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Springer Texts in Business and Economics

Thorsten Hens
Sabine Elmiger

Economic
Foundations
for Finance
From Main Street to Wall Street
Springer Texts in Business and Economics
Springer Texts in Business and Economics (STBE) delivers high-quality
instructional content for undergraduates and graduates in all areas of Busi-
ness/Management Science and Economics. The series is comprised of self-
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More information about this series at http://www.springer.com/series/10099

Thorsten Hens • Sabine Elmiger

Economic Foundations
for Finance
From Main Street to Wall Street

123
Thorsten Hens Sabine Elmiger
Department of Banking and Finance Department of Banking and Finance
University of Zurich University of Zurich
Zurich, Switzerland Zurich, Switzerland

ISSN 2192-4333 ISSN 2192-4341 (electronic)

Springer Texts in Business and Economics
ISBN 978-3-030-05425-0 ISBN 978-3-030-05427-4 (eBook)
https://doi.org/10.1007/978-3-030-05427-4

© Springer Nature Switzerland AG 2019

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Preface

In her book Casino capitalism, Strange (1986) picks up the idea of John Maynard
Keynes that financial markets can get detached from the real economy and argues
for more regulation. Unfortunately, she died in 1998 well before the financial crisis
of 2007/08, which ultimately proved that she was right. Moreover, after the financial
crisis, movements like the Occupy Wall Street protests show how many people now
share this view.
However, financial markets can only temporarily get detached from the real
economy. In the long term, the foundation of finance in the real economy becomes
apparent. To add some scientific input to the debate between Main Street and Wall
Street, we found it worthwhile writing a book that shows the economic foundations
of finance. The book developed out of the course “Economic Foundations of
Finance” that we have been teaching to quantitatively oriented master’s students
at the University of Zurich and the ETH Zurich. These students have no problem
following formal arguments, but they struggle to understand the connection between
the many ideas and concepts on which finance is based.
The main model in which we embed the different financial concepts is the
neoclassical growth model of Ramsey (1928), Koopmans (1965), and Cass (1966).
This model is based on the optimization of firms and households and the idea of a
steady-state equilibrium. We enrich the standard model by introducing capital and
stock markets so that the long-term co-development of the financial markets with
the real economy can be analyzed. Moreover, we extend the model by including
exhaustible resources in order to analyze the interdependence of financial markets
with commodity markets. In this holistic view, we embed classical results in finance
like the Absence of Money Illusion, the Theory of Interest Rates, the Equity
Premium, the Gordon Growth Model, Tobin’s q, the Capital Asset Pricing Model,
the Modigliani–Miller Theorems, Fisher’s Separation Theorem, and Hotelling’s
Rule as well as new results on the drivers of the capital income to labor income
ratio as identified by Piketty (2014).
Last but not least, we would like to thank all the people who contributed to
this book. We are particularly grateful to the research and teaching assistants
Amelie Brune, Urs Schweri, Nilufer Caliskan, Regina Hammerschmid, Luzius
Meisser, Gereon Sommer, and Andreas Schäfer for valuable inputs and suggestions.

v
vi Preface

Moreover, we would like to thank Simone Fuchs for helping us with Latex and Bjørn
Sandvik for working through the manuscript at an early stage.

Zurich, Switzerland Thorsten Hens

Zurich, Switzerland Sabine Elmiger
April 2019
About This Book

This book can serve as the basis for a bachelor’s or a master’s course in Financial
Economics. A course on the bachelor level should include the following chapters:

1. Introduction
2. Financial markets and institutions
3. The basic economic model
4. Extension of the model to capital

Thereafter, a bachelor’s course should be selective and choose from Chap. 5:

• Gordon growth model

• Modigliani–Miller theorems

from Chap. 6:

• Valuation of cash flows by the stochastic discount factor

• Derivation of the capital asset pricing model (CAPM)
• Equity premium

from Chap. 7:

• Hotelling’s rule

A master’s course can directly start from Chap. 5, but students are invited to study
preceding chapters as well. All mathematical concepts that are needed to understand
the book are explained in Appendix A. Further teaching and study material as well
as solutions to the exercises can be found on the following website:
www.bf.uzh.ch/de/studies/books/economic-foundations-of-finance.html.

