INFINITE-PERIOD FRAMEWORK CHAPTER 8 2BASICS Introduction Modern macroeconomic frameworks feature an infinite number of periods Especially useful for thinking about asset accumulation and asset pricing The intersection of modern macro theory and modern finance theory Here, suppose just one real asset Call it a “stock” – i.e., a share in the S&P 500 (In monetary analysis, two nominal assets: bonds and money) Index time periods by t, t+1, t+2, etc. Important: all analysis conducted from the perspective of the very beginning of period t… …so an “infinite future” (period t+1, period, t+2, period t+3, …) for which to save 3BASICS Introduction Timeline of events Notation ct: consumption in period t Pt: nominal price of consumption in period t Yt: nominal income in period t (“falls from the sky”) at-1: real wealth (stock) holdings at beginning of period t/end of period t-1 St: nominal price of a unit of stock in period t Dt: nominal dividend paid in period t by each unit of stock held at the start of t πt+1: net inflation rate between period t and period t+1 yt: real income in period t ( = Yt/Pt) Period t Period t+1 at-1 Economic events during period t: income, consumption, savings Economic events during period t+1: income, consumption, savings at at+1 Period t+2 Economic events during period t+2: income, consumption, savings at+2 … 1 1 1 1 t t t t t t P P P P P The “definining features” of stock 4BASICS Introduction Timeline of events Notation ct+1: consumption in period t+1 Pt+1: nominal price of consumption in period t+1 Yt+1: nominal income in period t+1 (“falls from the sky”) at: real wealth (stock) holdings at beginning of period t+1/end of period t St+1: nominal price of a unit of stock in period t+1 Dt+1: nominal dividend paid in period t by each unit of stock held at the start of t+1 πt+2: net inflation rate between period t+1 and period t+2 yt+1: real income in period t+1 ( = Yt+1/Pt+1) Period t Period t+1 at-1 Economic events during period t: income, consumption, savings Economic events during period t+1: income, consumption, savings at at+1 Period t+2 Economic events during period t+2: income, consumption, savings at+2 … 2 1 2 2 1 1 1t t tt t t P P P P P The “definining features” of stock 5SUBJECTIVE DISCOUNT FACTOR Macro Fundamentals Subjective discount factor β (a number between zero and one) measures impatience The lower is β, the less does individual value future utility Simple assumption about how “impatience” builds up over time Multiplicatively: i.e., discount one period ahead by β, discount two periods ahead by β2, discount three periods ahead by β3, etc. 6UTILITY Model Structure Preferences v(ct, ct+1 , ct+2 , …) with all the “usual properties” Lifetime utility function Strictly increasing in ct, ct+1, ct+2, ct+3 , … Diminishing marginal utility in ct, ct+1, ct+2, ct+3 , … Lifetime utility function additively-separable across time (a simplifying assumption), starting at time t ct ct+1 v(ct,ct+1,ct+2,ct+3, …)v(ct,ct+1,ct+2,ct+3, …) etc. 1 2 3 1 2 3 2 3( , , , ,...) ( ) ( ) ( ) ( ) ...t t t t t t t tv c c c c u c u c u c u c 7BUDGET CONSTRAINT(S) Model Structure Suppose again Y “falls from the sky” Yt in period t, Yt+1 in period t+1, Yt+2 in period t+2, etc. Need infinite budget constraints to describe economic opportunities and possibilities One for each period Period-t budget constraint Period t+1 budget constraint 1 1t t t t t t t t tPc S a Y S a Da Total income in period t: period-t Y + income from stock-holdings carried into period t (has value St and pays dividend Dt) Total expenditure in period t: period-t consumption + wealth to carry into period t+1 1 1 1 1 1 1 1t t t t t t t t tP c S a Y S a D a Total income in period t+1: period- t+1 