GRIPS Macroeconomics

Fall II Semester, 2016

Lecture 12: Intertemporal Substitution of Consumption

Junichi Fujimoto
January 11, 2017

Overview

The Keynesian model we studied earlier assumed that the marginal propensity to consume is constant, or equivalently, that the household always consumes a xed fraction of income. While this assumption greatly simplies the
analysis, it lacks the explanation on why the household chooses such a behavior.
A key feature of modern macroeconomics is to derive, as much as possible, the household's behavior from
rational households' dynamic optimization problems. This lecture examines a two-period consumption choice model
proposed by Irving Fisher, which is the easiest example of dynamic optimization.

Two-Period Consumption Choice Model

2.1 The Household's Optimization Problem

Let us consider the following household's optimization problem.

max

C1 ,C2

s.t.

(1)

U (C1 , C2 )
S1 =

Y1 C1

(2)

C2 =

Y2 + (1 + r)S1

(3)

The household lives for two periods, and receives income Yt and consumes Ct , in period t = 1, 2. S1 denotes
saving in period 1, whose real interest rate is r, and which is repaid in period 2. The household may borrow in
period 1in that case, S1 < 0. (2) and (3) denotes, respectively, the budget constraint in period 1 and 2. The
household maximizes utility subject to these constraints.

2.2 Indierence Curves and The Marginal Rate of Substitution

The household's preference on the consumption in two periods can be expressed by indierence curves. An indierence curve plots the combination of C1 and C2 that provides the household the same level of utility (Figure
1).
The absolute value of the slope of the indierence curve is called the marginal rate of substitution (MRS)
between the period 1 and 2 consumption. The MRS tells the rate at which the household is willing to substitute
C2 for C1 .
and totally dierentiating it, we obtain
Let us examine the MRS mathematically. Setting U (C1 , C2 ) = U

M U1 dC1 + M U2 dC2 = 0.
Rearranging this expression, we obtain

dC2
M U1
=
,
dC1
M U2

(4)

U
where M Ut C
(t = 1, 2). The LHS of (4) is the MRS. Thus, (4) implies that the MRS equals the ratio of the
t
marginal utility of period 1 consumption to that of period 2 consumption.

C2

C1
Figure 1: Indierence Curves

2.3 The Intertemporal Budget Constraint

By eliminating S1 from (2) and (3), we obtain the intertemporal budget constraint:

C1 +

Y2
C2
= Y1 +
.
1+r
1+r

(5)

This equation implies that the household's present value of lifetime consumption (LHS) equals the present value of
lifetime income (RHS). The graph of (5) is a line, whose slope is (1 + r), as drawn in Figure 2.

C2
(1

+ r )Y1 + Y2

C1

Y1 + Y2 /(1 + r )

Figure 2: Intertemporal Budget Constraint

2.4 Optimal Consumption

The optimal consumption is obtained by maximizing U (C1 , C2 ) subject to (5). The Lagrangian is

L = U (C1 , C2 ) + (Y1 +

Y2
C2
C1
),
1+r
1+r

so the rst order conditions are

U
= M U1
C1
2

(6)

U
= M U2
C2

.
1+r

Eliminating from these, we obtain

M U1 = (1 + r)M U2 .

(7)

The LHS of (7) denotes the increase in utility from a unit increase in period 1 consumption (i.e., the marginal
utility of period 1 consumption). The RHS corresponds to the increase in utility, if the household instead increases
the saving in period 1 by one unit, and increases period 2 consumption. This equation implies that they must be
equal under the optimal solution. The optimal C1 and C2 are obtained from (5) and (7).
Let us conrm where the optimal solution lies in a graph. By rearranging (7),

M U1
= 1 + r.
M U2

(8)

M RS = 1 + r.

(9)

Therefore, from (4) and (8),

This implies that at the optimal solution, the absolute value of the slope of the indierence curve equals 1 + r, so
the intertemporal budget constraint is tangent to the indierence curve (Figure 3).

C2

C2*

C1

C1*

Figure 3: Optimal C1 and C2

2.5 The Real Interest Rate and Consumption

Let us examine how the real interest rate r aects the optimal consumption, assuming that both C1 and C2 are
1
normal goods. First, note that we can normalize the price of period 1 good to 1, and that of period 2 to 1+r
(or,
1
we can consider that the relative price of period 2 good to period 1 good equals 1+r ). Then, as in a standard two
goods model, we can decompose the eect of changes in prices into the substitution eect and the income eect.
Suppose r rises. This makes period 2 good relatively cheaper, so the substitution eect implies that C1 falls
and C2 rises. On the other hand, the income eect has dierent implications, depending on whether the household
is a saver (S1 > 0) or a borrower (S1 < 0) in period 1. Here, let us consider the former case. Then, an increase
in r implies that the household's receipt of interest increases, so the income eect increases both C1 and C2 . So,
combining both eects, we can conclude that C2 unambiguously rises, but in general we cannot tell whether C1
rises or falls. (In Figure 4, E0 is initial endowment, E1 is the optimal consumption for the original r, and E2 is the
optimal consumption after the rise in r).

