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AGEC 608: Lecture 10

AGEC 608: Lecture 10. Objective: Examine arguments regarding the social discount rate and the “appropriate” discount rate Readings: Boardman, Chapter 10 Homework #3: Chapter 4, problem 2 Chapter 5, problem 1 Chapter 6, problem 4 due: today

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AGEC 608: Lecture 10

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  1. AGEC 608: Lecture 10 • Objective: Examine arguments regarding the social discount rate and the “appropriate” discount rate • Readings: • Boardman, Chapter 10 • Homework #3: Chapter 4, problem 2 Chapter 5, problem 1 Chapter 6, problem 4due: today • Homework #4: Chapter 7, problem 3 Chapter 10, problems 1 + 2 Chapter 13, problem 3due: April 11

  2. Discounting for time Choosing a social discount rate is equivalent to choosing a set of weights for the above problem.It is generally assumed that the weights decline over time (due to impatience and the productive role of investment). The value of weights is not a matter of agreement.

  3. Conceptual foundation See Fig. 10.1

  4. Five possibilities for wt 1. Marginal rate of return on private investment (rz) 2. Marginal social rate of time preference (pz) 3. Social opportunity cost of capital 4. Shadow price of capital 5. Hyperbolic discounting Plus, any of the above can be adjusted for: Risk or Real economic growth

  5. wt = marginal rate of return on private investment Argument (due to Harberger): Government removes resources from the private sector, so return on government project should exceed return on private investment s = arz + (1-a)pz where a = ΔI/(ΔI + ΔC) (a ≈ 1 “crowding out”): Main Criticism:If project if financed by taxes rather than loans, then consumption will be crowded out.

  6. wt = marginal social rate of time preference Argument: Social discount rate should equal rate at which individuals are willing to postpone consumption s = pz (low value 0 – 2%) Main Criticism:Aggregation across individuals is difficult. Future ignored.

  7. wt = weighted social opportunity cost of capital Argument: Projects are financed by domestic borrowing (a), foreign borrowing (b) and domestic consumption (1-a-b): WSOC = arz + bi + (1-a-b)pz (range 5%-7%) Main Criticism:Each project is financed differently, so each project must be assessed using a different rate.

  8. wt = shadow price of capital Argument : Projects generate flows of investment (≈15%) and consumption (≈85%). These should be weighted differently: δ=capital depreciation f = fraction of return reinvested Range 1.5%-2.5%Main criticism: complicated, w/high information requirement

  9. wt = hyperbolic discounting Argument: Empirical evidence suggests people use lower discount rates for event far in the future and constant discount rates assign very low weight to future events. Rate should decline over time, but this raises both theoretical and practical concerns.

  10. wt in practice US Office of Management and Budgetreal interest rates:1.6%-7.9% (1979-2003) www.whitehouse.gov/omb/circulars/a094/DISCHIST-2003.pdf 7% (2003) www.whitehouse.gov/omb/circulars/a094/a094.html

  11. Discounting for time and uncertainty no risk w/risk r = rate of return on investments (risk free (f) and risky portfolio (m)). beta = measure of systematic risk for investment i.

  12. Examples

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