Y + income from stock- holdings carried into period t+1 (has value St+1 and pays dividend Dt+1) Total expenditure in period t+1: period-t+1 consumption + wealth to carry into period t+2 can rewrite as can rewrite as 1 1( )t t t t t t t tPc S a a Y Da 1 1 1 1 1 1( )t t t t t t t tP c S a a Y D a Savings during period t (a flow) Savings during period t+1 (a flow) Dividend income during period t (a flow) Dividend income during period t+1 (a flow) And identical-looking budget constraints for t+2, t+3, t+4, etc… 8LAGRANGE ANALYSIS: SEQUENTIAL APPROACH Infinite-Period Model: Sequential Formulation Sequential formulation highlights the role of stock holdings (at) between period t and period t+1 Accords better with the explicit timing of economic events than the lifetime approach… …but yields the same result Advantage: allows us to think about interaction between asset prices and macroeconomic events (intersection of finance theory and macro theory) Apply Lagrange tools to consumption-savings optimization Objective function: v(ct, ct+1 , ct+2 , …) Constraints: Period-t budget constraint: Period-t+1 budget constraint: Period-t+2 budget constraint: etc… Sequential Lagrange formulation requires infinite multipliers 1 1 0t t t t t t t t tY S a Da Pc S a 1 1 1 1 1 1 1 0t t t t t t t t tY S a D a P c S a 2 2 1 2 1 2 2 2 2 0t t t t t t t t tY S a D a P c S a INFINITE constraints 9LAGRANGE ANALYSIS: SEQUENTIAL APPROACH Infinite-Period Model: Sequential Formulation Step 1: Construct Lagrange function (starting from t) Step 2: Compute FOCs with respect to ct, at, ct+1, at+1, ct+2, … with respect to ct: with respect to at: with respect to ct+1: 2 3 2 1 2 3 1 1 1 1 1 1 1 1 1 2 2 2 2 1 2 2 2 2 3 3 3 3 2 3 3 3 3 3 ...( ) ( ) ( ) ( ) ( ) ( ) ( ( .. ) ) t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t t u c u c u c u c Y S D a Pc S a Y S D a P c S a Y S D a P c S a Y S D a P c S a . First the lifetime utility function…. …then the period t constraint… …then the period t+1 constraint… …then the period t+2 constraint… …then the period t+3 constraint… Infinite number of terms IMPORTANT: Discount factor β multiplies both future utility and future budget constraints Everything (utility and income) about the future is discounted '( ) 0t t tu c P 1 1 1'( ) 0t t tu c P 1 1 1( ) 0t t t t tS S D Identical except for time subscripts Equation 1 Equation 2 Equation 3 10 THE BASICS OF ASSET PRICING Finance Fundamentals Equation 2 Much of finance theory concerned with pricing kernel Pricing kernel where macro theory and finance theory intersect To take more macro-centric view Solve equations 1 and 3 for λt and λt+1 Insert in asset-pricing equation '( ) 0t t tu c P 1 1 1'( ) 0t t tu c P 1 1 1( ) 0t t t t tS S D Equation 1 Equation 2 Equation 3 1 1 1( ) t t t ttS S D BASIC ASSET-PRICING EQUATION Future return Pricing kernel xPeriod-t stock price = Two components: 1. Future price of stock 2. Future dividend payment 11 MACROECONOMIC EVENTS AFFECT ASSET PRICES Macro-Finance Connections Consumption across time (ct and ct+1) affects stock prices Fluctuations over time in aggregate consumption impact St Inflation affects stock prices Fluctuations over time in inflation impact St ANY factor (monetary policy, fiscal policy, globalization, etc.) that affects inflation and GDP in principle impacts stock/asset markets 1 1 1 1'( '( ) ( ) )t t t t t t tS u c Pu P S D c 1 1 1 1 1 ( '( ) '( ) ) 1 t t t t t t u c u c S S D Using definition of inflation: 1+πt+1 = Pt+1 / Pt VIEW AS A CONSUMPTION-SAVINGS OPTIMALITY CONDITION 12 CONSUMER OPTIMIZATION Consumption-Savings View 1 1 1 1'( '( ) ( ) )t t t t t t tS u c Pu P S D c 1 1 1 1 '( ) 1 '( ) 1 t t t t t t u c S D u c S Move u’(ct) and βu’(ct+1) terms to