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1、ECON237NOTESONCHOOSINGTHEAPPROPRIATEDISCOUNTRATETherearefourgeneralapproachesforselectingthemostappropriatediscountrate.1.OpportunityCostofPublicFundsAssumeaclosedeconomy(i.e.,noinflowsoroutflowstoforeigncountries).Underthisassumption,Y=C+I+G[Thisisanidentityandisassum
2、edtohold]Y=outputoftheeconomyC=ConsumptionI=InvestmentG=GovernmentspendingThisimpliesthatasgovernmentspendingincreases,investmentorconsumption(orboth)mustdecrease.Thus,theopportunitycostofpublicfundsisacombinationof:1.Rateofreturnreflectingtheopportunitycostofconsumpti
3、on2.Rateofreturnreflectingopportunitycostofprivateinvestment3.Rateofreturnreflectingthe%ofconsumptionv.%ofprivateinvestmentdisplacedbythegovernmentexpenditure.2.IndividualRateofTimePreference(IRTP)orMarginalRateofTimePreference(MRTP)Ifgovernmentinvestmentcomesattheexpe
4、nseofconsumptionthisimpliesthatthegovernment,ineffect,isforcingconsumerstosave.Therelevantquestioniswhatistherateofreturnneededtoinduceconsumerstoforegonecurrentconsumption?Intheory,thiscanbedeterminedbytheoptimalsolutiontotheproblemofmaximizingutilityinthefaceofabudge
5、tconstraintthatreflectstheindividual’sincomeacrosstwotimeperiods.Seefigure1below.12Theslopeoftheindifferencecurvesinthefigurearedefinedas:slope=dCt+1/dCt=MRS=IRTPThissloperepresentstherateatwhichconsumerscantransferconsumptionfromthecurrenttimeperiodtofuturetimeperiods
6、.Itisessentiallythemarketrateonconsumers’savings,rc.Infigure1,thebudgetconstraintisdefinedasfollows:Y=Ct+Ct+1/(1+rc),whereYistheindividual’stotalincomeoverthetwoyears.Solvingforconsumptioninyeart+1gives,Ct+1=Y(1+rc)-(1+rc)Ct,,whereY(1+rc)=theinterceptontheverticalaxis(
7、1+rc)Ct,=slopeofthebudgetconstraint.Iftherewereonlyasinglercintheeconomy,thenMRS1=MRS2=MRS3=....Isrcthesocialrateoftimepreference(i.e.,thesocialdiscountrate)?Itcouldbeifinequilibriumitappliedtoallindividuals.Ifthiswerethecase,anunderlyingassumptionisthatcapitalmarketsa
8、reperfect,andthentheIRTPwouldbeidenticalforallindividualsinequilibrium.However,therearesomeproblemswiththisapproach.-
