Fall Semester 05-06

Akila Weerapana
LECTURE 21: Inter-Temporal Optimization
I. INTRODUCTION
Todays lecture is the beginning of the nal phase of this course: dynamic optimization. This
section will be the most challenging material you have covered this semester: much of what
you learn in the next 5 lectures forms the basis (not in a mathematical sense) for a rst
semester graduate school program.
The basic problem that we are learning how to solve here is a dynamic optimization problem
where actions taken in this period aect the optimization decisions faced in future periods.
Todays class discusses how to solve simple versions of these types of dynamic optimization
problems, mostly using techniques that we already know from the static optimization cases
studied earlier.
The next two lectures will look at solving more complicated, multi-period optimization de-
cisions in discrete time, while the nal two lectures will examine the solutions to dynamic
optimization decisions in continuous time.
II. INTERTEMPORAL CONSUMER OPTIMIZATION: TWO PERIOD
MODEL
Two Constraints
We will rst look at a simple two period optimization decision. Suppose that an individual
lives for two periods, denoted period 1 (today) and period 2 (tomorrow). We also assume
that the individual discounts future utility by a discount factor 0 1, resulting in a two-
period utility function of the form U(C
1
) + U(C
2
), where U(C) is a well-dened concave
utility function.
A low value of indicates that the individual is impatient, preferring current consumption
to future consumption. If she does not care at all about future consumption = 0. If the
individual cares equally about current and future consumption then = 1.
Sometimes, we see things expressed in terms of a discount rate > 0 instead of a discount
factor. The relationship between the two is that =
1
1+
. If we use discount rates, then
an individual who cares equally about current and future consumption will have = 0. An
individual who does not care about future consumption will have = .
In period 1, the individuals budget constraint is Y
1
+ (1 + r)A
0
= C
1
+ A
1
where Y
t
is
exogenous income at time t, and A
t
represents assets/debts that she accumulates in period t.
Note that A could be either positive or negative - the consumer can either save for the future
and borrow against the future.
In this setup A
0
can be interpreted as either an inheritance (A
0
> 0) or a debt burden
(A
0
< 0) passed down from a previous generation.
In period 2, the individuals budget constraint is Y
2
+ (1 + r)A
1
= C
2
+ A
2
. Note that A
2
can be interpreted as either a bequest (A
2
> 0) or a debt burden (A
2
< 0) passed down to
the next generation.
In order to get sensible solutions, we typically impose some restrictions on A
2
- either A
2
0
or that A
2
is a nite negative number otherwise the person can die leaving behind innite
debts making the optimization decision meaningless.
The Lagrangian for the above model can be written as
L = U(C
1
) +U(C
2
) +
1
(Y
1
C
1
+ (1 +r)A
0
A
1
) +
2
(Y
2
C
2
+ (1 +r)A
1
A
2
)
+
0
(AA
0
) +
1
[AA
2
]
Note that A is the amount of the inheritance and A is the amount of the bequest. These
are exogenously given. They can be positive or negative, but nite for the solution to be
meaningful.
We therefore have 9 choice variables - C
1
, C
2
, A
0
, A
1
, A
2
,
1
,
2
,
0
,
1
Note that even though A
0
and A
2
are considered to be unconstrained variables in the opti-
mization, although of course the constraints will bind them in the end.
The 9 FOCs corresponding to the 9 choice variables C
1
, C
2
, A
0
, A
1
, A
2
,
1
,
2
,
1
,
2
would be
U

(C
1
)
1
= 0 (1)
U

(C
2
)
2
= 0 (2)
(1 +r)
1

0
= 0 (3)

1
+ (1 +r)
2
= 0 (4)

1
= 0 (5)
Y
1
+ (1 +r)A
0
= C
1
+A
1
(6)
Y
2
+ (1 +r)A
1
= C
2
+A
2
(7)
A
0
= A (8)
A
2
= A (9)
We can solve this system for the endogenous variables. Of course a 9 equation system is
extremely cumbersome, so we can simplify the process as follows.
We can combine FOCs (1), (2), and (4) to get
U

