INTERTEMPORAL CHOICE & ASSET MARKETS

We now consider consumer behavior by considering the choices involved in saving and consuming
over time: intertemporal choices.
The Budget Constraint
The issue: how much of some good to consume in each of two time periods.
We think of this good as being a composite good, though we can think of it as being a specific
commodity if we wish.
Denote the amount of consumption in each period by (𝑐1 , 𝑐2 ); let prices of c in each period Birr 1.
The amount of money the consumer will have in each period is denoted by (𝑚1 , 𝑚2 ).
Say, the consumer has no:
a) way of earning interest: at t2 he gets what he keeps at t1.
b) possibility of borrowing money
Implying that the most he can spend in period 1 is m1.
His budget constraint will then look like the one depicted in Figure 1.

Figure 1 Budget constraint. Budget constraint at r = zero and no borrowing is allowed.

We see that there will be two possible kinds of choices:
• Consume at (𝑚1 , 𝑚2 ): just consumes his income each period,
• Consume less than his 𝑚1 income during the t1: saving some 𝑐1 for a later date.
Next, allow the consumer to
• borrow and
• lend money at some interest rate r.
• Keep p = Birr 1 for convenience, and derive the budget constraint.
1. The case of a saving individual: so
𝑐1 < 𝑚1
He will then earn interest on the amount he saves, 𝑚1 − 𝑐1, at the interest rate r. 𝑐2 becomes
𝑐2 = 𝑚2 + (𝑚1 − 𝑐1 ) + 𝑟(𝑚1 − 𝑐1 ) = 𝑚2 + (1 + 𝑟)(𝑚1 − 𝑐1 ) . (10.1)
𝑐2 is his income at t2 plus the amount saved from t1, plus the interest that he earned on his savings.
2. The case of a borrower;
𝑐1 > 𝑚1

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He pays interest in the second period will be r(c1 −m1), and the amount that he borrowed, 𝑐1 − 𝑚1
This means his budget constraint is given by
𝑐2 = 𝑚2 − 𝑟(𝑐1 − 𝑚1 ) − (𝑐1 − 𝑚1 )
= 𝑚2 + (1 + 𝑟)(𝑚1 − 𝑐1 )
which is just what we had before: the difference is the sign of m1 −c1: when positive, then the
consumer earns interest on this savings; when m1 − c1 is negative, then the consumer pays interest
on his borrowings.
c1 = m1, => c2 = m2; the consumer is neither a borrower nor a lender.
We can rearrange the budget constraint for the consumer to get 2 alternative forms that are useful:
(1 + 𝑟)𝑐1 + 𝑐2 = (1 + 𝑟)𝑚1 + 𝑚2 => 𝑐2 = (1 + 𝑟)(𝑚1 − 𝑐1 ) + 𝑚2
𝑐2 𝑚2
𝑐1 + = 𝑚1 + => 𝑐2 = (1 + 𝑟)(𝑚1 − 𝑐1 ) + 𝑚2
(1 + 𝑟) (1 + 𝑟)
Note that both equations have the form
𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑝1 𝑚1 + 𝑝2 𝑚2
In 1st equation p1 = 1+r and p2 = 1. In 2nd equation, p1 = 1 and p2 = 1/(1 + r).
• The 1st expresses the budget constraint in terms of future value
• The 2nd expresses the budget constraint in terms of present value.
In the figure below, the PV of an endowment of money in 2 periods is the amount of money in t1
that would generate the same budget set as the endowment. This is just the horizontal intercept of
the budget line, which gives the maximum amount of first-period consumption possible.

Figure 2 Present and future values. The vertical intercept of the budget line measures future value, and the horizontal
intercept measures the present value.
2 𝑚
The budget constraint, this amount is 𝑐1 = 𝑚1 + (1+𝑟) i.e., the PV of the endowment.

The vertical intercept is the maximum amount of 2nd period c, which occurs when c1 = 0.
The budget constraint, is 𝑐2 = (1 + 𝑟)𝑚1 + 𝑚2 , i.e., the future value of the endowment.
The PV form is the more important way (it measures the future relative to the present)
Note that the BL passes through (m1, m2), as it is always an affordable; and the slope is −(1 + r).
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10.2 Preferences for Consumption
Consider a consumer’s preferences, as represented by his IC; its shape indicates the consumer’s
tastes for consumption at different times. An IC
• with a constant slope of, say −1, represent tastes of a consumer who doesn’t care whether
he consumed today or tomorrow. His MRS between today and tomorrow is −1.
• for perfect complements shows a consumer that wants to consume equal amounts today
and tomorrow; he would be unwilling to substitute consumption from one to the other time.
• the intermediate preferences is more reasonable; a consumer is willing to substitute some
amount of consumption today for consumption tomorrow;
o willingness to substitute depends on his particular pattern of consumption.
Convex preferences are natural in this context; that the consumer prefers an “average” amount of
consumption each period rather than have a lot today and nothing tomorrow or vice versa.
10.3 Comparative Statics
Given a consumer’s budget constraint and his preferences for consumption in each of the two
periods, we can examine the optimal choice of consumption (c1, c2). A consumer choosing at a
point where:
• c1 < m1, is a lender, and
• c1 > m1, is a borrower.