2.6 An Example
maxC1 ,C2 1 logC1 + 2 logC2 (1 > 0, 2 > 0)
s.t.

C1 +

C2
1+r

= Y1 +

Y2
1+r

C2

E2
E1

E0

Y2

C1

Y1

Figure 4: An Increase in r
The Lagrangian is

L = 1 logC1 + 2 logC2 + (Y1 +

Y2
C2
C1
),
1+r
1+r

(10)

so the rst order conditions are

1
C1
2
C2

= ,

.
1+r

By eliminating from these equations, we obtain (the computation technique will be explained in the lecture)

1
1 + 2
1 + 2
2
=
.
= C2 =
C
Y2
2
C1
C1 + 1+r
Y1 + 1+r
1+r
Y2
Y2
1
2
Therefore, C1 = 1+
(Y1 + 1+r
(1 + r)(Y1 + 1+r
) and C2 = 1+
). Thus, the expenditure share of each good is
2
12
2
independent of r, and is respectively equal to 1 +2 and 1 +2 . This is an important feature of the log utility.

Practice Question 1
1. The solution will be the same as above, if the utility function is U (C1 , C2 ) = C11 C22 . Why is this ?
2. Consider a N period model, in which the utility function is U (C1 , . . . , CN ) = 1 logC1 +2 logC2 + N logCN (i >
0), and the income in period t is Yt (t = 1, 2, N ). Assume that the real interest rate is constant at r, and
obtain the optimal consumption {Ct }N
t=1 .

Introduction of the Government and Ricardian equivalence

3.1 The Government's Budget Constraint

Let us now introduce the government. The government purchases in each period, G1 and G2 , are given exogenously,
and the government nances them by tax revenues from the household in the two periods, T1 , T2 . Just like the
4

household, the government can save or borrow in period 1 at the the real interest rate r. Let B1 denote the
government's borrowing in period 1. Then the government's budget constraint in period 1 and 2 are,

B1

= G1 T1 ,

(11)

G2

= T2 (1 + r)B1 .

(12)

By eliminating B1 from (11) and (12), we obtain the government's intertemporal budget constraint

G1 +

G2
T2
= T1 +
.
1+r
1+r

(13)

3.2 Ricardian equivalence

Ricardian equivalence is a proposition that states that the timing of taxation does not aect the household's
consumption behavior. We will discuss this again in the lecture on the government budget, but its essence can be
understood in a two period model. The household's budget constraint in each period is:

S1

Y1 C1 T1 ,

(14)

C2

Y2 + (1 + r)S1 T2 .

(15)

Eliminating S1 from (14) and (17), we obtain the intertemporal budget constraint,

C1 +

Y2
T2
C2
= Y1 +
T1
.
1+r
1+r
1+r

(16)

C1 +

C2
Y2
G2
= Y1 +
G1
.
1+r
1+r
1+r

(17)

Using (13), we can rewrite (16) as

Equation (17) implies that the household's intertemporal budget constraint is aected by the present value of
G2
the government purchases, G1 + 1+r
, but not by the amount of taxes in each period, T1 and T2 . So the timing of
taxation does not aect the household's consumption, such that Ricardian equivalence holds in this model.

3.3 The Eect of The Borrowing Constraint

If, for example, the government increases G1 keeping G2 constant, the present value of household's lifetime disposable
G2
income falls, as observed from (17); so C1 and C2 fall. If the government instead increases G1 keeping G1 + 1+r
constant, there is no change to C1 and C2 . Also, since the timing of taxation does not aect the household's
consumption, whether the government nances G1 by T1 or B1 does not aect C1 and C2 . These results contrast
with the implication in the Keynesian model, in which an increase in the government purchases and a decrease in
taxes increase consumption, with the impact being greater for the former.
The result may change, however, when the household faces a borrowing constraint. Suppose S1 is restricted
to be nonnegative, such that the household may save but may not borrow. Then the household's intertemporal
budget constraint is expressed as the dark line in Figure 5. If the situation is as in this gure, the household chooses
(C1 , C2 ) if there is no borrowing constraint. But due to the borrowing constraint, the household is forced to choose
(Y1 T1 , Y2 T2 ). Then, if the government decreases T1 and increases T2 , C1 increases.
Note that the presence of the borrowing constraint alone is not sucient for this result. For example, if the
situation is as in Figure 6, the borrowing constraint is not binding, so decreasing T1 has no eect on C1 .

Practice Question 2
Solve the household's optimization problem below, and obtain the optimal C1 and C2 .

maxC1 ,C2 1 logC1 + 2 logC2 (1 > 0, 2 > 0)

s.t.

C1 +

C2
1+r

= Y1 +

Y2
1+r

G1

G2
1+r

C2

Y2 T2

C2*

C1

Y1 T1 C1*

Figure 5: Binding Borrowing Constraint

C2

C2*
Y2 T2

C1*

C1

Y1 T1

Figure 6: Non-binding Borrowing Constraint