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Introduction to Economics Elements of Personal Finance 3. Thursday, Oct. 3, Lecture Three: "Housing loans; demand for mortgage credit; determinants of personal income" Housing loans: interest and equity demand for mortgage credit Determinants of personal income

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Introduction to economics l.jpg

Introduction to Economics

Elements of Personal Finance


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3. Thursday, Oct. 3, Lecture Three: "Housing loans; demand for

mortgage credit; determinants of personal income"

Housing loans: interest and equity

demand for mortgage credit

Determinants of personal income

tastes for leisure and income

Reading Assignment:

O’Sullivan and Sheffrin: Ch.3, “ Markets in

the Global Economy”

emphasis: comparative advantage and circular flow

O’Sullivan and Sheffrin, Appendix to Ch. 7, " Consumer

Choice Using Indifference Curves”, pp. 155-162

Internet Resource: http://www.mortgage101.com


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Problems O & S Text

p. 60: 2, 4, 5, 6

p. 162: 1, 2, 3


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Econ 109 Class Page

  • Econ Home Page:http://www.econ.ucsb.edu


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Announcements

  • E-mail addresses

    • Llad Phillips <[email protected]>

    • Donghun Cho<[email protected]>

    • Taeil Kang<[email protected]>

    • Kirk Lesh<[email protected]>


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Concepts

  • Lecture: Assets, Liabilities, Net Worth

  • Lecture: Demand for Housing Loans

  • Lecture: The Importance of Saving

  • Lecture: Learning and Earning

  • Text: Markets, the Magic and the Mantra


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Chapter 3

Markets and Governmentin the Global Economy


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Markets as a Social Institution

  • Adam Smith: The Wealth of Nations(1776)

    • argues for free markets and free exchange

  • Markets allocate resources so supply meets demand

  • If markets are competitive, thenthe value that the last consumer entering the market is willing to pay equals the additional cost of producing one more unit of the good

    • this is the magic of markets: efficiency

  • The political mantra is that markets solve all problems: false if there is monopoly power


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Current Economic Events

  • Labor Dispute between the shipping association and the longshoremen

    • lockout

    • cost to the economy: $1 B per day

  • What is at stake?


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Major Trading Partnersof the United States, 1999


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WorldEconomy

European

Union

Japan

Mexico

Japan

US Economy

YOU

Me


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Part I: Wealth (Net Worth) and Debt

  • Personal Wealth

    • a million millionaires

    • ordering the population form the poorest fifth to the richest fifth by income and net worth

    • the home is the big ticket asset

  • Liabilities: credit card debt

    • consumer debt service as a % of personal disposable income (after taxes)


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Net Worth in 1995

Source: http://www.irs.gov


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Families: Average Income and Average Net Worth, 1995

Source: Consumer Federation of America


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Demographics and Per Capita Wealth


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A Household’s Home Is By Far the Most Frequent Asset

http://www.census.gov/hhes/www/wealth/1995/wealth95.html.


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Net Worth = Assets -Liabilities


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Assets-Liabilities Statement


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http://research.stlouisfed.org/fred/data/business/cmdebt


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http://research.stlouisfed.org/fred/data/business/cdsp


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Credit Cards Have High Interest Rates On Average: 15-20%

You pay 15 % to borrow and you get, currently, 1-2%, to lend


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Planning Tools

  • Assets-Liabilities Statement

    • Assets Minus Liabilities = Net Worth

      • measure of wealth

  • Income-Expenditure Statement

    • Income Minus Expenditures = Saving

      • measure of change in wealth


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Part II: Housing Loans, Demand


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Life Cycle Approach: Planning

Education: Investment in

Human Capital or Earning

Power

Accumulating Assets

cars

appliances

furnishings

---------------------

house

financial assets

Spending

Age

Nurturing

High School

Education

College

Work

Retirement


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Life Cycle Approach: The Planners

100%

You

50%

Parents

0 %

Age

Infancy

Adolescence

Young Adult

Adult

Senescence


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Strategies for Meeting Future Expenses

  • Buy a House

    • most valuable asset for most US households

    • commitment to monthly payment

  • Tax-Sheltered Savings Plans

    • commitment to monthly payment

  • Stocks and Bonds


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Positives

provides space

builds equity

interest is deductible

Negatives?

down payment requires saving for this goal

interest payments are front-loaded, equity growth delayed

opportunity cost of not investing in stocks

Buying a House


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2000


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Example for an $80,000 House

  • price: $80,000

  • down payment: $20,000

  • loan: $60,000

  • interest rate: 10%

  • loan term: 25 years


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calculated using TKSOLVER Level Debt Service Module


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Slow Growth In Equity

  • Interest is front loaded

  • Start with $20,000 equity in example

  • After 10 years, gained about $10,000 equity

  • After 20 years, gained about $35,000 equity

  • Last 5 years, gain last $25,000 in equity

    • less interest payments for tax deductions

    • may not want to refinance, since you are paying off principal


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Interest Cost

  • You may not care so much

    • if you are experiencing capital gains

      • i.e. the value of the house is rising


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1999


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Demand for Housing Loans

  • You are more likely to buy a house if the mortgage rate is low

    • your behavior is sensitive to the national economy

  • More people will be buying houses and demanding mortgage credit if the mortgage rate is low

  • More people will be buying houses and demanding mortgages if their income is rising