A Borrower B Lender
Figure 3 Borrower and lender. Panel A depicts a borrower, since c1>m1, and panel B depicts a lender, since c1<m1.
How would a consumer react to a change in the interest rate.
From
𝑐2 = 𝑚2 + (1 + 𝑟)(𝑚1 − 𝑐1 )
we see that increasing the r must tilt the budget line to a steeper position: for a given reduction in
c1 he will get more consumption in the 2nd period. Note: the endowment always remains affordable,
so the tilt is really a pivot around the endowment.
Does the position of borrower or a lender change as the interest rate changes? There are two cases
depending on whether the consumer is a initially a borrower or initially a lender.
Initially a lender: as the interest rate increases, the consumer remains a lender.

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Figure 4 If a person is a lender and the interest rate rises, he or she will remain a lender. Increasing the interest
rate pivots the budget line around the endowment to a steeper position; revealed preference implies that the new
consumption bundle must lie to the left of the endowment.
The consumer shifts his consumption; but not to the right of the endowment: this violates the
principle of revealed preference: the new optimal bundle must be a point outside the old budget
set—it must be to the left of the endowment. The consumer remains a lender when the r increases.
There is a similar effect for borrowers: if the consumer is initially a borrower, and the interest rate
declines, he or she will remain a borrower: sketch a diagram and spell out the argument.
If a person is a
• lender and r increases, he will remain a lender.
• borrower and r decreases, he will remain a borrower.
On the other hand, if a person is a
• lender and r decreases, he may well decide to switch to being a borrower;
• borrower and r increases, he may become to become a lender:
• Revealed preference tells us nothing about these last two cases.
We can use revealed preference to make judgments about changes in consumer welfare as r
changes. If the consumer is initially a
• borrower, and r rises, and he decides to remain a borrower, then he must be worse off at
the new r; he must be operating at a point that was affordable under the old budget set but
was rejected, which implies that he must be worse off.

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Figure 5 A borrower is made worse off by an increase in the interest rate. When the interest rate facing a borrower
increases and the consumer chooses to remain a borrower, he or she is certainly worse off.
4 The Slutsky Equation and Intertemporal Choice
We use the Slutsky equation to decompose the change in demand due to a change in r into I effects
and S effects. Suppose that the r rises. The effect on c in each period?
Here it is easier to analyze by using the future rather than the present-value budget constraint. In
terms of the future-value budget constraint, raising r is like raising p of c today as compared to c
tomorrow. With p1 = 1+r and p2 = 1
Writing out the Slutsky equation we have
𝜕𝑐1𝑡 𝜕𝑐1𝑠 𝜕𝑐1𝑚
= + (𝑚1 − 𝑐1 )
𝜕𝑝1 𝜕𝑝1 𝜕𝑚
The S effect works opposite the direction of price: here p1 consumption goes up, so the S effect
says the consumer should consume less 1st period
Assuming c1 is a normal good, so that the last term will be positive. So, we put a + under last term.
Now the sign of the whole expression will depend on the sign of (m1 − c1).
𝜕𝑐1𝑡 𝜕𝑐1𝑠 𝜕𝑐1𝑚
𝜕𝑝1 = 𝜕𝑝1 + (𝑚1 − 𝑐1 ) 𝜕𝑚
(? ) (−) (? ) (+)
If the person is a borrower, (𝑚1 − 𝑐1 ) < 0 and the whole expression will is negative: for a
borrower, an increase in the r must lower c1.
When r rises, there is always an S effect towards less c1 today. For a borrower, an increase r means
pay more interest tomorrow. This effect induces him to borrow less, and consume less, in 1st period.
For a lender the effect is ambiguous. The total effect is the sum of a -ve S effect and a +ve I effect.
For the lender an increase in r may give him so much extra income that he may increase c1.
5 Inflation
Our analysis was based i.t.o. a general “c” good. Give up Δc1 today to buy (1 +r)Δc2 tomorrow.
Here we assumed that the “p” of consumption doesn’t change (no inflation or deflation).