vii
Contents

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 1
2 Financial Markets and Institutions . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 5
3 The Basic Economic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11
3.1 Definition of the Market Equilibrium . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11
3.2 Basic Features of the Market Equilibrium . . . . . . .. . . . . . . . . . . . . . . . . . . . 13
3.3 Production and Utility Function Properties and Implications .. . . . . . 15
3.4 Technological Progress and Population Growth .. . . . . . . . . . . . . . . . . . . . 18
3.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 23
3.6 Exercises.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 23
4 Extension of the Model to Capital.. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 25
4.1 Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 26
4.2 Central Planner’s Problem .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 33
4.3 Illustration of the Market Equilibrium . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 34
4.4 Cobb–Douglas Production Function and Logarithmic Utility . . . . . . 37
4.4.1 Effect of Population Growth . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 40
4.4.2 Effect of Technological Progress. . . . . . . . .. . . . . . . . . . . . . . . . . . . . 42
4.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 43
4.6 Exercises.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 44
5 Extension of the Model to an Infinite Horizon .. . . . . . .. . . . . . . . . . . . . . . . . . . . 47
5.1 Intertemporal Market Equilibrium . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 47
5.2 Financial Capital and Payout Irrelevance . . . . . . . .. . . . . . . . . . . . . . . . . . . . 54
5.3 Illustration of the Market Equilibrium . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 55
5.4 Effect of Population Growth .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 59
5.5 Effect of Technological Progress . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 63
5.6 Income Inequality .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 67
5.7 Introduction of Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 71
5.8 A Special Case: The Gordon Growth Model . . . .. . . . . . . . . . . . . . . . . . . . 74
5.9 Return on Equity and Debt . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 75
5.10 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 76
5.11 Exercises.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 77

ix
x Contents

6 Extension of the Model to Uncertainty . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 79

6.1 Uncertainty Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 79
6.2 Concave Utility and Risk Aversion.. . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 81
6.3 Intertemporal Planner’s Problem . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 83
6.4 Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 85
6.4.1 Household’s Decision Problem . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 85
6.4.2 Firm’s Decision Problem .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 86
6.5 Stochastic Discount Factor and Asset Prices . . . .. . . . . . . . . . . . . . . . . . . . 88
6.5.1 Capital Structure and Payout Irrelevance .. . . . . . . . . . . . . . . . . . . 91
6.5.2 Equity Premium from the Household’s Perspective.. . . . . . . . 93
6.5.3 Equity Premium from the Firm’s Perspective . . . . . . . . . . . . . . . 97
6.5.4 Stochastic Discount Factor from Market Returns .. . . . . . . . . . 101
6.5.5 Capital Asset Pricing Model . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 102
6.5.6 Technological Progress and Population Growth . . . . . . . . . . . . 104
6.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 107
6.7 Exercises.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 107
7 Extension of the Model to Exhaustible Resources . . . .. . . . . . . . . . . . . . . . . . . . 111
7.1 Hotelling’s Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 112
7.2 Central Planner’s Problem .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 112
7.3 Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 116
7.4 Cobb–Douglas Production Function and Logarithmic Utility . . . . . . 120
7.4.1 Sustainable Technological Progress . . . . .. . . . . . . . . . . . . . . . . . . . 121
7.4.2 Technological Progress as a Growth Driver . . . . . . . . . . . . . . . . . 124
7.4.3 Pricing Implications . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 128
7.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 130
7.6 Exercises.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 131
8 Aggregation .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 133
8.1 Complete Markets.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 133
8.2 Arbitrage and the Fundamental Theorem of Asset Pricing . . . . . . . . . 135
8.3 Market Equilibrium with Multiple Agents . . . . . . .. . . . . . . . . . . . . . . . . . . . 136
8.4 First Welfare Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 140
8.5 Aggregation of Households.. . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 141
8.6 Aggregation of Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 144
8.7 Individual or Aggregate Rationality? . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 147
9 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 149

A Mathematical Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 153

A.1 Notation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 153
A.2 Sequences and Series . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 153
A.3 Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 154
A.4 Concave and Convex Functions . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 154
A.5 Differences and Rates of Change.. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 156
A.6 First and Second Derivative . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 156
Contents xi

A.7 The Product Rule and Chain Rule . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 157

A.8 Partial Derivatives .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 157
A.9 Homogeneous Functions.. . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 158
A.10 Constrained Optimization . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 158
A.11 Envelope Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 159
A.12 Expectation, Variance and Covariance .. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 160
A.13 Convex Sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 161
A.14 Jensen’s Inequality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 161
A.15 The Intercept Theorem.. . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 162
A.16 Vectors and Matrices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 162
A.17 System of Linear Equations . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 164

B Sufficiency of the First Order Conditions . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 165

C Covariance of the SDF and Returns . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 169

