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Lecture 5: Last updated 23/03/2010

CHAPTER 12: Intertemporal Choice- Silberberg and Suen
and Chapter 17- Capital and Time- Nicholson and Snyder

Outline of the Lecture:
I- Intertemporal Utility Maximization
II- The Fisher Separation Theorem
III- Stocks and Flows: (an example)

I- Intertemporal Utility Maximization
We now apply the theory of consumer choice to the allocation of consumption over time. Objects of the
choice in the analysis are consumption now and in the future. We shall deal with a situation in which the
individual may lend and borrow on the capital market.

Assumptions: In the first part of analysis we rule out the possibility that the consumer is able to engage in
production. Also we assume that the capital market is perfect, that the single rate of interest r is completely
influenced by amounts in which the individual does so, then the budget constraint is a straight line.

Time dimension in capital analysis: Capital is durable, it is bought now and it provides services for an
extended period of time (years). But income and profits received in the future time is not valued as highly as
present income or profit.

Supply of capital is created by consumers who are willing to postpone some of their current consumption in
order to increase their consumption in future time periods. Then they expect to be rewarded for their
postponement of current consumption. This reward in turn, affects the price and quantity supplied of capital.
So, the existence of a price that allocates resources across time periods to their most highly valued uses. This
price is interest rate. How interest rate is charged to borrowers is affected by the possibility of future price
changes.

Consider consumption in two time periods.
1
x : consumption in period 1
2
x : consumption in period 2
1
I :

income in period 1
2
I :

income in period 2.
Suppose the individual can borrow and lend at interest rate r in the capital market.

If the consumer does not consume the income y today, next year he gets (1 ) y r + .
So consuming y today has the price (1 ) r + in terms of future goods. Then;

Price of present consumption is (1 ) r + units of future consumption.
Price of future consumption is
1
(1 ) r +
units of present consumption.

The interest rate (to quote Irving Fisher) is the premium for earlier availability of goods.
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1. Intertemporal Budget Constraint

The wealth W in the present is defined as the present value of current and future income. The
intertemporal budget constraint shows that the consumer cannot spend more than his wealth, i.e.

) )
2 1 2 1
1 1 x r x I r I W + + = + + =



Intertemporal budget constraint: the set of consumption- saving possibilities for a consumer.


)

income present
of value future
I r I x x
1 2 2 1
1 0 + + = =


)

income future
of value present
r
I
I x x
+
+ = =
1
0
2
1 1 2


Slope of budget constraint
) )
1 1 2 2
1 1 x r I r I x + + + =

) r
dx
dx
+ = 1
1
2

As interest rate increases slope gets larger, budget line gets steeper.



2. Intertemporal Utility Function
) )
2 1
1 2
1 2
,
dx U
U x x slope MRS
dx U
= = =


The intertemporal utility maximization problem can be stated as;
x2
x1
x
1
> I
1
, x
2
< I
2
, s < 0, net
borrower

B
C
A
)
1 2
1 I r I + +
2 2
I x =
'
2
x
1 1
I x =
1
x

x
1
< I
1
, x
2
> I
2
, s > 0, net saver
3

3. Intertemporal Utility Maximization

max U(x
1
,x
2
)

s.t. ) )
1 2 1 2
1 1 I r I x r x + + = + +

) ) ) . J
1 2 1 2 2 1
1 1 , x r x I r I x x U L + + + + =

)
1
1
2
2
(1) 1 0
(2) 0
L
U r
x
L
U
x

= + =

= =

)

1
2
(1 )
U
r
U
= + .

(The consumers marginal value of present consumption,
1
2
U
U
, equals the opportunity cost of present
consumption in terms of future consumption forgone.)

) )
1 1 2 1
(3) 1 1 0
L
I r I x r x

= + + + =

.
Solution

For a net saver for a net borrower

For given r whether the individual is a net saver or borrower, depending on his utility function.


Effect of change in r : Let us show the effect of a change in interest rate on individuals consumption and
saving decisions and ultimately on the supply of capital.

) 1 (
1
2
r
dx
dx
+ =
B
x
1
x
2
2 2
I x =
1 1
I x =
B
x
1
x
2
2 2
I x =
1 1
I x =
U
1
*
U
2
*
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Reason: as r increases, future value of present income increases
1
(1 ) r I + , so this enables consumer
potentially increase his consumption in period 2.



Saving and the level of rate of interest.
Effect of an increase in r on present consumption and saving
a) for a net borrower

(the dashed line is the hypothetical budget line)

As r increases price of consumption in period 1 has increased relative to period2.
See on the graph that the substitution effect is negative. (try to show it on the diagram)
Increased r reduces the present value of individuals future income.
Assuming
1
x is a normal good, as income decreases,
1
x decreases too. So a negative effect. (referred to as
windfall effect. (show on the diagram)
For a net borrower both income and substitution effects are in the same direction so, total effect of
increase in r results in a decrease in
1
x . So
1 1
0 S I x = (present consumption)

As r increases,
1
x decreases, dissaving decreases.




2
x
1
x
2
I
1
I
1
U
B
2
U
x
2
x
1
As r increases budget line rotates
clockwise
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b) for the net saver

(the dashed line is the hypothetical budget line)

1. again substitution effect is negative. (show on the diagram)
2. as r increases, future value of the present income increases.
1
x is a normal good so as income
increases
1
x increases too (windfall effect).
3. So substitution and income effects are in opposite direction. (show on the diagram)

The total effect will depend on their magnitudes.
** If substitution effect is greater than income effect, then as r increases
1
x decreases. (savings increase)**
** if substitution effect is less than income effect, than as r increases
1
x increases too. (savings decrease)**


Time Preference
People are impatient. (Impatience: A given level of income will generate less utlity if it is consumed in the
future rather than the present.)