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We can modify the model to deal with inflation. Let us suppose that the c now has a different price
in each period. It is convenient to choose p1 rice of c1 = 1 and to let p2 be the price of c2.
So that the monetary value of the endowment in period 2 is p2m2. Then the amount of money the
consumer can spend in the second period is given (p1 = 1 and p2 = 1/(1 + r)).
𝑝1 𝑐1 + 𝑝2 𝑐2 = 𝑝1 𝑚1 + 𝑝2 𝑚2 => 𝑝2 𝑐2 = 𝑝2 𝑚2 + (1 + 𝑟)(𝑚1 − 𝑐1 )
𝑝2 𝑐2 = 𝑝2 𝑚2 + (1 + 𝑟)(𝑚1 − 𝑐1 )
and the amount of consumption available second period is
1+𝑟
𝑐2 = 𝑚2 + (𝑚1 − 𝑐1 )
𝑝2
Note that this equation is very similar to the equation given earlier: use (1 + r)/p2 not 1 + r.
Express this BC i.t.o. the rate of inflation (π): the rate at which prices grow. Since p1 = 1, we have
𝑝2 = 1 + 𝜋,
which gives us
1+𝑟 1+𝑟
𝑐2 = 𝑚2 + (𝑚1 − 𝑐1 ); let 1 + 𝜌 =
1+𝜋 1+𝜋
be the real interest rate; so that the budget constraint becomes
𝑐2 = 𝑚2 + (1 + 𝜌)(𝑚1 − 𝑐1 )
One plus the real interest rate measures how much extra consumption you can get in period 2 if
you give up some consumption in period 1. It tells you how much extra consumption not how
many extra dollars you can get.
The interest rate on Birr is the nominal rate of interest. The relationship between the two:
1+𝑟 1 + 𝑟 − (1 + 𝜋) 𝑟 − 𝜋
𝜌 = −1= =
1+𝜋 1+𝜋 1+𝜋
This is an exact expression for the real interest rate, but we use an approximation. If π isn’t too
large, the denominator will be only slightly > 1. Thus, the real rate of interest is approximated by
𝜌 ≈ 𝑟 − 𝜋,
Nominal rate minus the rate of inflation. If the r is 18%, but π is 10%, then the 𝜌 (the extra
consumption you can buy next period if you give up some consumption now) will be roughly 8%.
• Note that we may know the r for the next period, but the π for next period is unknown.
• 𝜌 is usually taken to be the r - expected π.
• As people have different estimates about what the next year’s π, they will have different
estimates of the 𝜌.
• If π can be reasonably well forecast, these differences may not be too large.
6 Present Value: A Closer Look
Let us return to the 2 forms of the BC described earlier:
(1 + 𝑟)𝑐1 + 𝑐2 = (1 + 𝑟)𝑚1 + 𝑚2

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and
𝑐2 𝑚2
𝑐1 + = 𝑚1 +
1+𝑟 1+𝑟
st
Consider the RHS of these two equations. The 1 expresses the value of the endowment i.t.o. FV
and the 2nd expresses it in terms of PV.
Future value:
If we can borrow and lend at an interest rate of r, what is the future equivalent of $1 today?
The answer is (1 + r) dollars.
That is, Birr 1 today can be turned into (1 +r) dollars next period by lending it to the bank at r.
Thus Birr (1 + r) next period is equivalent to Birr 1 today, since that is how much you pay next
period to borrow Birr 1 today.
(1 + r) is just the price of Birr 1 today, relative to $1 next period.
The 1st BC is expressed in terms of FV—2nd period Birr has a price of 1, and 1st period Birr.
Present value:
This is the reverse: everything is measured in terms of today’s Birr.
How much is a Birr next period worth in terms of a Birr today?
The answer is 1/(1+r) Birr.
This is because Birr 1/(1 + r) can be turned into a Birr next period by saving it at the r.
The present value of a dollar to be delivered next period is 1/(1 + r).
PV gives us another way to express the BC for a two-period consumption problem: A consumption
plan is affordable if the PV of consumption equals the PV of income.
In the goods market: If the consumer can freely buy and sell goods at constant prices, then the
consumer would always prefer a higher-valued endowment to a lower-valued one.
In the case of intertemporal decisions: if a consumer can freely borrow and lend at a constant r,
then he would always prefer a pattern of income with a higher PV to a pattern with a lower PV.
Higher endowment gives rise to a budget line that is farther out: the new budget set contains the
old budget set: An endowment with a higher PV dominates one with a lower PV (the consumer
can have larger c in every period by buying endowments with higher PV that she could get by
selling endowment with lower PV.
If the PV of one endowment is higher than another, then the FV will be higher as well.
PV is more convenient to measure the purchasing power of an endowment of money over time.
7 Analyzing Present Value for Several Periods
Consider a 3-period model: Suppose that we can borrow or lend money at an interest rate r each t
and that it will remain constant over the 3 periods. Thus, the price of consumption in t2 in terms of
t1 consumption will be 1/(1+r), just as before.
What will the price of t3 consumption be?