References .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 173

Index . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 177
Introduction
1

Finance, a relatively young science, is a combination of three fields: business admin-

istration, economics, and mathematics. Learning finance without its foundations
might lead to a misunderstanding and misapplication of financial theory. The aim of
this book is to cover the economic foundations of finance and to give an introduction
to financial economics.
Another goal is to give finance students a better understanding about the long-
run dynamics of financial markets. The book explains how population growth,
technological progress and natural resources affect long-term asset prices. It shows
how “Wall Street”, i.e., the financial system, is connected to “Main Street”, i.e., the
real economy over the long run.
The book builds on a few basic ideas. The probably most important one is
the assumption that decision makers (households and firms) act—more or less—
rationally in the long run. They pursue their goals on average in an optimal
way given their human, physical and financial constraints. Of course, households
and firms make some errors, but these errors average out over time and over
all households and firms. Phases of collective mistakes, as they occurred in the
world economic crisis in the thirties of the last century or the recently experienced
global financial crisis, are indeed an extremely fascinating topic for research and
will remain in our memory. However, these are fortunately more exceptions rather
than the rule, so that stock prices, dividends, interest rates, etc. can be explained
rationally in the long run. For example Fig. 1.1 shows the long-run behavior of the
S&P500 Composite Index. We see that although being quite volatile, the S&P500
follows its fundamental value in the long run. The fundamental value is computed
by discounting future dividends at a constant discount rate of 5%. An explanation
of how the fundamental value is calculated and how the discount rate is determined
can be found in Chaps. 5 and 6.
For modeling financial markets, we need to further specify the principle of
rationality in a meaningful way. We need to assume reasonable goals as well as
restrictions for households and firms that guide their actions. The assumption of

© Springer Nature Switzerland AG 2019 1

T. Hens, S. Elmiger, Economic Foundations for Finance, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-030-05427-4_1
2 1 Introduction

10000

1000

100

10
1870 1890 1910 1930 1950 1970 1990 2010

S&P500 Present value of future dividends

Fig. 1.1 Excess volatility. The real S&P500 Composite Stock Price Index and prices calculated
with the discounted dividend model using a discount rate of 5% from 1871 to 2015. Adapted from
Irrational Exuberance, by R. J. Shiller, 2005, Princeton University Press

rationality in the sense of acting consistent with an overall goal is meaningless if

the goal is not reasonably chosen: any imprudent action like investing a substantial
amount of wealth into incomprehensible financial products could be considered
rational if we define an equally imprudent goal like going bankrupt as fast as
possible.
Households are assumed to maximize utility, which describes the pleasure that
the households obtain from consumption. The main restriction that we place on
the households’ objectives is that the utility increases at a decreasing rate with the
amount of goods consumed (food, clothing, housing, transportation, etc.). Thus,
the households’ marginal utility is decreasing. Let us illustrate this point with the
example of fresh water as a consumption good. The first glass that you drink is a
treat, the second and the third are still pleasant, but there is not much value per glass
of water after the fifth glass. This simple idea has far-reaching consequences for
financial decisions: households tend to spread consumption evenly over different
time periods (for instance, youth and old age). Moreover, this assumption implies
that households dislike risk. They prefer to consume the same amount independently
of certain events such as the development of stock markets rather than becoming
very wealthy after a large stock market boom and becoming very poor after a stock
market crash.
Analogously, firms are assumed to maximize their profits. Similarly to the
assumption of increasing utility and decreasing marginal utility for households, we
assume that the productivity of firms is increasing in the production factors but that
marginal productivity is decreasing. In other words, the more work is done or the
more investments are made, the more production there is. However, if there already
1 Introduction 3

Box 1.1 Basic Assumptions

• Rationality
– Decreasing marginal utility
– Decreasing marginal productivity
• Market equilibrium

exists a high level of production, then additional labor input or investments can only
further increase production at a lower rate.
In addition to rationality and the principles of decreasing marginal utility and
productivity, all models in this book are based on the idea that supply needs to
equal demand, i.e., the idea of market equilibrium. Markets are assumed to be
well-organized so that there exists an equilibrium between demand and supply. If
supply is larger than demand, prices fall in such a way that the suppliers decrease
production and the consumers increase demand. This market equilibrium is not
static, but has a dynamic structure. It varies depending for example on the growth
of the population and technological progress, so that new equilibrium levels are
reached over time. During these transition periods, previous structures of the market
become irrelevant and new ones are created. Although market prices can carry large
errors for a prolonged time, as we observed in the internet bubble or the recent
financial crisis, in the very long run, equity returns reflect technological progress
and the growth rate of the population.
Given the basic ideas outlined above and summarized in Box 1.1, we show that
profits, dividend payments, share prices and real wages grow at a similar rate, while
real interest rates remain constant on average. For this purpose, the book develops
step by step an economic model where the interaction between goods, labor, capital
and energy markets can be studied. Chapter 6 introduces uncertainty into the model.
This lets us obtain a simple trade-off between risk and return, which is further
refined in subsequent finance books on investments, asset pricing and derivatives.
A major contribution of this book is that all market prices are considered from the
perspective of the households as well as the firms. Both approaches need to lead to
the market prices that balance supply and demand, otherwise the market equilibrium
is not complete. Unfortunately, this central point is often neglected in favor of more
specialized models. Most books on asset pricing focus solely on how households
allocate their money, and most books on investments only consider the perspective
of the firm.
Financial Markets and Institutions
2

