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Samenvatting Elective Household Finance Erasmus B3EL113
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Here is a summary of the 3rd year course Household Finance lectures
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Household Finance LecturesLecture 1:
What is household finance?
The study of how households use financial products to attain them objectives (Badarinza,
Campbell and Ramadorai, 2016)
– For example: Your objective may be to buy a house
In order to do this, you would save for a deposit
You may borrow from the bank
The house itself has elements of being a financial product (it is an
investment)
What this course IS
• A framework for how to think about financial decision-making, why they make then, how
they finance them
Financial decision making major 2 categories borrowing and saving/investing and how
they make those decision over the course of their lives.
• Design of new financial products
• Regulation of existing financial products
• An overview of the major financial decisions made by people during them lives
• An attempt to give you a global overview, though with a focus on Western Europe
1. Intertemporal consumption smoothing: A framework for thinking about financial
decisions
Before we dive into specific questions, we need a broad framework for thinking about these
issues!
• Why do people invest / save?
• What assets and liabilities do people have? What is human capital?
• What is a household? Who makes financial decisions?
Our ultimate aim is to be able to put specific decisions in a broader context
Normative vs. positive household finance
• Normative household finance: How households should make financial decisions
• Positive household finance: How households actually make decisions
• This course: Start with normative framework, move to positive decision-making
However, major caution: Very hard to define “rationality” and what people should do
2. Why do people invest and Save, Intertemporal consumption smoothing?
The goals of this section
• Understand why people want to smooth consumption
• Medieval peasant farmer example/ Middeleeuwse boerenvoorbeeld
• Recap of utility functions
• Understand how finance allows people to smooth consumption
1
,Imagine a medieval peasant without access to finance
• What happens if they have a good harvest?
• What about a bad one?
• Being near starvation in one year and having too much to eat in another is not a
great outcome
• How would they get educated? Other job with educating earn more money
• High returns, but no upfront capital
3. Detour: Recap of utility functions
Utility functions Why are we covering this?
To understand WHY people want to smooth consumption!
• In your prior studies, you will have learned about utility functions
• A utility function is a way to mathematically represent preferences over bundles of
goods
• E.g. a consumer only has €5 to spend and must choose which mix of ham and
cheese to buy for his sandwich
• His utility function might be
• A consumer chooses the bundle of goods that maximizes their utility
• Maximum of a function à take the derivative, set it = 0, check whether the point
you have found is a maxima or a minima (last bullet point not really important)
But some issues arise
• Utility representations of bundles of different goods (e.g. ham vs. cheese) or a
single good
• But in household finance we are concerned with two things:
• Utility maximization of the same good over time
• Utility maximization with uncertain payoffs (e.g. stocks)
• Generally focused on utility of wealth
• Payoffs of investments over time etc.
• U(W)
in household finance we typically maximize utility over one good, so either total
wealth or total consumption.
An assumption to start from
• We typically assume that people display:
• Positive but diminishing marginal utility of wealth / altijd Positief maar afnemend
marginaal nut van rijkdom - €100 is always worth something, but worth a lot more to you
than to a billionaire* so when someone give u money you always will be happy, but the
more money you have the utility will diminish
• Implies a concave utility function
• Examples of these utility functions:
* Technically a very bad example as utility cannot be
compared across people
2
,Uncertain payoffs
Why are we talking about risk?
Not relevant yet, but this is an important stepping stone to future concepts, so we will cover
it now
• 50% chance of winning 0, 50% chance of winning €100
• The expected return is €50
• In utility terms using the utility function from the previous slide:
what you see is that de utility of the lottery square root of expected return of 50
is higher than the expected utility person will rather have the 7 than the 5 (lottery) risk
averse!
Risk attitudes
• A person can be either
-risk averse (see above example, (U(W) > E(U(W))
-risk neutral (The U(W)= E(U(W)))
-risk loving (U(W) < E(U(W))
• In the example on the previous slide, the person is risk averse
• In general, we assume that most people are risk averse in most matters
• Clearly some exceptions
Uncertain payoffs
• As seen in the previous slides, incorporating uncertainty with discrete payoffs is very easy
à risk attitudes come directly from weighing each payoff vs. the expected payoff
- Zoals in de vorige dia's is te zien, is het opnemen van onzekerheid met discrete
uitbetalingen zeer eenvoudig à De risicohouding komt rechtstreeks voort uit het afwegen van
elke uitbetaling versus de verwachte uitbetaling.
• However, it is possible to get more sophisticated and include risk as a term in the
EXPECTED utility calculation
• This is useful for real-world investments, where we understand the distribution of
outcomes
• Note: These utility functions consider variance of wealth to be risk that people care
about à of course, this is not realistic, but functions that take into account more
sophisticated risk measures are well beyond this video
Multiperiod expected utility This is relevant for why finance exists!
• A key principle of household finance (and the raison d’etre for finance) is that people do
not simply want to maximize consumption today, they want to maximize the utility of
consumption over their lifetime
• Medieval peasant farmer gets more utility from consuming 1000 calories
Per day for 2 years than 1 calories per day in 1 year and 3000 calories per day in another
3
, why does the farmer want too
smoot their consumption, because his
utility will be higher when he
consumes 1000 calories per day for 2
year in stead of 1 day 1000 and
another day 3000. because the
utility fuction is diminishing
Neoclassical consumption model: MODEL 1
• The neoclassical consumption model says that consumers maximize lifetime
utility of consumption with some caveats (voorbehouden):
• Future consumption is worth less than consumption today (i.e. it is discounted)
and an “impatience” parameter determines the degree to which that is true
if I say I give you either today 100 EUR or when your 16 your prefer today, but you
still want to smooth your consumptions out.
• People can use financial markets to transfer consumption across time and that
this transfer either earns a return or incurs a cost (brengt kosten met zich mee).
Neoclassical consumption model continued
• The consumer maximizes the sum of the utility of consumption today + the utility of all
future consumption
• They are bound by a budget constraint that is equal to their wealth today plus the return
on the wealth they do not consume today
• Obviously: Not realistic. People have income.
you have a expected income in mind and you are going too smooth consumption
with that income in mind
• Over their lifetimes, consumers consume all their wealth
• The utility maximization problem leads to the Euler equation
• A person must be indifferent between consuming an additional unit today vs.
saving the money and consuming the unit in the future.
IMPORTANT TAKEAWAY from smoothing theory is that when you have now 100 EUR you
will be barrowing and when you have 250 K then you will save that 100 EUR because you
have so much more money to spend.
A basic framework Why is this slide relevant? It outlines the role of financial transactions
(saving + borrowing) in intertemporal consumption smoothing
• Consumers attempt to maximize lifetime expected utility (from consumption)
• Financial products allow for the transfer consumption from one period too another
(“intertemporal substitution”)
• Deferring consumption/ Consumptie uitstellen = saving (= investing, lending)
• Bringing forward consumption / Consumptie vervroegen = borrowing
• Financial products and wealth by themselves provide no utility
• What happens if we relax this assumption?
4
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