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You invest Birr 1 today, it will grow into Birr (1+r) next period; and if you leave this money
invested, it will grow into Birr (1 + r)2 dollars by t3.
You start with Birr 1/(1+r)2 today, you can turn this into Birr 1 in t3: The price of t3 consumption
relative to t1 consumption is therefore 1/(1 + r)2.
Each extra dollar’s worth of consumption in period 3 costs me 1/(1 + r)2 dollars today. This
implies that the budget constraint will have the form
𝑐2 𝑐2 𝑚2 𝑚3
𝑐1 + + 2
= 𝑚1 + +
1 + 𝑟 (1 + 𝑟) 1 + 𝑟 (1 + 𝑟)2
This is like the budget constraints we saw before, where the price of period-t ct in terms of c1 is
1
𝑝𝑡 =
(1 + 𝑟)𝑡−1
Moving to an endowment that has a higher PV at these prices will be preferred by any consumer,
as it shifts the budget set outward.
We can generalize to a changing r case; say r earned on savings from t1 to t2 is r1, and that from t2
to t3 is r2. Then Birr 1 in period 1 will grow to (1+r1)(1+r2) dollars in t3. The PV of Birr 1 in t3 is
therefore 1/(1 + r1)(1 + r2). This implies that the correct form of the budget constraint is
𝑐2 𝑐2 𝑚2 𝑚3
𝑐1 + + = 𝑚1 + +
1 + 𝑟1 (1 + 𝑟1 )(1 + 𝑟2 ) 1 + 𝑟1 (1 + 𝑟1 )(1 + 𝑟2 )
This expression is not so hard to deal with, but we will typically be content to examine the case of
constant interest rates.
Table 1 contains some examples of the present value of Birr 1 T years in the future at different r.
• The PV goes quickly for “reasonable” interest rates. At an r = 0.10, the value of Birr 1; 20
years from now is only 15 cents.
Table 1 The present value of $1 t years in the future.

Rate 1 2 5 10 15 20 25 30

.05 .95 .91 .78 .61 .48 .37 .30 .23

.10 .91 .83 .62 .39 .24 .15 .09 .06

.15 .87 .76 .50 .25 .12 .06 .03 .02

.20 .83 .69 .40 .16 .06 .03 .01 .00

Interest rate in continuous time:

Investing Birr 1 in an asset yielding an interest rate r where the r is paid once a year.
After T years you will have (1 + r)T dollars.
Suppose now that the r is paid monthly. This means that the monthly interest rate will be r/12, and
there will be 12T payments, so that after T years you will have

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 𝑟 12𝑇
Birr (1 + )
12
.If the interest rate is paid daily, you will have
𝑟 365𝑇
(1 + )
365
and so on.
In general, if the interest is paid n times a year, you will have
𝑟 𝑛𝑇
(1 + )
𝑛
after T years.
How much money you will have if the interest is paid continuously: the limit of this expression as
n goes to infinity. It turns out that this is given by the following expression:
𝑟𝑇
𝑟 𝑛𝑇
𝑒 = lim (1 + ) ,
𝑛→∞ 𝑛
where e is 2.7183 . . ., the base of natural logarithms.

8 Use of Present Value

The PV is the only correct way to convert a stream of payments into today’s Birr, as it measures
the value of a consumer’s endowment of money.
As long as the consumer can borrow and lend freely at a constant r, an endowment with higher PV
can always generate more consumption in every t than an endowment with lower PV.
Regardless of tastes for consumption in different t, you should always prefer a stream of money
that has a higher PV to one with lower PV—as it always gives more c possibilities in every t.