    • they can afford a higher monthly payment and a lower loan term


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Price,

Mortgage

Rate

Demand for Mortgage Credit

10 %

7 %

Quantity of Mortgage Credit


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Demand for Mortgage Credit

Price,

Mortgage

Rate

Higher Personal Income

10 %

Quantity of Mortgage Credit


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Expressing The Demand For Mortgage Credit

1. Words

Quantity of Mortgage Credit Mortgage Rate, Personal

Income

2. Symbols

Q = f(r, Y)

rule of correspondence: if you know the mortgage

rate, r, and if you know personal income, Y, then you

can determine the demand for mortgage credit, Q

3. Pictures

r

Q


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Price,

Mortgage

Rate

Demand for Mortgage Credit

10 %

7 %

Quantity of Mortgage Credit


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The importance of saving

  • commitment

    • discipline

  • personal income

    • determinants

  • managing expenses

    • income-expense statement

      • budgeting


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Part III: Learning and Earning, the Human Capital Story

  • Stocks

    • assets

    • debts

    • net worth(wealth)

  • Flows

    • income

    • saving (this flow is the increase inyour wealth)


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Determinants of Personal Income

The Life Cycle Model


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An Individual’s Life Cycle for a Socially Productive Life

  • Learning over the life cycle

  • Accumulating earning power or human capital

  • Earnings depend upon

    • ability

    • knowledge

    • work experience


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Productive Life Cycle

Social Institution

Family - PreSchool - School - College - Job - Retirement

Function

Learning: Accum. Human Capital - Earning - Spending

Age Line

0 4 6 18 23 65


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Accumulating Human Capital

Inflow

Outflow

Stock


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Accumulating Human Capital

Net Inflow

Inflow

Outflow

+

Stock

-


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Accumulating Human Capital

Investment

Depreciation

Learning

+

Human

Capital

-

Human Capital: An Asset Like a Car or a House:

It Depreciates


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Allocation of Your Time

Build Capital

by Learning

Human Capital

Use Capital

for Earning


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24 hours

Time Endowment


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Leisure

(learning)

0 hours

24 hours


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Allocation of Your Time

Build Capital

by Learning

Human Capital

Use Capital

for Earning


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Earnings

Opportunities for trading leisure

for earnings (income) at a rate,

$20 per hour, the market wage,

determined by your stock of human

capital(step one of the paradigm:

describing the alternatives for choice)

$480

$ 0

Leisure

(learning)

0 hours

24 hours


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Salaries by Education Level, CAFull Time* Workers

*Full Time: >35 hrs/wk, >48 wks/yr.; Source: LA Times, 1-10-93


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The Rich Get Richer and the Poor Get Poorer

  • Why does poverty persist in an affluent country like the US?


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Comparative market wages as determined by accumulated

knowledge

Earnings

$480

college grad

$240

dropout

$ 0

Leisure

(learning)

0 hours

24 hours


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Choosing Between Learning and Earning

  • How much time for learning?

  • How much time for earning?

  • This choice, like all choices depends on your tastes

    • Do you want to earn and consume now?

    • Do you want to learn, earn more in the future, and consume more in the future?


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Depicting your tastes graphically: iso-preference or

indifference curves

Earnings

Iso-Preference Curves:

You value all points on

a curve equally(step two of

the paradigm: valuing the

alternatives for choice)

$480

$ 0

Leisure

(learning)

24 hours

0 hours


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Depicting your tastes graphically

Earnings

low value

Iso-Preference Curves:

You value all points on

a curve equally

high

$480

high value

$ 0

Leisure

(learning)

0 hours

24 hours


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The choice between leisure and earning now:picking the

best alternative

Earnings

Iso-Preference Curves:

You value all points on

a curve equally

high

$480

alternatives

high value

low value

$ 0

Leisure

(learning)

0 hours

24 hours


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Individual’s Supply of Labor

Earnings

low value

high

$480

Optimum

$180

for 9 hrs

of work

high value

Leisure

(learning)

$ 0

15 hours

of leisure

0 hours

24 hours


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Earnings

low value

slope of the iso-preference

curve through the 24 hour

endowment is the lowest

wage at which you are

willing to work

high

$480

$ 0

Leisure

(learning)

0 hours

24 hours


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Earnings

low value

slope of the iso-preference

curve through the 24 hour

endowment is the lowest

wage at which you are

willing to work

high

$480

$96

$ 0

Leisure

(learning)

0 hours

24 hours

dropout is unwilling to work for $4/hr


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Why does the youth drop out?

  • may not like school

  • may receive bad or no advice

    • parents

    • counselors


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Life Cycle Approach: The Planners

100%

You

50%

Parents

0 %

Age

Infancy

Adolescence

Young Adult

Adult

Senescence


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Participation in the Labor Force:Willing to look for work

  • If your market wage exceeds your reservation wage

    • college grad, @$20/hr, participates

    • the junior high dropout, @ $4/hr, does not

  • We assumed the college grad and the dropout both have the same values for income and leisure

  • Only their learning histories differ


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Earnings

low value

slope of the iso-preference

curve through the 24 hour

endowment is the lowest

wage at which you are

willing to work

high

$480

$96

$ 0

Leisure

(learning)

0 hours

24 hours

dropout is unwilling to work for $4/hr


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low value

Higher value

high

$480

Savings,

$ from

home

$96

$ 0

0 hours

24 hours


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median

demand curve

mortgage rate

personal income

mortgage credit

rule of correspondence

stock

inflow

outflow

time endowment

allocation of your time

learning(leisure)

earning in future

earning now

iso-preference curves

reservation wage

Summary-Vocabulary-Concepts


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