Utility function with impatience can be written as
) )
)
p +
+ =
1
,
2
1 2 1
x U
x U x x V , p is rate of time preference, 0 > p (the amount by which future goods
are discounted on the margin relative to present goods for all reasons.)

At the consumer equilibrium
slope of the budget line = slope of the indifference curve.
)
1
1
x U
dx
dV
' =

)
p +
' =
1
1
2
2
x U
dx
dV

2
x
1
x
2
I
1
I
B
2
2
U
1
2
U
1
U
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)
)
)
2
1
1
2
2
1
1
x U
x U
dx
dx
dx
dV
dx
dV
'
'
+ = = p
Slope of indifference curve = slope of budget line : (1 ) r +

Then, at the consumer choice:
)
)
) 1 (
1
1
2
1
p +
+
=
'
' r
x U
x U

Consumption is affected by consumers preferences for earlier availability, ) p + 1 , and market price of
earlier availability (1 ) r + .

Along the 45
0
line
1 2
x x = , slope of the I-curve is (1 ) p + and hence it is less than 1.

in (1)
if p = 0, at equilibrium. MRS = (1 ) r + so choice is above the 45
0
line. Consumer consumes more of the
future goods than present goods, x
2
> x
1
.

if p > 0 but r p , again x
2
> x
1
.

if p > 0 but r p > , x
1
> x
2



Tendency of consumers to even out the flow of consumption:
When income is earned in an uneven pattern, individuals attempt to smooth out their consumption through
borrowing and lending.

Assume r p = , so
M M
i j
x x = , consumption must be the same in any two adjacent time period.
Assume further that 0 r p = = .



The total value of consumption is measured by the area under the compensated demand curve. Consider the
total benefits of consuming various levels of present consumption.

Consumer tends to even out the consumption when income is earned in an uneven pattern. In the diagram
above he will either consume first x x (
0
1
, and more in the second period x x ( +
0
1
, or he will even out his
B
C
A
0
1
x x x ( +
0
1
x x (
0
1
U
x
1
1
x
P
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income in the two period and consume
0
1
x in both of the periods. But regarding the area under the demand
curve we have;

Total benefit from consuming
0
1
x for two years is 2 2 A B + .
Total benefits from the feast-famine pattern are ( ) 2 2 2 A B C A A B C A B + + + = + + +
Thus, income is valued more highly if it is consumed at an even rather than an uneven rate.





II- The Fisher Separation Theorem:
Suppose that consumer now can choose among alternative income plans so that the income earned in a given
year is part of the utility maximization decision.
-Assume the individual can produce a combination of consumption points indicated as the PPF
1 2
( , ) g x x k = .
-Assume also that the consumer can borrow and lend at the same interest rate.



It is geometrically obvious that with efficient capital markets the bundle produced need not be the bundle
consumed. The consumer maximizes utility by first maximizing wealth (at A) and then rearranging
consumption (by borrowing and lending at some unique interest rate) moves along the budget line to some
point of tangency B.
This famous result is known as Fisher Separation Theorem.

We can still go further by removing the assumption of same interest rate in borrowing and lending.
Suppose the individual can transfer income from the future to the present at price 1
b
r + ( b for borrowing),
and he can transfer income from present to the future at the price 1
l
r + ( l for lending).

Assuming
b l
r r > , the above diagram becomes;

B
* *
1 2

( , )
A
x x

*
* 2
1
1
x
W x
r
= +
+

1 2
( , ) g x x k =
2
x
1
x
1 2
( , ) V x x
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Without more detailed knowledge of the individuals utility function it is not possible to determine which
segment of the ' ' L LBB , the consumer will choose. The individuals present wealth at
*
X evaluated with
b
r (which is higher in this case) is
*
* * 2
1
1
b
x
W x
r
= +
+
. We cannot decide whether this is a larger number than
some points along ' L L , where a higher of future consumption 1
l
r + prevails.

Thus the exact correspondence of wealth and utility maximization is not present when borrowing and
lending rates diverge. Then Fisher separation theorem may not hold. Maximization of wealth may nod lead
to utility maximization.


III- Stocks and Flows: (an example)
For the most part, goods that provide income in the future are durable. Most interest in capital goods focuses
on those goods that last over several or many time periods. So we have to distinguish the physical item,
called the stock, from the flow of services derived from the stock.

A convenient illustration: the distinction between a house and the flow of housing services we derive from
owning or renting a house. The price of the stock is the present value of anticipated net rents.

These topics will be covered in the next lecture 6 but we can still investigate here, how the prices and
quantities of stocks and flows, and the rate of investment, are affected by changes in interest rate.

Example: Decrease in the interest rate results in lower rental prices in short run. Is it true or false?
Houses: stock,
Housing services: flow.
Suppose the real interest rate is decreased due to some exogenous factor. This will have no predictable effect
on demand for housing relative to other contemporaneous goods. A fall in the interest rate is a decrease in
the price of present relative to future consumption. The mix of present goods should not be affected in any
particular way. So we expect no change in the rental price R .

In short run, only price of houses will increase. However, in long run demand for new houses increases.
P and Q of new houses increase Q of houses increase house stock increases Supply of housing
services shifts right (in LR) Rental rate decreases (in LR)

*
X
L'
' B
B
L
1 2
( , ) g x x k =
2
x
1
x
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In long run, demand for house increases, people buy more houses and Price increases. S increases, rental rate
decreases in long run.
This analysis shows the futility of policies to make housing more affordable by attempting to lower the
real interest rate. The short-term effect will simply be to raise the price of houses.


Housing services
Rental 1
S
2
S
0
R
1
R
D
New Houses
Price
Houses
Price
1
P
2
P
1
D
2
D
2
D
1
D
S
S
2
P
1
P