Re: JNU MA Economics Past Year Paper- 2011 Doubts

Posted by Ankit Agrawal on May 09, 2013; 4:05am
URL: http://discussion-forum.276.s1.nabble.com/JNU-MA-Economics-Past-Year-Paper-2011-Doubts-tp7580450p7580526.html

This is a question of 'intertemporal choice'.
I've made it unnecessarily long. But it is for those who know nothing about it.

All you need to do in such questions is to calculate the 'Present Value'(PV) of the amounts.

Skip this paragraph if you already know what Present value is.
What is Present value?
Present value is today's worth of a future cash inflow/outflow. Example: You can either take Rs. 105 from me after a year or Rs. 100 now. What will you choose? Well, you'll think in this way. "I can take Rs. 100 now and invest it for a year somewhere. I will get a return on the investment. Now, if i get:
(a) 2% p.a.- I'll receive 102 after a year. However I am getting Rs. 105 after a year from Ankit. Hence, I'll take 105 after a year.
(b) 5% p.a.- I'll receive 105 after a year. I am also getting 105 from Ankit. I'll be indifferent.
(c) 10% p.a.- I'll receive 110 after a year. Ankit is giving me only 105. So I'll take 100 now and invest it.

How to calculate the PV

It is extremely simple.

PV= Amount that you will receive after a year/(1+rate of interest)

Considering this question:

Option 1: You'll receive 112 after a year. Interest=12%

PV=112/(1+12%)
   =112/(1+0.12)
   =112/(1.12)
   =100
This means that you are effectively receiving Rs. 100 now

Option 2:
Now here you have a different time period. All you need to do is to simply change the Rate of interest. It is 12% for 12 months. So it will be 9% for 9 months.

PV= {55/(1.09)} + {56/(1.12)}
   = 50.46 + 50
   = 100.46

This means that you are effectively receiving 100.46 now, if you choose option 2.

So you will choose option 2 over option 1.

Hence answer is (b).

I just saw that the answer on 'Answer key' page is (d). I don't know why.