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The Basic Tools of Finance (Chapter 14 of Mankiw) : IBE201 Principles of Macroeconomics, Sophia University FLA

This document summarizes key concepts from finance including present value, future value, compounding, and discounting. It also discusses risk aversion and utility. Specifically, it defines: - Present value as the amount of money today that would produce a given future amount, using prevailing interest rates. - Future value as the amount a given amount of money today will yield in the future, using prevailing interest rates. - The utility function as showing how subjective well-being depends on wealth, with diminishing returns to additional wealth.

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119 views

The Basic Tools of Finance (Chapter 14 of Mankiw) : IBE201 Principles of Macroeconomics, Sophia University FLA

This document summarizes key concepts from finance including present value, future value, compounding, and discounting. It also discusses risk aversion and utility. Specifically, it defines: - Present value as the amount of money today that would produce a given future amount, using prevailing interest rates. - Future value as the amount a given amount of money today will yield in the future, using prevailing interest rates. - The utility function as showing how subjective well-being depends on wealth, with diminishing returns to additional wealth.

Uploaded by

bohuagario123
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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The Basic Tools of Finance (Chapter 14 of Mankiw)

N. Gregory Mankiw, “Principles of Macroeconomics,” 8th Edition, Cengage Learning.

IBE201 Principles of Macroeconomics, Sophia University FLA

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Introduction

Finance:
Studies how people make decisions:
Allocation of resources over time
Handling of risk
Present value
Amount of money today that would be
needed, using prevailing interest rates, to
produce a given future amount of money

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Introduction

Future value
Amount of money in the future that an amount of
money today will yield, given prevailing interest
rates
Compounding
The accumulation of sum of money in, say, a bank
account, where the interest earned remains in the
account to earn additional interest in the future

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Present value

If you put $100 in a bank account today, how much will it


be worth in N years?
Present value:
Interest rate = r
Future value =

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Present value

How much would you have to deposit in a bank right now


to yield $200 in N years?
Future value:
Interest rate = r
Present value=

Discounting:
Find present value for a future sum of money

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Present value

General formula for discounting:


r: interest rate
X: amount to be received in N years (future value)
Then,

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Managing risk

Risk aversion
Dislike of uncertainty
Utility
A person’s subjective measure of
well-being/satisfaction

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Managing risk

Utility function
Every level of wealth provides a certain amount of
utility
Exhibits diminishing marginal utility
The more wealth a person has, the less utility
the person gets from an additional dollar

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The Utility Function

Figure 1 The Utility Function


Utility

Utility gain from


winning $1,000

Utility loss from


losing $1,000

0 Wealth
$1,000 loss Current $1,000 gain
wealth

This utility function shows how utility, a subjective measure of satisfaction, depends on wealth.
As wealth rises, the utility function becomes flatter, reflecting the property of diminishing marginal
utility. Because of diminishing marginal utility, a $1,000 loss decreases utility by more than a
$1,000 gain increases it.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 9
management system for classroom use.
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