left-hand-side, and St to right-hand-side Some sort of price ratio…MRS between period t consumption and period t+1 consumption i.e., ratio of marginal utilities 13 CONSUMER OPTIMIZATION Consumption-Savings View Recover Chapter 3 & 4 framework by setting t =1 and β = 1 1 1 1 1'( '( ) ( ) )t t t t t t tS u c Pu P S D c 1 1 1 1 '( ) 1 '( ) 1 t t t t t t u c S D u c S Move u’(ct) and βu’(ct+1) terms to left-hand-side, and St to right-hand-side Analogy with Chapters 3 & 4: must be (1+rt) MRS between period t consumption and period t+1 consumption i.e., ratio of marginal utilities Recall real interest rate is a price CONSUMPTION-SAVINGS OPTIMALITY CONDITION 14 CONSUMER OPTIMIZATION Consumption-Savings View Recover Chapter 3 & 4 framework by setting t =1 and β = 1 Infinite-period framework is sequence of overlapping two-period frameworks 1 1 1 1'( '( ) ( ) )t t t t t t tS u c Pu P S D c 1 1 1 1 '( ) 1 '( ) 1 t t t t t t u c S D u c S Move u’(ct) and βu’(ct+1) terms to left-hand-side, and St to right-hand-side Analogy with Chapters 3 & 4: must be (1+rt) MRS between period t consumption and period t+1 consumption i.e., ratio of marginal utilities Recall real interest rate is a price CONSUMPTION-SAVINGS OPTIMALITY CONDITION c1 c2 slope = - (1+r1) optimal choice between p1 and p2 c2 c3 optimal choice between p2 and p3 c3 c4 optimal choice between p3 and p4 etc. slope = - (1+r2) slope = - (1+r3) 15 A LONG-RUN THEORY OF MACRO Modern Macro Consumption-savings optimality condition at the heart of modern macro theories Emphasize the dynamic nature of aggregate economic events Foundation for understanding the periodic ups and downs (“business cycles”) of the economy (Chapter 14: business cycle theories) 1 '( ) 1 '( ) t t t u c r u c NEXT: Impose “steady state” and examine long-run relationship between interest rates and consumer impatience 1 1 r STEADY-STATE OF INFINITE-PERIOD ECONOMY: WHY ARE LONG-RUN REAL INTEREST RATES POSITIVE? 17 STEADY STATE Macro Fundamentals Steady state A concept from differential equations (Optimality conditions of economic models are differential equations…) Heuristic definition: in a dynamic (mathematical) system, a steady- state is a condition in which the variables that are moving over time settle down to constant values In dynamic macro models, a steady state is a condition in which all real variables are constant. But nominal variables (i.e., price level) may still be moving over time (will be important in monetary models – Chapter 15) Simple example Suppose Mt/Pt = ct is an optimality condition of an economic model (ct is consumption, Pt is nominal price level, Mt is nominal money stock of economy) Even if ct eventually becomes constant over time (i.e., reaches a steady- state), it is possible for both Mt and Pt to continue growing over time (at the same rate of course…) Bottom line: in ss, real variables do not change over time, nominal variables may change over time 18 REAL INTEREST RATE Macro Fundamentals Recall earlier interpretation of r Price of consumption in a given period in terms of consumption in the next period (Chapter 3 & 4: r measures the price of period-1 consumption in terms of period-2 consumption) Now a second interpretation of r: long-run (i.e., steady state) real interest rate simply a reflection of degree of impatience of individuals in an economy The lower is β, the higher is r The more impatient a populace is, the higher are interest rates Which came first, β or r? Modern macro view: β < 1 causes r > 0, not the other way around A deep view of why positive real interest rates exist in the world 1 1 r Inverse of subjective discount factor (one plus) real interest rate
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