount investors wish to lend.
In this simple world, equilibrium interest rates are determined by investors
tastes and income.
Individual Choice Problem Solution Equilibrium Interest Rates
Determining Equilibrium Interest Rates
In the above example, the investor wishes to consume $8, 000 in period
1 and lend the remainder of his income, namely $2, 000, at r=5%.
Summing across all investors who wish to lend when r=5% gives one
point on the supply curve.
Similarly, summing across all investors who wish to borrow when r=5%
gives one point on the demand curve.
By varying the interest rate, the supply and demand curves can be
traced out.
The equilibrium interest rate is rate at which the demand and supply
curves intersect the rate at which the amount investors wish to
borrow is equal to the amount investors wish to lend.
In this simple world, equilibrium interest rates are determined by investors
tastes and income.
Individual Choice Problem Solution Equilibrium Interest Rates
Determining Equilibrium Interest Rates
In the above example, the investor wishes to consume $8, 000 in period
1 and lend the remainder of his income, namely $2, 000, at r=5%.
Summing across all investors who wish to lend when r=5% gives one
point on the supply curve.
Similarly, summing across all investors who wish to borrow when r=5%
gives one point on the demand curve.
By varying the interest rate, the supply and demand curves can be
traced out.
The equilibrium interest rate is rate at which the demand and supply
curves intersect the rate at which the amount investors wish to
borrow is equal to the amount investors wish to lend.
In this simple world, equilibrium interest rates are determined by investors
tastes and income.
Individual Choice Problem Solution Equilibrium Interest Rates
Determining Equilibrium Interest Rates
In the above example, the investor wishes to consume $8, 000 in period
1 and lend the remainder of his income, namely $2, 000, at r=5%.
Summing across all investors who wish to lend when r=5% gives one
point on the supply curve.
Similarly, summing across all investors who wish to borrow when r=5%
gives one point on the demand curve.
By varying the interest rate, the supply and demand curves can be
traced out.
The equilibrium interest rate is rate at which the demand and supply
curves intersect the rate at which the amount investors wish to
borrow is equal to the amount investors wish to lend.
In this simple world, equilibrium interest rates are determined by investors
tastes and income.
Individual Choice Problem Solution Equilibrium Interest Rates
Determining Equilibrium Interest Rates
In the above example, the investor wishes to consume $8, 000 in period
1 and lend the remainder of his income, namely $2, 000, at r=5%.
Summing across all investors who wish to lend when r=5% gives one
point on the supply curve.
Similarly, summing across all investors who wish to borrow when r=5%
gives one point on the demand curve.
By varying the interest rate, the supply and demand curves can be
traced out.
The equilibrium interest rate is rate at which the demand and supply
curves intersect the rate at which the amount investors wish to
borrow is equal to the amount investors wish to lend.
In this simple world, equilibrium interest rates are determined by investors
tastes and income.

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