Question

14. a) Explain what is meant by the Fisher Separation Theorem (FST). Graphically demonstrate FST for the case where an individual ends up lending in financial markets. (40 marks) b) Graphically analyse the effect of an increase in the interest rate on the utility of lenders. Discuss whether or not the lenders are better off as a result of the interest rate rise. (30 marks) c) Critically evaluate the assumptions upon which the Fisher Separation Theorem is based and assess the extent to which these limit its usefulness in financial decision-making. (30 marks)

Answer 1

→ Assume the individual is initially endowed, at point A with current income of y, and end-of- period income of y. Using the market rate, the present value of his endowment is his current wealth, W.: W. =y, The individual will take on investment up to the point where the marginal rate of return on investment equals the market rate of interest at point B. This determines the optimal investment in production (P., P.). Finally, in order to achieve his maximum utility (on indifference curve U the individual will lend (..e., consume less than P.) along the capital market line until he reaches point C. At this point his optimal consumption is which has a present value of W: C+1+ - B Y W WC,