Intertemporal Choice

Optimization over time, Borrowing/Lending

Intertemporal Choice
Receive income in lumps (monthly salary)
o How is lump income spread over following month (save now, consume later)?
o How is consumption financed by borrowing now again received at end of month?

Present and Future Values

2 periods; r = interest rate per period
Future Value
ex. if r = 0.1
- 100 saved at start of period 1 $110 at start of period 2
value of next period of $1 saved now = FV of that dollar
FV 1 period from now of $1
FV = 1 + r
FV 1 period from now of $m:
FV = m(1 + r)
Present Value
Paying $1 now for $1 next period = bad idea; if you save than $1 will increase
How much $ would have to be saved now to obtain $1 at start of next period?
o $m saved now $m(1+r) at start of next want value of m
m(1+r) = 1
m = 1/(1+r) the PV of $1 obtained at the start of next period
PV of $m available at start of next period
PV = m / (1 + r)
Ex. r = 0.1, most you should pay now for $1 available next period:
PV = 1/ (1 + 0.1) = $0.91
r = 0.2 PV = 1/ (1 + 0.2) = $0.83
Intertemporal Choice Problem
M1,m2 = incomes received in periods 1,2
C1,c2 = consumptions in periods 1,2
P1,p2 = prices of consumption in periods 1,2
Given incomes and consumption prices, what is the most preferred intertemporal consumption
bundle (c1,c2)?
o Need to know:
Intertemporal budget constraint
Intertemporal consumption preferences
Intertemporal Budget Constraint
Ignore price effect by:
P1 = p2 = $1
Consumer chooses not to save/borrow:
o Consumed in period 1 c1 = m1
o Consumed in period 2 c2 = m2
o (c1,c2) = (m1,m2) = consumption bundle
consumer spends nothing on consumption in period
o c1 = 0 saves s1 = m1
o int rate r
o period 2 consumption level m2
saving + interest from period 1 = (1 +
income in period 2: m2 + (1+r)m1

c2 = m2 + (1+r)m1

consumer spends everything on consumption period 1

o c2 = 0

1:

r)m1

most can borrow in period 1 against period 2 income of $m

b1 = borrowed amount in p1
$m2 to pack back $b1 b1(1+r)=m2 b1 = m2(1+r)
largest consumption level in periods 1 C1 = m1 + m2/(1+r)

c1 consumed in period 1 costs $c1, leaves m1-c1 saves

period 2 consumption :
c2 = m2 + (1+r)(m1-c1)
c2 = -(1+r)c1 +m2 +(1+r)m1
-(1+r) = slope

m2 +(1+r)m1 = intercept

(1 + r)c1 + c2 = (1 + r)m1 + m2
o
o

FV for of budget constraint (all terms in period 2 values

Equivalent tto PV

C1 + c2/(1 + r) = m1 + m2/(1+r)
o PV form of constraint (period 1 values)

Adding prices
How does it affect budget constraint?
Endowment (m1,m2) and prices (p1,p2) what intertemporal bundle (c1*,c2*) qill be
chosen?
o Max possible expenditure in period 2:
M2 + (1 + r)m1
o Max possible consumption in period 2:
C2 = [m2 + (1+r)m1]/p2
o Max possible expenditure in period 1:
M1 + m2/(1+r)
o Max possible consumption in period 1:
C1 = [m1 + m2/(1+r)]/p1
C1 units consumes in period 1 spends p1c1 in period 1 leaving m1 p1c1 for period 2
o Available income in period 2:
m2 + (1+r)(m1-p1c1)
p2c2 = m2 + (1+r)(m1-p1c1)
o Rearranged:
(1+r)p1c1= (1+r)m1 + m2 FV form of budget constraint
p1c1 + [p2/(1+r)]c2 = m1 + m2(1+r) PV
Future Value Budget Constraint

Interest paid for Borrowing > Int earned on Lending

Price

Inflation
Inflation rate p1(1 + ) = p2
P1 = 1 p2 = 1 +
can rewrite budget constraint
p1c1 + [p2/(1+r)]c2 = m1 + m2(1+r)
to
c1 + [(1+)/(1+r)]c2 = m1 + m2/(1+r)
rearrange

Ex. = 0.2 20% inflation

= 1.0 100% inflation

no price inflation (p1=p2=1)

o slope of budget constraint = -(1+r)
with price inflation
o slope of BC= -(1+r)(1+)
-(1+p) = -(1+r)/(1+) p = real interest rate
low inflation ( ~= 0) p ~= r
higher inflation approx. becomes poor

Real Interest Rate

Comparative Statics
slope of budget constraint
-(1+p) = - (1+r)/(1+)
constraint becomes flatter if:
o interest rate r falls
o inflation rate rises
both decreased the real rate of interest p

p = (r )/(1 + )

Life-Cycle Model
Budget Line
Co = consumption in period o
Mo = income in period o
i interet rate
right side of equiation FV of income stream
left side FV of consumption bundle
slope = -(1+i) = opp cost
Co(1 + i) + C1 = Mo(1 + i) + M1 FV
Co + C1/(1+i) = Mo + M1/(1+i) PV

Co = Mo, C1 = M1 endowment
As i increases budet line pivots on endowment

Intermporal Allocation of Lifetime Income

To max utility consumption bundle on budget line where
o MRS = (1+i) or
o Marginal rate of time preference = (1+i)