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Figure 6 Higher PV. An endowment with higher PV gives the consumer more consumption possibilities in each
period if he can borrow and lend at the market interest rates.
(𝑚1′ , 𝑚2′ ) is a worse c bundle than the consumer’s original endowment, (m1, m2), since it lies
beneath the IC through your endowment.
The consumer would prefer (𝑚1′ , 𝑚2′ ) to (m1, m2) if he can borrow and lend at the interest rate r.
This is true because with the endowment (𝑚1′ , 𝑚2′ ) she can afford to consume a bundle such as (c1,
c2), which is better than her current c bundle.
An important application of PV: valuing the income streams offered by different kinds of
investments; say to compare two different Is that yield different streams of payments and see which
is better, compute the two PVs and choose the larger one.
Sometimes we have to purchase an income stream by making a stream of payments over time.
Example: purchase apartment by borrowing from a bank and make mortgage payments over t.
Say the income stream (M1, M2) can be purchased by making a stream of payments (P1, P2).
In this case we can evaluate the investment by comparing the PV of the income stream to the PV
of the payment stream. If
𝑀2 𝑃2
𝑀1 + ≥ 𝑃1 + 4
1+𝑟 1+𝑟
the PV of the income stream exceeds the PV of its cost, so this is a good investment
An equivalent way to value the investment is to use the idea of net present value.
To do so, we calculate at the net cash flow in each t and then discount this stream back to the
present. In this example, the net cash flow is (M1−P1, M2−P2), and the net present value is
𝑀2 − 𝑃2
𝑁𝑃𝑉 = 𝑀1 − 𝑃1 +
1+𝑟
Investment should be purchased if and only if the NPV is positive.
The NPV calculation is convenient since it allows us to add all of the positive and negative cash
flows together in each period and then discount the resulting stream of cash flows.
EXAMPLE: Valuing a Stream of Payments: 2 investment options, A and B.
Investment A pays $100 now and will also pay $200 next year.
Investment B pays $0 now, and will generate $310 next year. Which is the better investment?
The answer depends on the interest rate. If the interest rate is zero, the answer is clear—just add
up the payments. For if the interest rate is zero, then the present-value calculation boils down to
summing up the payments. If the interest rate is zero, the present value of investment A is
𝑃𝑉𝐴 = 100 + 200 = 300,
and the present value of investment B is
𝑃𝑉𝐵 = 0 + 310 = 310,
so B is the preferred investment.

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But we get the opposite answer if the interest rate is high enough. Suppose, for example, that the
interest rate is 20 percent. Then the present-value calculation becomes
200
𝑃𝑉𝐴 = 100 + = 266.67
1.20
310
𝑃𝑉𝐵 = 0 + = 258.33
1.20
Now A is the better investment. The fact that A pays back more money earlier means that it will
have a higher present value when the interest rate is large enough.
Bonds
Securities are financial instruments that promise certain patterns of payment schedules.
There are many kinds of financial instruments because there are many kinds of payment
schedules that people want.
Financial markets give people the opportunity to trade different patterns of cash flows over time.
Such cash flows are typically used to finance consumption at some time or other.
Bonds are issued by governments and corporations; mechanism to borrow money.
Borrower: the agent who issues the bond and promises to pay:
a) a fixed number of Birr x (the coupon) each period until a certain date T (maturity date),
b) at maturity date: the borrower will pay F (the face value) to the holder of the bond.
Thus, the payment stream of a bond looks like (x, x, x, ..., F). If the interest rate is constant, the
present discounted value of such a bond is easy to compute. It is given by
𝑥 𝑥 𝐹
𝑃𝑉 = + + · · · + .
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)𝑇
The PV of a bond will decline if the interest rate increases, because as r increases the price for $1
now delivered in the future decrease=> the future payments of the bond are worth less now.
Observed: the market value of outstanding bonds will fluctuate as the r fluctuates since the PV of
the stream of payments represented by the bond will change.
Consols or perpetuities: a bond that makes payments forever. Consider a consol that promises to
pay Birr x a year forever. To compute the value of this consol we have to compute the infinite sum:
𝑥 𝑥
𝑃𝑉 = + +···
(1 + 𝑟) (1 + 𝑟)2
The trick to computing this is to factor out 1/(1 + r) to get
1 𝑥 𝑥
𝑃𝑉 = [𝑥 + + +···]
1+𝑟 (1 + 𝑟) (1 + 𝑟)2
But the term in the brackets is just x plus the present value! Substituting and solving for PV :
1 𝑥
𝑃𝑉 = [𝑥 + 𝑃𝑉 ] =
1 + 𝑟 𝑟