(C
1
) = (1 +r)U

(C
2
)
We can combine FOC (6),(7),(8),(9) to get
Y
1
+
Y
2
1 +r
+ (1 +r)A = C
1
+
C
2
1 +r
+
A
1 +r
These two equations can then be solved for C
1
and C
2
. Equations (6) or (7),along with
(8),(9) allow us to back out A
0
, A
1
and A
2
. Equations (1) and (2) give us
1
and
2
. Finally,
equations (3) and (5) give us
0
and
1
.
Single Constraint
We can also solve this problem in a much less complicated way by collapsing all the constraints
into a single constraint at the outset.
First, we plug in for the exogenous values of the inheritance and the bequest. In period 1,
therefore, the individuals budget constraint is Y
1
+ (1 +r)A = C
1
+A
1
and in period 2, the
individuals budget constraint is Y
2
+ (1 +r)A
1
= C
2
+A.
Then, we can solve for A
1
from one of the budget constraints and substitute into the other
to get Y
2
+ (1 +r) [Y
1
+ (1 +r)AC
1
] = C
2
+A, which simplies to
(1 +r)Y
1
+Y
2
+ (1 +r)
2
A = (1 +r)C
1
+C
2
+A
This constraint basically states that lifetime income (in terms of current value in period 2) is
equal to lifetime consumption (in terms of current value in period 2).
Sometimes, this is expressed in present value terms as follows:
Y
1
+
Y
2
(1 +r)
+ (1 +r)A = C
1
+
C
2
1 +r
+
A
1 +r
The Lagrangian for the above model can be written as
L = U(C
1
) +U(C
2
) +

(1 +r)Y
1
+Y
2
+ (1 +r)
2
A(1 +r)C
1
C
2
A

The maximization is now much simpler, over the variables

(C
1
, C
2
, ). The FOCs are
U

(C
1
) (1 +r) = 0 (10)
U

(C
2
) = 0 (11)
(1 +r)Y
1
+Y
2
+ (1 +r)
2
A = (1 +r)C
1
+C
2
+A (12)
We can solve this system for the endogenous variables: C
1
, C
2
, .
Note that we can combine FOCs (10) and (11) to get the following two equation system,
identical to what we had before.
U

(C
1
) = (1 +r)U

(C
2
) (13)
(1 +r)Y
1
+Y
2
+ (1 +r)
2
A = (1 +r)C
1
+C
2
+A (14)
The Core Intuition Behind an Inter-Temporal Optimization
The equation U

(C
1
) = (1 + r)U

(C
2
) lies at the heart of the solution to the optimization
decision. What it states is the following: suppose you give up $1 consumption today. The
utility cost to you will be U

(C
1
).
In return, you will get $(1 +r) of additional consumption tomorrow, giving us a utility gain
of (1 +r)U

(C
2
). Since this is received in the next period, it needs to be discounted back to
the present, so the benet is (1 +r)U

(C
2
).
What the above equation states is that U

(C
1
)+(1+r)U

(C
2
) = 0, i.e. feasible reallocations
of consumption cant increase your utility.
This equation also tells us about the path of consumption. When (1 + r) > 1, U

(C
1
) >
U

(C
2
), which given diminishing marginal utility implies that C
2
> C
1
. Since the return from
saving overwhelms the impatience factor, we prefer to consume more in the future.
Suppose instead that (1 +r) < 1, then U

(C
1
) < U

(C
2
), which given diminishing marginal
utility implies that C
1
> C
2
. Since the impatience factor overwhelms the return from saving
we prefer to consume more now.
Finally, suppose (1+r) = 1, then U

(C
1
) = U

(C
2
), which given diminishing marginal utility
implies that C
1
= C
2
. The impatience factor and the return from saving balance each other
out so we are indierent between current and future consumption.
In the next section, we will assume a form of the utility function and solve explicitly for the
path of consumption.
A Specic Example
Assume that the utility function is U(C) = 2

C. Marginal utility is U

(C) =
1

C
. The
equation we derived relating consumption in one period to consumption in the next period
can then be written as
1

C
1
= (1 +r)
1

C
2
, which in turn simplies to
C
2
= [(1 +r)]
2
C
1
Recall that the budget constraint is (1 +r)Y
1
+Y
2
+ (1 +r)
2
A = (1 +r)C
1
+C
2
+A
We can then solve for the consumption path:
C

1
=
Y
1
+
Y
2
(1+r)
+ (1 +r)A
A
(1+r)
1 +
2
(1 +r)
C

2
=

2
(1 +r)
2

Y
1
+
Y
2
(1+r)
+ (1 +r)A
A
(1+r)

