CORE-Econ - The Economy 2.0: Microeconomics - Chapter 9 Summary
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The Open University (OU)
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The Economy 2.0: Microeconomics
A summary of Chapter 9 of CORE-Econ's book: The Economy 2.0:Microeconomics. The summary includes: notes on all content covered in the chapter; graphs, tables and diagrams (alongside explanations for clarity); and a bullet point summary of the chapter.
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Unit 9: Lenders and Borrowers and Differences in Wealth
Wealth refers to the total value of assets owned by an individual or household, including property, financial assets,
and intellectual property. This encompasses items such as homes, cars, shares, and works of art. To determine net
wealth, debts are subtracted from these assets. For example, if you own a house worth $300,000 but owe $100,000
on a mortgage, your net wealth from the house is $200,000. Wealth may generate income (e.g., rental income) or
provide other benefits, but also includes negative wealth if there are debts.
Note: Wealth can also refer to human capital, which includes skills, knowledge, and health, but this chapter will
focus on material wealth that can be spent or invested.
Figure 9.1: Wealth, income,
Income, or disposable income, is the flow of money received over time, which can be depreciation, and consumption:
spent or saved without altering one's wealth. It includes earnings from labour, the bathtub analogy.
profits, interest, dividends, and transfers from the government, minus taxes. Income
is a flow measured over time (e.g., annual or monthly), whereas wealth is a stock
measured at a single point in time.
To illustrate the difference, think of wealth as the amount of water in a bathtub, and
income as the water flowing into it. Wealth is the current volume of water (stock),
while income is the rate at which water is added (flow).
Consumption is the flow of spending on goods and services, which reduces wealth,
analogous to water draining from the bathtub. Saving occurs when consumption is
less than net income, leading to an increase in wealth. Saving can take various forms, such as bank deposits, stocks,
or bonds. Each investment option varies in risk and return. Depreciation is the reduction in value of physical assets
over time, such as the decline in a car's value due to mileage and age. This is a negative flow that reduces the asset's
value.
Borrowing and Lending: Individuals and entities borrow and lend based on their wealth and income. Governments
and companies borrow by issuing bonds - borrowing at a fixed rate of
interest that is paid at a specified time - with government bonds
being safer and generally offering lower returns than corporate
bonds. Shares, representing ownership in a company that can be
bought and sold, are riskier but can offer higher returns compared
to bonds.
, Figure 9.2: Who owns what? Who owes what? Wealth Inequality: Data on U.S. households show significant disparities. The
wealthiest quarter owns the majority of directly held stocks and business
equity, while the poorest quarter holds minimal assets and has substantial
education debt. The richest households also have a greater share of
residential home equity compared to their debt, unlike poorer households.
Understanding these concepts helps clarify how wealth and income affect
borrowing, investment opportunities, and overall financial stability.
Understanding Borrowing, Lending, and Consumption Over Time
Borrowing and lending are mechanisms for shifting consumption and
production across different time periods. A person's wealth influences their
ability to shift these resources. For instance, a moneylender provides funds
to a farmer to buy fertilizer now, with repayment occurring after the crop
matures. Similarly, a payday borrower needs immediate funds for food but
will repay the loan at the end of the month. Essentially, borrowing allows
individuals to bring future purchasing power to the present.
To analyse borrowing and lending, we use concepts like feasible sets and indifference curves. A feasible set includes
all possible combinations of goods or outcomes a person can choose given their constraints. Indifference curves
represent different levels of utility from various combinations of goods. In this framework, a person must make
decisions about borrowing, lending, and investing as ways of moving purchasing power forward (to the present) or
backward (to the future) in time, a concept modelled by the intertemporal choice model. This model shows how
giving up some current consumption can lead to greater future consumption and vice versa, highlighting the
opportunity cost involved.
Figure 9.3: Borrowing, Julia currently has no money but will receive $100 at the end of the
the interest rate, and year as income for labour. This situation represents her endowment,
the feasible set.
meaning her current consumption is $0, and future consumption is
$100. With a 10% interest rate, Julia can borrow up to $91 now and
repay $100 later. Alternatively, she could borrow $70 now and repay
$77 later, leaving her with $23 for future consumption. If she
borrows $30 now, she would repay $33 later, resulting in $67 for
future consumption.
By considering different borrowing and repayment scenarios, Julia's
feasible set, or feasible frontier, is established. This frontier
represents all possible combinations of current and future
consumption available to her at a 10% interest rate. However, if the
interest rate rises to 78%, Julia's borrowing capacity decreases significantly, limiting her to a maximum loan of $56.
Consequently, the feasible set at this higher interest rate becomes smaller, as the higher cost of borrowing reduces
her ability to shift consumption to the present.
Borrowing and lending enable the shifting of consumption across time, but the interest rate plays a crucial role in
determining how much consumption can be moved from the future to the present. Higher interest rates reduce the
capacity to shift resources forward in time, thereby impacting consumption choices.
The Economics of Consumption Smoothing: Motivations and Mechanisms
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