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This wasn’t hard to do, but there is an easy way to get the answer right off. How much money, V,
would you need at an interest rate r to get x dollars forever? Just write down the equation
𝑉 𝑟 = 𝑥,
which says that the interest on V must equal x. But then the value of such an investment is
𝑥
𝑉 = .
𝑟
Thus, it must be that the PV of a consol that promises to pay x dollars forever must be x/r.
Thus, an increase in r reduces the value of a bond.
Suppose, for example, that a consol is issued when the interest rate is 10 percent. \
If it promises to pay Birr 10 a year forever, it will be worth
𝑥 10
𝑉 =
.= = Birr 100
𝑟 0.1
now—since $100 would generate $10 a year in interest income.
Now suppose that the interest rate goes up to 20 percent. The value of the consol must fall to
𝑥 10
𝑉 = .= = Birr 50
𝑟 0.2
$50, since it only takes $50 to earn $10 a year at a 20 percent interest rate.
The formula for the consol can be used to calculate an approximate value of a long-term bond.
If the interest rate is 10 percent, for example, the value of Birr 1, 30 years from now is only 6 cents.
EXAMPLE: Installment Loans
Suppose that you borrow Birr 1000 that you promise to pay back in 12 monthly installments of
Birr 100 each. What rate of interest are you paying? At first glance it seems that your interest rate
is 20 percent: you have borrowed $1000, and you are paying back $1200. But this analysis is
incorrect. For you haven’t really borrowed $1000 for an entire year. You have borrowed $1000
for a month, and then you pay back $100. Then you only have borrowed $900, and you owe only
a month’s interest on the $900. You borrow that for a month and then pay back another $100. And
so on. The stream of payments that we want to value is
(1000, −100, −100, . . . , −100).
We can find the interest rate that makes the present value of this stream equal to zero by using a
calculator or a computer. The actual interest rate that you are paying on the installment loan is
about 35 percent!
ASSET MARKETS
Assets: goods that provide a flow of services over time; say consumption services, like housing
services, or a flow of money that can be used to purchase consumption.
Financial assets: those that provide a monetary flow.
Example, bonds. The flow of services they provide is the flow of interest payments.
Others: corporate stock provide different patterns of cash flows.

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1 Rates of Return
Hypothesis: if there is no uncertainty about the cash flow provided by assets, then all assets have
to have the same rate of return.
Reason: if two assets are identical, but one had a higher rate of return (RoR), then no one would
want to buy the asset with the lower RoR. So, in equilibrium, all assets that are actually held must
pay the same RoR.
Consider an asset A that has current price p0 and is expected to have a price of p1 tomorrow.
Everyone is certain about what today’s p of the asset is, and everyone is certain about
tomorrow’s p.
Assume: no dividends or other cash payments between periods 0 and 1.
Suppose: there is another investment, B, that one can hold between periods 0 and 1 and pays an
interest rate of r.
Consider two possible investment plans: either invest one Birr in asset A and cash it in next period,
or invest one Birr in asset B and earn interest of r dollars over the period.
What are the values of these two investment plans at the end of the first period?
We ask: how many units of the asset we must purchase to make a one Birr investment in it.
Letting x be this amount we have the equation
𝑝0 𝑥 = 1
or
1
𝑥 =
𝑝0
It follows that the future value of one Birr’s worth of this asset next period will be
𝑝1
𝐹𝑉 = 𝑝1 𝑥 =
𝑝0
On the other hand: if we invest one Birr in asset B, we will have 1 + r dollars next period. If assets
A and B are both held in equilibrium, then a Birr invested in either one of them must be worth the
same amount 2nd period. Thus, we have an equilibrium condition:
𝑝1
1+𝑟 =
𝑝0
If this equality is not satisfied; there is a sure way to make money. For example, if
𝑝1
1+𝑟 >
𝑝0
people who own asset A can sell one unit for p0 dollars in the 1st period and invest the money in
asset B. Next period their investment in asset B will be worth p0(1 + r), which is greater than p1
by the above equation.
This will guarantee that 2nd period they will have enough money to repurchase asset A, and be
back where they started from, but now with extra money.

