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,Click to edit Master Title Style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,*,Chapter 5:Household Saving and Investment Decisions,Objective,Financial decisions in an,uncertain world;Human,capital,permanent income,decisions over,life cycle,1,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,Chapter 5:Household Savin,Chapter 5 Contents,5.1 A Life-Cycle Model of Savings,5.2 Taking Account of Social Security,5.3 Deferring Taxes through Voluntary Retirement Plans,5.4 Should you Invest in a Professional Degree?,5.5 Should you Buy or Rent?,2,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,Chapter 5 Contents5.1 A Life-C,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,3,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,ObjectivesHow much to save for,5.1 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 income is$30,000/year until age 65,Interest rates exceed inflation by 3%/year,4,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,5.1 A Life-Cycle Model of Savi,How Much Should I Save and Consume?,Consider two approaches:,Target replacement rate of pre-retirement income,Maintain the same level of consumption spending,5,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,How Much Should I Save and Con,Target replacement rate of pre-retirement income,First compute the retirement income.Many experts recommend a rate of 75%of the pre-retirement income.,$30,000*0.75=$22,500/year,using your calculator compute the present value of the retirement funds as an regular annuity,n=15,i=3,FV=0,PMT=-22,500-PV=268,604,6,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,Target replacement rate of pre,Target replacement rate of pre-retirement income(Cont.),Next compute the retirement income,Next compute how much you need to save each year,n=15,i=3,PV=0,FV=-268,604-PMT=5,646,To obtain a real$22,500 you need to save$5,646 per year,7,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,Target replacement rate of pre,Target replacement rate Conclusion,You will have noticed that your pre-retirement consumption is$30,000-$5,646=24,354;but the real retirement income is only$22,500,The next method equates consumption,8,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,Target replacement rate Conclu,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,n=30,i=3,FV=0,PMT=3,000,CPT PV,n=45 CPT PMT gives$23,982,The savings are then$30,000-$23,982=,$6,018,9,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,Maintain the same level of con,Human Capital and Permanent Income,Human capital,The present value of ones future labor income,Permanent income,The constant level of(real)consumption spending that has a present value equal to ones human capital,10,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,Human Capital and Permanent In,11,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,11Copyright 2009 Pearson Edu,12,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,12Copyright 2009 Pearson Edu,The Inter-temporal Budget Constraint,i=real interest rate,R=number of years to retirement,T=number of years of remaining life,W,0,=initial wealth,B=bequest,13,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,The Inter-temporal Budget Cons,Omars Life-Cycle Savings Plan,14,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,Omars Life-Cycle Savings Plan,5.2 Taking Account of Social Security,In many countries the government obliges citizens to participate in a mandatory retirement income system called social security,Contributors pay a tax during their working years,and in return qualify for a lifetime annuity in their old age,15,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,5.2 Taking Account of Social S,Social Security as Investment Substitute,If social security pays a return equal to 3%in the last example,then just reduce the savings by the social security tax,The analysis becomes progressively more complex as we make the assumptions more realistic.,What if you dont know your date of death.,returns are risky,et cetera?,16,Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall,Social Security as Investment,5.3 Deferring Taxes Through Voluntary Retirement Plans,Many countries encourage voluntary savings for retirement through provisions of the tax code.,In the US employees are permitted to set up Individual Retirement Accounts(IRA)that defer payment of t
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