1 +
2
(1 +r)
We can understand some interesting results about consumption behavior mathematically by
looking at a couple of special cases from the above analysis.
Case 1: No rst period income, no bequests and no inheritance, i.e.
Y
1
= A = A = 0
The solutions are now
C

1
=
Y
2
/(1 +r)
1 +
2
(1 +r)
> 0 Y
1
C

2
=

2
(1 +r)
2
[Y
2
/(1 +r)]
1 +
2
(1 +r)
=

2
(1 +r)Y
2
1 +
2
(1 +r)
< Y
2
So the consumer always dissaves in period 1, earning 0 but spending a portion of her lifetime
income. In period 2, spending has to be less than income in order to repay her initial period
borrowings.
Case 2: No second period income, inheritance or bequests. Y
2
= A = A = 0
The solutions are now
C

1
=
Y
1
1 +
2
(1 +r)
< Y
1
C

2
=

2
(1 +r)
2
Y
1
1 +
2
(1 +r)
> Y
2
0
The consumer always saves in period 1, in order to facilitate consumption via dissaving in
the second period.
Case 3: Equal income Y
1
= Y
2
= Y , no bequests and no inheritance A = A = 0
The solutions are
C

1
=
(2 +r)Y
[(1 +r) +
2
(1 +r)
2
]
C

2
=
2
(1 +r)
2

(2 +r)Y
(1 +r) +
2
(1 +r)
2

Note that even though income is equal in the two periods, consumption is not identical. Why?
Because future utility is discounted at a rate , which leads us to consume more today, and
because a unit saved today is worth more (1 + r) > 1 tomorrow which leads us to consume
less today.
The relative amounts of consumption depend on the magnitudes of and (1 + r). So if
(1 + r) > 1, i.e. we do not discount the future very much relative to the interest we can
earn, C
2
> C
1
, consumption is higher tomorrow.
If (1 + r) < 1, i.e. we discount the future more than the interest we earn, C
2
< C
1
,
consumption is higher tomorrow.
Consumption in the two periods will be equal only if (1 + r) = 1, in other words if the
discount factor and the interest rate oset each other.
Case 4: Savers vs. Dissavers, assuming no inheritance and no bequests A = A = 0
We can see under what circumstances an individual will be a saver vs. a dissaver. In the
initial period net savings is
Y
1
C

1
= Y
1

Y
1
+
Y
2
(1+r)
1 +
2
(1 +r)

2
(1 +r)Y
1

Y
2
(1+r)
1 +
2
(1 +r)

The individual is a saver when

Y
1
C

1
> 0
2
(1 +r)Y
1
>
Y
2
1 +r

2
(1 +r)
2
Y
1
> Y
2
The individual is a dissaver when
Y
1
C

1
< 0
2
(1 +r)Y
1
<
Y
2
1 +r

2
(1 +r)
2
Y
1
< Y
2
III. INTERTEMPORAL CONSUMER OPTIMIZATION: MULTI-PERIOD
MODEL
Multiple Constraints
We can generalize the analysis we did above to a multi-period consumption problem.
Consider the maximization decision of an individual who lives for T periods. We assume that
the individual discounts future utility at a rate per period.
In period t, the individuals budget constraint is Y
t
+ (1 + r)A
t1
= C
t
+ A
t
where Y
t
is
exogenous income at time t, and A
t
represents assets/debts that she accumulates in period t.
Note that A could be either positive or negative - the consumer can either save for the future
and borrow against the future.
The Lagrangian for the above model can be written as
L = max
T

t=1

t1
U(C
t
) +
T

t=1

t
[Y
t
+ (1 +r)A
t1
A
t
C
t
] +
0
[AA
0
] +
T1
[AA
T
]
Note that the maximization is over the variables
(C
1
, C
2
C
T
, A
0
, A
1
, A
2
A
T
,
1
,
2
, ,
T
,
0
,
T1
)
We therefore have 3T+3 choice variables composed of T dierent C variables (C
1
, C
2
, , C
T
),
T + 1 dierent A variables (A
0
,A
1
, A
2
, , A
T
), T dierent (
1
,
2
, ,
T
) variables and
2 dierent variables (
0
,
T
). [This matches up with the 2 period case where we had
3(2)+3=9 choice variables]
Note that even though A
0
and A
T
are considered to be unconstrained variables in the opti-
mization, although of course the constraints will bind them in the end.
The FOCs with respect to C, A, and respectively would be

t1
U

(C
t
)
t
= 0 [T such equations for t = 1, , T] (15)

