Transcript Lecture 3 - UCSB Economics

Introduction to Economics
Elements of Personal Finance
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3. Thursday, Oct. 3, Lecture Three: "Housing loans; demand fo
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 Government
in 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, then the 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?
Major Trading Partners
of the United States, 1999
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World Economy
Japan
Japan
European
Union
Mexico
US Economy
YOU
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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
# of Wealth Holders
13,000
27,000
82,000
249,000
1,202,000
Net Worth Millions
> 20
10-20
5-10
2.5-5
1-2.5
Source: http://www.irs.gov
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Families: Average Income and
Average Net Worth, 1995
Quintile
Lowest 20%
Second 20%
Third 20%
Fourth 20%
Highest 20%
Av. Income
$8,032
$17,916
$28,965
$43,930
$73,058
Av. Net Worth
$3,000
$14,600
$31,185
$51,133
$118,171
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
Net Worth
Cash (inter.)
stocks
bonds
insurance
(surrender)
other
house equity
personal
property
Total
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Amount
9.6%
8.4%
?
?
29.3%
44.4%
8.3%
100 %
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Assets-Liabilities Statement
Amount
Amount Liability
Asset
bank loan
cash
margin loan
stocks
bonds
policy loans
insurance
(surrender)
card balances
other
mortgage
house equity
car loan
personal
property
Total
Total
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Household Credit Market Debt in $ Billions, Seasonally Adjusted
10000
9000
y = 1E-75e0.0908x
8000
7000
Billions
6000
5000
4000
3000
2000
1000
0
1950
1960
1970
1980
1990
2000
2010
Date
http://research.stlouisfed.org/fred/data/business/cmdebt
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Consumer Debt Service Payments as a Percent of Diposable Personal Income
10
9
8
7
Percent
6
5
4
3
2
1
0
1975
1980
1985
1990
1995
2000
2005
Date
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
Assets
Statement
Minus Liabilities = Net Worth
 measure
of wealth
 Income-Expenditure
Income
Minus Expenditures = Saving
 measure
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Statement
of change in wealth
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Part II: Housing Loans, Demand
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Life Cycle Approach: Planning
Education: Investment in Accumulating Assets Spending
Human Capital or Earning
cars
Power
appliances
furnishings
---------------------
house
financial assets
Nurturing High School College
Education
Work
Age
Retirement
Life Cycle Approach: The Planners
100%
You
50%
Parents
0%
Infancy Adolescence Young Adult Adult Senescence
Age
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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Buying a House

Positives
 provides
space
 builds equity
 interest is
deductible
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
Negatives?
 down
payment
requires saving for
this goal
 interest payments
are front-loaded,
equity growth
delayed
 opportunity cost of
not investing in
stocks
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Median Housing Price: Santa Barbara South Coast
700000
2000
600000
572000
500000
$
400000
300000
200000
100000
41500
0
1970
1975
1980
1985
1990
1995
2000
2005
Year
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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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Equity in an $80,000 House, $20,000
Down .
80000
25 years
70000
60000
20 years
Equity
50000
40000
15 years
30000
5 years
20000
10 years
1 year
10000
0
0
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50
100
150
200
Payment Number
250
calculated using TKSOLVER Level Debt Service Module
300
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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 as a Fraction of the Monthly
Payment
1
0.9
Fraction
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0
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50
100
150
200
Payment Number
250
300
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Interest Cost of $60,000 Loan Vs. Term in Years
120000
monthly
payment, $545.22
Total Interest
100000
80000
monthly
payment, $579.01
60000
monthly
payment, $644.76
40000
20000
0
0
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5
10
15
Loan Term
20
25
35
Total Interest Cost of $60,000-25 Year Loan Vs.
Interest Rate .
120000
Total Interest
100000
80000
60000
40000
20000
0
0
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2
4
6
Interest Rate
8
10
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Interest Cost
 You
if
may not care so much
you are experiencing capital gains
 i.e.
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the value of the house is rising
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Median Housing Price, Santa Barbara South Coast
1999
500000
475100
450000
400000
350000
300000
$ 250000
200000
150000
100000
41500
50000
0
1970
1975
1980
1985
1990
1995
2000
2005
Year
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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
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lower loan term
Price,
Mortgage
Rate
10 %
Demand for Mortgage Credit
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
10 %
Demand for Mortgage Credit
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
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(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
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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
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4
6
18
23
65
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Accumulating Human Capital
Inflow
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Stock
Outflow
50
Accumulating Human Capital
Inflow + Net Inflow
Stock
Outflow
-
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Accumulating Human Capital
Learning
+ Investment
-
Human
Capital
Depreciation
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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0 hours
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Leisure
24 hours
(learning)
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Allocation of Your Time
Build Capital
by Learning
Human Capital
Use Capital
for Earning
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Earnings
$480
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)
$0
0 hours
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24 hours
Leisure
(learning)
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Salaries by Education Level, CA
Full Time* Workers
Education
No HS Dipl.
HS Dipl.
Bachelor’s
Master’s
Doctorate
Professional
Salary
$26,115
$27,326
$44,426
$52,787
$59,348
$77,877
Wage
$13.06
$13.69
$26.39
$26.97
$29.67
$38.94
*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
0 hours
Leisure
24 hours (learning)
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
$480
Iso-Preference Curves:
You value all points on
a curve equally(step two of
the paradigm: valuing the
alternatives for choice)
$0
0 hours
24 hours Leisure
(learning)
Depicting your tastes graphically
Earnings
low value
$480
high
Iso-Preference Curves:
You value all points on
a curve equally
high value
$0
0 hours
Leisure
24 hours (learning)
The choice between leisure and earning now:picking the
best alternative
Earnings
high
$480
alternatives
Iso-Preference Curves:
You value all points on
a curve equally
high value
low value
$0
0 hours
24 hours
Leisure
(learning)
Individual’s Supply of Labor
Earnings
low value
$480
$180
for 9 hrs
of work
high
Optimum
high value
Leisure
(learning)
$0
0 hours
15 hours
of leisure
24 hours
Earnings low value
$480
high
slope of the iso-preference
curve through the 24 hour
endowment is the lowest
wage at which you are
willing to work
$0
0 hours
Leisure
24 hours (learning)
Earnings low value
$480
high
slope of the iso-preference
curve through the 24 hour
endowment is the lowest
wage at which you are
willing to work
$96
$0
0 hours
Leisure
24 hours (learning)
dropout is unwilling to work for $4/hr
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%
Infancy Adolescence Young Adult Adult Senescence
Age
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
$480
high
slope of the iso-preference
curve through the 24 hour
endowment is the lowest
wage at which you are
willing to work
$96
$0
0 hours
Leisure
24 hours (learning)
dropout is unwilling to work for $4/hr
low value
$480
$96
Higher value
high
Savings,
$ from
home
$0
0 hours
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24 hours
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Summary-Vocabulary-Concepts






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


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now
iso-preference curves
reservation wage
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