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This kind of operation—buying some of one asset and selling some of another to realize a sure
return—is known as riskless arbitrage, or arbitrage for short.
As long as there are people around looking for “sure things” we would expect that well-functioning
markets should quickly eliminate any opportunities for arbitrage.
Another way to state our equilibrium condition: there should be no opportunities for arbitrage.
We’ll refer to this as the no arbitrage condition.
Arbitrage works to eliminate inequality: if 1 + r > p1/p0, then anyone who held asset A would want
to sell it 1st period, since they were guaranteed enough money to repurchase it 2nd period.
But who would they sell it to? Who would want to buy it? There would be plenty of people willing
to supply asset A at p0, but there wouldn’t be anyone foolish enough to demand it at that price.
This means that supply would exceed demand and therefore the price will fall. How far will it fall?
Just enough to satisfy the arbitrage condition: until
𝑝1
1+𝑟 =
𝑝0
2 Arbitrage and Present Value
We can rewrite the arbitrage condition in a useful way by cross multiplying to get
𝑝1
𝑝0 =
1+𝑟
This says that the current p of an asset must be its PV.
Here future value comparison is converted to PV comparison: The arbitrage condition to a PV
comparison.
If the no arbitrage condition is satisfied, then assets must sell for their PV. Any deviation from
present-value pricing leaves a sure way to make money.
3 Adjustments for Differences among Assets
No arbitrage rule assumes that the asset services provided by the two assets are identical, except
for the purely monetary difference.
If the services provided by the assets have different characteristics, then we would want to adjust
for those differences before we assert that the two assets must have the same equilibrium RoR.
For example:
1. one asset might be easier to sell than another (more liquid than another). A house worth
Birr 10,000,000 is probably less liquid asset than Birr 10,000,000 in Treasury bills.
2. one asset might be riskier than another. The RoR on one asset may be guaranteed, while
the RoR on another asset may be highly risky.
Here we want to consider two other types of adjustment we might make. One is adjustment for
assets that have some return in consumption value, and the other is for assets that have different
tax characteristics.
4 Assets with Consumption Returns
Many assets pay off only in money; but there are other assets that pay off in terms of consumption.

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Example: of this is housing: If you own a house that you live in, then you don’t have to rent living
quarters; thus, part of the “return” to owning the house is that you live in the house without paying
rent: You get to pay the rent for your house to yourself.
You don’t make an explicit rental payment to yourself, but it is fruitful to think of a homeowner
as implicitly making such a payment.
The implicit rental rate: the rate at which you could rent a similar house; is the rate at which you
could rent your house to someone else on the open market (the opportunity cost).
Let the implicit rental payment on your house be Birr T per year. Part of the return to owning your
house is that it generates for you an implicit income of Birr T dollars per year.
But that is not the entire return on your house. You pay a significant amount of money for a hose
when you buy it; you expect to earn a monetary return on this investment as well, through an
increase in the value of your house (appreciation).
Let us use A represent the expected appreciation in the Birr value of your house over a year.
Total return to owning your house is the sum of the rental return, T, and the investment return, A.
Let your house initially cost P, then the total rate of return on your initial investment in housing is
𝑇 + 𝐴
ℎ = .
𝑃
This total rate of return is composed of the consumption RoR (T/P) and the investment RoR ( A/P).
Let r represent the RoR on other financial assets. Then in equilibrium the total RoR on housing
must equal to r:
𝑇 + 𝐴
𝑟 = .
𝑃
Think about the following options; at the beginning of the year invest P in a
1. bank and earn rP dollars, or
2. house and save T dollars of rent and earn A dollars by the end of the year.
The total return from these two investments has to be the same.
If T +A < rP you will be better off investing your money in the bank and paying T dollars in rent.
At the end of the year, you will have rP −T > A Birr at the end of the year.
If T +A > rP, then housing would be the better choice: we are ignoring the real estate agent’s
commission and other transactions costs associated with the purchase and sale.
In reality the financial rate of return A/P will generally be less than the rate of interest.
In general, assets that pay off in consumption will in equilibrium have a lower financial RoR
5 Taxation of Asset Returns
Generally, there are 2 kinds of taxes on asset returns for purposes of taxation:
Tax on dividend or interest return: Taxes paid periodically over the life of the asset. (30% if
you withdraw your dividend.)

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Tax on capital gains: occur when an asset is sold at a price higher than the price at which it is
bought; capital gains are taxed only when the asset is sold.
Is taxing capital gains at the same rate as ordinary income a “neutral” policy? Not true for 2 two
reasons.
1. Capital gains taxes are only paid when the asset is sold, while taxes on dividends or interest
are paid every year. As capital gains taxes are deferred until time of sale makes the effective
tax rate on capital gains lower than the tax rate on ordinary income.
2. Inflation tends to make the tax on capital gains higher than that on ordinary income.
Which of the two effects dominates is a controversial question.
The fact that different assets are taxed differently means that the arbitrage rule must adjust for
the tax differences in comparing RoR. Suppose that one asset pays a before-tax interest rate, rb,
and another asset pays a return that is tax exempt, re. Then if both assets are held by individuals
who pay taxes on income at rate t, we must have
(1 − 𝑡)𝑟𝑏 = 𝑟𝑒.
Thus, the after-tax return on each asset must be the same.
6 Market Bubbles
Suppose you are thinking of buying a house that is absolutely certain to be worth Birr 22,000,000
a year from now and that the current r (reflecting your alternative investment opportunities) is
10%. A fair price for the house would be the present value,
𝑥 22,000,000
𝑃𝑉 = = = 20,000,000
(1 + 𝑟) 1.1
Many people believe that the house will be worth Birr 22,000,000 in a year, but there are no
guarantees. Expect that the house would sell for somewhat less than Birr 22,000,000 due to the
additional risk associated with purchase.
Suppose the year goes by and the house is worth Birr 24,000,000, far more than anticipated. The
house value went up by 20%, even though the prevailing interest rate was 10%.
This experience will lead people to revise their view about how much the house will be worth in
the future— who knows, maybe it will go up by 20% or even more next year.
If many people hold such beliefs, they can bid up the price of housing now—which may encourage
others to make even more optimistic forecasts about the housing market.
The higher price will tend to reduce current demand but it also may encourage people to expect an
even higher return in the future.
The first effect—high prices reducing demand—tends to stabilize prices.
The second effect—high prices leading to an expectation of even higher prices in the future—
tends to destabilize prices.
This is an example of an asset bubble. In a bubble, the price of an asset increases, for one reason
or another, and this leads people to expect the price to go up even more in the future. But if they
expect the asset price to rise significantly in the future, they will try to buy more today, pushing
prices up even more rapidly.

