Flashcard finanziarie: concetti chiave di Equilibrio e mercati

What key assumptions are made in the two-period model regarding an individual's starting and

ending financial positions, and why are these assumptions important?

Answer:

The model assumes that an individual begins at time t with zero financial assets and liabilities (no

prior economic activity) and must end at time t + 1 with zero net financial assets (the “no residual

debt” condition). This ensures that every surplus or deficit generated during the period is fully

resolved, preventing any accumulation of unrepaid loans or unreturned funds and simplifying the

analysis by confining all transactions within a finite timeframe.

Flash Card 12

Question:

How does the "no residual debt" condition reflect economic realities, and what complications might

arise in an infinite-horizon model compared to the two-period framework?

Answer:

The "no residual debt" condition means that individuals must finish their economic life with no

outstanding debt, ensuring that any borrowed funds are repaid. This mirrors the economic ideal that

one should not leave unfulfilled financial obligations at life's end. In an infinite-horizon model (like

for the public sector), debt can be deferred over many periods, raising complex issues about

sustainability, eventual repayment, or bankruptcy that are much simpler to resolve in the two-period

framework.

Flash Card 13

Question:

Why does the sum of net financial assets (or financial balances) across all individuals or sectors

always equal zero in this framework?

Answer:

Every financial asset corresponds to a liability on someone else’s balance sheet. For example, a

bank loan is an asset for the bank and a liability for the borrower. When you add up all individual

net positions (assets minus liabilities), the positive and negative values cancel out exactly. This

zero-sum outcome is a fundamental feature of the flow-of-funds identity in the economy.

Flash Card 14

Question:

How does the flow-of-funds identity extend across different sectors such as families, firms, the

public sector, and the foreign sector?

Answer:

The flow-of-funds identity holds for every economic agent or sector, meaning that each sector’s

financial balance (the change in net financial assets) is determined by its revenues minus its costs.

For families, it is savings; for the public sector, it is taxes minus public expenditure and transfers;

for the foreign sector, it is defined by the trade balance. When these individual balances are summed

across all sectors, the total must equal zero, reflecting the interconnected nature of financial

transactions.

Flash Card 15

Question:

In the context of the intertemporal budget constraint, how do the definitions of revenues and costs

differ among various sectors, and what effect does this have on their financial balances?

Answer:

Different sectors define revenues and costs in ways that reflect their roles in the economy. Families

earn revenues through labor income, investment returns, and pensions, while their costs include

consumption and taxes, leading to savings as their financial balance. The public sector, however,

collects revenues via taxes and incurs costs through public expenditures and transfers. For firms,

revenues come from sales and costs from wages and investments, with profits being transferred to

owners. These differing definitions determine each sector’s financial balance, which collectively

must sum to zero across the economy, illustrating the integrated nature of financial flows.

Flash Card 16

Question:

What is the basic structure of the private sector’s intertemporal budget constraint and how does it

link consumption decisions across two periods?

Answer:

The private sector’s intertemporal budget constraint is built on two linked equations—one for each

period. In period t, the financial balance is the difference between income (net of taxes) and

consumption, which establishes the amount of wealth accumulated (W). In period t + 1, income

includes both labor income and the financial return on wealth, given by the gross rate of return (R =

ₜ₊₁

1 + r). By imposing the “no residual debt” condition (W = 0), the two equations are combined

into a single reduced-form budget constraint that links current and future consumption decisions to

the available incomes and returns.

Flash Card 17

Question:

How is wealth (W) defined in this framework, and what role does it play in shaping the

intertemporal budget constraint for families?

Answer:

Wealth (W) represents the net financial assets—financial assets minus liabilities—that a family

holds. In the first period, families start with zero wealth, meaning no financial income is earned

initially. However, any surplus (income minus consumption) builds up as wealth, which then

generates financial income in the subsequent period (through interest or returns). Thus, wealth

serves as the bridge between periods, affecting future consumption by providing additional income

via its return.

Flash Card 18

Question:

What is the “no residual debt” condition, and how does it influence the formulation of the

intertemporal budget constraint?

Answer:

The “no residual debt” condition stipulates that by the end of the second period (or the end of life),

individuals must have zero net wealth—that is, all debts are repaid and no unutilized assets remain.

