Mel and Christy Are Co-Workers with Different Risk Attitudes

question 50

Essay

Mel and Christy are co-workers with different risk attitudes. Both have investments in the stock market and hold U.S. Treasury securities (which provide the risk free rate of return). Mel's marginal rate of substitution of return for risk (
/ MU R_P, σ_{P) is}


=
where RP is the individual's portfolio rate of return and σ_P is the individual's portfolio risk. Christy's
=
. Each co-worker's budget constraint is R_{P =} R_F +
σ_P, where R_j is the risk-free rate of return, R_m is the stock market rate of return, and σ_m is the stock market risk. Solve for each co-worker's optimal portfolio rate of return as a function of R_j, R_m, and σ_m.

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Definitions:

Real Balances

Real balances refer to the purchasing power of money holdings, adjusted for changes in the price level, indicating how much can be bought with a given amount of money.

Line Segment QR

A part of a line that is bounded by two distinct end points, Q and R, and contains every point on the line between Q and R.

Unemployed Resources

Factors of production that are available for use but are not currently engaged in the production of goods or services.

Keynesian Model

An economic theory stating that government intervention through fiscal policies is necessary to moderate the boom and bust cycles of an economy.