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Bubbles eventually burst: Prices fall; people left holding assets worth less than they paid for them.
8 Financial Institutions
Asset markets allow people to change their pattern of consumption over time:
Example: 2 people A and B who have different endowments of wealth.
A has Birr 100 today and nothing tomorrow
B has Birr 100 tomorrow and nothing today.
Say each would rather have Birr 50 today and Birr 50 tomorrow.
This pattern of consumption reached by trading: A gives B 50 today, and B gives A 50 tomorrow.
Here the interest rate is zero: A lends B 50 and only gets 50 in return the next day.
If people with convex preferences over consumption today and tomorrow would like to smooth
their consumption over time, rather than consume everything in one period, even if the r were zero.
One individual might have an endowment that provides a steady stream of payments and prefer to
have a lump sum (a twenty-year-old individual might want to have a lump sum of money now to
buy a house)
Another might have a lump sum and prefer a steady stream (a sixty-year-old might want to have a
steady stream of money to finance his retirement).
Financial institutions exist to facilitate these trades.
The sixty-year-old can put his lump sum of money in the bank,
The bank can then lend it to the twenty-year-old.
The twenty-year-old then makes mortgage payments to the bank,
Transferred to the sixty-year-old as interest payments.
Banks are the most common intermediaries established to carry out such transfers.
The bank takes its cut for arranging the trade, but if the banking industry is sufficiently
competitive, this cut should end up pretty close to the actual costs of doing business.
Another important intermediary is the stock market.
Suppose an entrepreneur starts a company that becomes successful.
To start it, he had some financial backers who put up money to help him get started and pay up
early expenditure—startup capital.
Once the company has been established, the owners of the company have a claim to the profits
that the company will generate in the future: they have a claim to a stream of payments.
If the owners prefer a lump-sum reward for their efforts now => sell the firm to other people via
the stock market by issuing shares in the company that entitle the shareholders to a cut of the future
profits of the firm in exchange for a lump-sum payment now.
People who want to purchase part of the stream of profits of the firm pay the original owners for
these shares. In this way, both sides of the market can reallocate their wealth over time.
There are a variety of other institutions and markets that help facilitate intertemporal trade.
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What happens when the buyers and sellers aren’t evenly matched?
If more people want to sell consumption tomorrow than want to buy it; the price will fall (the price
of consumption tomorrow will fall). The price of consumption tomorrow was given by
1
𝑝 =
1+𝑟
so this means that the r must rise.
The increase in r induces people to save more and to demand less consumption now, and thus that
equate demand and supply.
11 Choice of the Interest Rate
In the above discussion, we’ve talked about “the interest rate.”
In real life there are many interest rates: there are nominal rates, real rates, before-tax rates,
after-tax rates, short-term rates, long-term rates, and so on.
Which is the “right” rate to use in doing present-value analysis?
The answer rests on the fundamentals:
PV arose because we wanted to be able to convert money at one point in time to an equivalent
amount at another point in time. “The r” is the return on an investment that allows us to transfer
funds this way.
So, we ask: which r has the properties most like the stream of payments we are trying to value; if
the stream of payments
• Is not taxed, we should use an after-tax interest rate.
• will continue for 30 years, we should use a long-term interest rate.
• is risky, we should use the r on an investment with similar risk characteristics.
The r measures the opportunity cost of funds—the value of alternative uses of your money. So,
every stream of payments should be compared to your best alternative that has similar
characteristics in terms of tax treatment, risk, and liquidity.

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