It is obvious that economies depend on markets for labor and for products, such as
consumption goods. In these markets, the so-called “Main Street”, employers find
employees who are most suitable for them, and households find products which
are best for them. So why then is there a need for Wall Street? That is, why is
there a need for bond markets, stock markets and a variety of option markets, where
enigmatic persons such as Warren Buffet, George Soros and Bernard Madoff snatch
each other’s money? And why do workers and entrepreneurs of “Main Street” need
to rescue institutions of Wall Street (investment banks, commercial banks, mortgage
banks, etc.) from collapse with billions of dollars in the end? These controversial
questions can only be answered if one understands the functions of financial markets
and their institutions.
The first main function of financial markets is to allow for the intertemporal
substitution of consumption. This means the following: it lies in the nature of man
that there are phases of life where one is unable to work, but still needs to eat,
dress, and have a place to live, etc. This is the case in childhood and in old age for
instance. On the other hand, there is the phase of medium age when one can earn a
high income, but when one also has to work so much that only little time remains
for actual consumption. Hence, it is sensible to create institutions which enable
individuals to distribute consumption as evenly as possible over time. Figure 2.1
illustrates this idea using the principle of decreasing marginal utility in consumption.
One possible institution which could allow for intertemporal substitution of
consumption is the extended family in which at least three generations live together
in one household. A disadvantage of the extended family is, however, that it prevents
mobility in the labor market. Another institution is a financial market, where one can
borrow and lend money. Whether the money saved in the financial market is booked
on an individual account or collected in a pension fund is irrelevant for the basic
mechanism of intertemporal substitution.

© Springer Nature Switzerland AG 2019 5

T. Hens, S. Elmiger, Economic Foundations for Finance, Springer Texts
in Business and Economics, https://doi.org/10.1007/978-3-030-05427-4_2
6 2 Financial Markets and Institutions

U
U1
U1 ΔU1
U0 ΔU0

U0

C0 C0 +Δ C1 -Δ C1 C
Fig. 2.1 Properties of the utility function. First of all, the utility function increases in consump-
tion, i.e., the higher consumption, C, the higher the utility, U . In other words, the household prefers
more consumption to less consumption. Second, the utility function is concave, i.e., if the level
of consumption is lower in one situation, C0 , compared to the level of consumption in another
situation, C1 , the decrease in utility resulting from a reduction of consumption in situation 1 by 
is less than the gain in utility resulting from an increase in consumption by the same amount  in
situation 0. Hence, it is sensible to transfer income from situation 1 to situation 0

An interesting question arises whether on such a financial market, as for example

the bond market,1 a positive real interest rate2 exists. Or in other words, whether
reducing consumption in one period will be rewarded by more consumption in a
later period. If there is, for example, a generation with many people such as the
“baby boomers” which is followed by a “baby bust” generation, then it could well be
that the “baby boomers” get back less consumption in old age than the consumption
which they have saved in medium age. The reason for these negative interest rates
being that the “baby boomers” save so much that there are not enough profitable
projects to invest those savings into. On the other hand, there is hope that due to
technological progress, much more can be produced at a later point in time such
that these cohort problems will have no far-reaching consequences. This discussion
shows that it is not a priori clear that real interest rates must be positive. In this book,
we formally analyze the question of a positive interest rate.
The second main function of the financial market is to enable risk sharing among
many individuals. If there was no financial market, Main Street would need to do
this itself. In fact, there are also mechanisms to spread risks in rural societies. An

1A bond is an obligation to pay, which in addition to the repayment of debt usually also requires
the payment of interests. Bonds are primarily issued by the state and by large corporations.
2 The real interest rate describes how many additional goods can be purchased in the next period

for one good saved in this period, i.e., the real interest rate equals the nominal interest rate minus
the inflation rate.
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