This assumption ensures that any surplus generated during the first period is completely used to

support consumption in the future, making the overall budget constraint balance neatly. It allows the

intertemporal equation to be expressed in reduced form by substituting the wealth accumulated in

the first period into the second period’s consumption decision, thus eliminating wealth as an

independent variable.

Flash Card 19

Question:

How does the process of substitution work to reduce the two-equation intertemporal budget

constraint to a single reduced-form equation?

Answer:

Since wealth (W) appears in both the first- and second-period equations, the natural step is to solve

the first equation for W (i.e., wealth equals income at time t minus taxes and consumption) and

substitute this expression into the second-period equation. This substitution removes wealth as an

independent variable and combines the two periods into one reduced-form budget constraint that

directly relates consumption today and tomorrow to the incomes in both periods and the gross rate

of return (R). This reduced form mirrors the typical consumer theory budget constraint but in an

intertemporal setting.

Flash Card 20

Question:

In what way does this intertemporal budget constraint for the private sector differ from the classical

consumer theory budget set, and what implications does that have for understanding intertemporal

choice?

Answer:

The classical consumer theory budget set typically involves one equation where the sum of

expenditures on various goods is limited by current income. In contrast, the intertemporal budget

constraint is divided into two periods, linking present and future consumption through the

accumulation of wealth and the return on investments. This framework reflects the dynamic nature

of decision-making over time, where choices made today influence future consumption

possibilities. Despite its complexity, when reduced, it yields a familiar form that demonstrates the

trade-off between current and future consumption given income constraints and the interest rate.

Flash Card 21

Question:

How is the intertemporal budget constraint represented graphically, and what does the line illustrate

about consumption choices?

Answer:

It is represented by a straight line on a graph with current consumption on the x-axis and future

consumption on the y-axis. The line illustrates the trade-off between consuming today versus

tomorrow, showing the maximum possible future consumption if current consumption is zero (and

vice versa), thereby highlighting the concept of consumption smoothing.

Flash Card 22

Question:

What determines the slope of the intertemporal budget line, and what does the slope signify?

Answer:

The slope is determined by the gross rate of return on wealth (R = 1 + r), with an appropriate

negative sign. It signifies how many units of future consumption must be forgone to obtain an

additional unit of consumption today—or conversely, how much future consumption is gained by

sacrificing current consumption.

Flash Card 23

Question:

What is the "income point" on the intertemporal budget line, and why is it significant?

Answer:

The income point is the point on the budget line where an individual consumes exactly their current

income without borrowing or saving. It serves as a benchmark, indicating the level of consumption

achievable solely from current income, while any deviation from this point requires borrowing (if

consuming more today) or saving (if consuming less today).

Flash Card 24

Question:

How does the intertemporal budget constraint allow individuals with differing income profiles (rich

today but poor tomorrow, or vice versa) to achieve the same lifetime consumption?

Answer:

Financial markets enable consumption smoothing. An individual who is rich today but poor

tomorrow can save excess income to supplement future consumption, while someone poor today

but rich tomorrow can borrow against future income. This mechanism allows both types to adjust

their consumption over time and reach a common lifetime consumption level.

Flash Card 25

Question:

How does borrowing fit into the intertemporal consumption framework, and what does the anecdote

about the early 20th-century engineer illustrate?

Answer:

Borrowing allows individuals to consume more than their current income by financing present

consumption with future income, creating negative wealth temporarily. The anecdote of the

engineer who couldn’t secure institutional financing but relied on neighbors shows that while

financial markets are designed to allocate resources effectively for consumption smoothing and

investment, in practice the allocation process can sometimes be imperfect or constrained.

Flash Card 1

Question:

How does eliminating the wealth variable transform the intertemporal budget set for the private

sector, and how does the reduced-form equation relate to classical consumer theory?

Answer:

By substituting out the wealth variable (W), the two-period intertemporal budget set is reduced to a

single equation that resembles the classical consumer budget constraint. This reduced-form equation

directly relates current and future consumption, much like choosing between two goods in standard

consumer theory. It simplifies analysis by expressing lifetime consumption choices without

explicitly including wealth as an independent variable.

Flash Card 2

Question:

What role does the slope of the intertemporal budget line play, and how is it determined when taxes

are ignore