Chapter 5: Household Saving and Investment Decisions
Objective
Financial decisions in an
uncertain world; Human
capital, permanent e
decisions over
life cycle
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
Contents
A Life-Cycle Model of Savings
Taking Account of Social Security
Deferring Taxes through Voluntary Retirement Plans
Should you Invest in a Professional Degree?
Should you Buy or Rent?
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
Objectives
How much to save for retirement
Whether to defer taxes or pay them now
Whether to get a professional degree
Whether to buy or rent an apartment
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
A Life-Cycle Model of Saving
Assume that you are currently 35 years old, expect to retire in 30 years at 65, and then live for 15 more years until 80
Your real labor e is $30,000/year until age 65
Interest rates exceed inflation by 3%/ year
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
How Much Should I Save and Consume?
Consider two approaches:
Target replacement rate of pre-retirement e
Maintain the same level of consumption spending
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
Target replacement rate of pre-retirement e
pute the retirement e. Many experts mend a rate of 75% of the pre-retirement e.
$30,000* = $22,500/year
using your pute the present value of the retirement funds as an regular annuity
n=15, i = 3, FV=0, PMT=-22,500 -> PV=268,604
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
Maintain the same level of consumption spending
Assume that your level of real consumption is C
The present value of consumption over the next 45 years must equal the present value of earnings over the next 30 years
Using annuity formula we got C = $23,982
The savings are then $30,000 - $23,982 = $6,018
A more general formula:
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