1:Economic Planning and Consumption Smoothing

Fundamental Economic Background

• The national pension system functions as a consumption smoother, where workers pay a portion of their income to the state and receive a monthly amount after retirement.
• Some individuals save to bequeath wealth to others, including family or for altruistic reasons, like Yvon Chouinard's $3 billion donation.
• Economic planning involves a single individual making plans over different years, indexed from "0" (this year) to "T" (the last year of life).
• Available income ( Yt ≥ 0) can be allocated to consumption (e.g., food, medicine) and, Ct denotes the total monetary equivalent of consumption in year t.
• Consumption leads to utility – shorthand for happiness from wealth - Utility in a period depends on the amount consumed, with more consumption equating to greater utility
• "Hand-in-mouth" behavior involves consuming all available income immediately and this lifetime consumption implies Yt = Ct.
• If income remains constant (Yt = Yt+1), then utility also remains constant for all t, Ut = Ut+1 – this is in accordance with traditional economics.
• Income changes over the lifecycle, peaking during working ages and decreasing before and after, impacting utility.
• Austrian household income, after taxes/pensions is higher during working years aged 18-64.
• Income changes are more pronounced across age levels in the U.S. compared to Austria
• Vulnerability exists in retirement ages, which can lead to monetary issues, especially pertinent for females.
• Saving money is one strategy to avert economic challenges; individuals save rather than spend all income, where Yt = Ct + St and St are the savings.
• Saving money in certain economies can create financial issues as people get older
• Lifetime consumption turns into an intertemporal problem where year to year decisions affect outcomes later
• Individuals set money aside, and then use those funds after retirement and this economic strategy is consumption smoothing

Consumption Smoothing

• From t = {0,1,..., t}, an individual chooses to save (St > 0).
• From t = {t, t + 1,..., T}, an individual chooses to spend (St < 0) saved funds.
• Milton Friedman and Franco Modigliani were awarded Nobel prizes in economics for their work on consumption smoothing.
• Consumption smoothing is achieved when people forgo consuming €100 today in order to boost spending during retirement.
• It is possible to equilibrate consumption by saving now and consuming at a later date.
• Saving requires patience and trading instant gratification for delayed gratification.
• Individuals must have no problematic debt, a high enough income or some other source of wealth.

Course Focus and Motivation

• This course assumes individuals have preconditions such as wealth, and aims to assist with how to spend it.
• Differences in wealth after 4 years are seen depending on interest rates, and a small difference can dramatically affect these outcomes.
• To understand the impact of interest rates on wealth creation, one must understand compound interest.
• Consider folding a 0.1mm thick piece of paper 42 times.
• If folding the paper 42 times, thickness is about 439,805 km thick!
• Growth is exponential, because the growth compounds!
• If we were stacking the paper (0.1mm each time) to achieve same growth = 4.5 Trillion
• 100% growth at each step, is outlandish, but principles hold true with percentage based wealth growth
• The interest rate is only four times higher, but earnings are more than nine times higher with compound interest vs linear growth. This can be applied directly to investment portfolios.
• High savings, low interest yields mostly linear growth
• Low savings, high interest yields mostly exponential growth
• High savings, high interest yields linear and exponential growth

Summary

• The course assumes availability of funds for investment and focuses on effective utilization.
• Higher interest rates directly correlate with higher final wealth.
• Interest compounds and this is increasingly more important, impacting growth
• Investment horizon is long for young investors and extremely relevant.