1
(1 +r) +
0
= 0 [1 such equation] (16)

t
+
t+1
(1 +r) = 0 [T-1 such equations for t = 1, ..., T 1] (17)

T
+
T
= 0 [1 such equation] (18)
Y
t
+ (1 +r)A
t1
= C
t
+A
t
[T such equations for t = 1, ...., T] (19)
A
0
= A [1 such equation] (20)
A
T
= A [1 such equation] (21)
We can solve this system for the endogenous variables. Of course a (3T+3) equation system
is extremely cumbersome, so we can simplify the process as follows.
Combine the T equations in (15) and the T 1 equations in (17) to get the T 1 equations

t1
U

(C
t
) =
t
(1 +r)U

(C
t+1
).
Combined the T equations in (19) to get the single equation
C
T
+A = Y
T
+ (1 +r) [Y
T1
+ (1 +r)A
T2
C
T1
]
C
T
+ (1 +r)C
T1
+A = Y
T
+ (1 +r)Y
T1
+ (1 +r)
2
A
T2
C
T
+ (1 +r)C
T1
+A = Y
T
+ (1 +r)Y
T1
+ (1 +r)
2
[Y
T2
+ (1 +r)A
T3
C
T2
]
C
T
+ (1 +r)C
T1
+ (1 +r)
2
C
T2
+A = Y
T
+ (1 +r)Y
T1
+ (1 +r)
2
Y
T2
+ (1 +r)
3
A
T3
.
.
.
.
.
.
T

t=1

(1 +r)
Tt
C
t

+A =
T

t=1

(1 +r)
Tt
Y
t

+ (1 +r)
T
A
This system of T equations, given below, can be solved for C
1
, C
2
, , C
T
.
U

(C
t
) = (1 +r)U

(C
t+1
) [T-1 such equations for t = 1, ..., T 1]
T

t=1

(1 +r)
Tt
C
t

+A =
T

t=1

(1 +r)
Tt
Y
t

+ (1 +r)
T
A
We can then nd the solutions for the remaining 2T+3 variables as follows: back out
1

T
from (15). Use (16) and (18) for
0
,
T1
. Use (19), (20) and (21) for A
0
, , A
T
.
Single Constraint
As in the two variable case, we can simpify this problem enormously by collapsing all the
constraints into a single constraint at the outset. We showed above that this constraint is
T

t=1

(1 +r)
Tt
C
t

+A =
T

t=1

(1 +r)
Tt
Y
t

+ (1 +r)
T
A
This constraint basically states that lifetime income (in terms of current value in period T)
is equal to lifetime consumption (in terms of current value in period T).
Sometimes, this is expressed in present value terms as follows:
T

t=1

C
t
(1 +r)
t1

+
A
(1 +r)
T1
=
T

t=1

Y
t
(1 +r)
t1

+ (1 +r)A
The Lagrangian for the above model can be written as
L =
T

t=1

t1
U(C
t
) +

t=1

(1 +r)
Tt
Y
t

+ (1 +r)
T
AA
T

t=1

(1 +r)
Tt
C
t

The maximization is now much simpler, over the variables

(C
1
, C
2
, , C
T
, ). The (T+1) FOCs are

t1
U

(C
t
) (1 +r)
Tt
= 0 [T such equations for t=1, , T] (22)
T

t=1

(1 +r)
Tt
C
t

+A =
T

t=1

(1 +r)
Tt
Y
t

+ (1 +r)
T
A (23)
These T+1 FOCs represent the solution to the T+1 endogenous variables: C
1
, C
2
, , C
T
,
Note again that we can eliminate and write the following system, which is identical to what
we had before.
U

(C
t
) = (1 +r)U

(C
t+1
) [T-1 such equations for t=1, , T 1]
T

t=1

(1 +r)
Tt
C
t

+A =
T

t=1

(1 +r)
Tt
Y
t

+ (1 +r)
T
A
Note that you now know how to do dynamic optimization! It is simply a messier version
of static optimization. We will, after the midterm, learn more elegant ways of solving such
problems, but you can always resort to the brute force method described above.