Two period model of intertemporal consumer choices focus on individuals’ choices across

time by ignoring leisure. According to this consumer theory individuals live for two time

periods in which the first period is the “present” while second period is the “future”. The

underlying assumption of this model is that individuals have no control over their income. In

these given two periods individual will receive income and based on the income, the

individual will have to decide about his consumption patterns (Attanasio, 1999). An

individual may choose to either save or borrow in the first period. It is further assumed that

consumer will face trade off in decision making whether to consume today and save nothing

or to save and consume in future (Gillman, 2011). In this trade off of consumption choices

there are three options available for an individual (Bowman, et al., 1999). The consumer can

decide to consume his current income in first period and the future income in second period

hence there will be no borrowing and no savings. Secondly if he decides to save, the

consumer will give up his consumption for assets in first period hence more assets will be

accessible in future (Blundell, et al., 1994). Finally the borrowing resembles negative savings

when individual opts to consume more than his provided income in first period and borrows

hence will pay back the loan in second period.

Two period model assumes that individual has no control on his income which leads to

budget constraint where consumer has to decide his consumption pattern (Williamson, 2005).

The budget constraint in first period is stated as:

c+s=y–t

Where c is the individual’s current consumption

s is the consumer’s current savings

y is the real income for first period

 t is the lump sum tax paid in current period

The budget constraint specifies that consumption and savings must equate disposable income

otherwise in case if savings are greater than 0; the consumer is saving over consumption and

he becomes lender. If the savings are less than zero then consumer is dissaving and he

becomes the borrower. Budget constraint in second period supports the argument that in

future period certain increment is paid against current period as stated below:

c’ = y’ – t’ + (1 + r) s

Where c’ is the individual’s future consumption

s is the consumer’s current savings

r is the increment on current period savings

y’ is the real income for second period

t’ is the lump sum tax paid in future period

In second period consumption should equate disposable income plus the returns on savings.

Similarly this pattern can be combined to attain the lifetime budget constraint where

optimised consumption can be attained when present value of lifetime consumption is equal

to present value of lifetime disposable income (Henderson, 2008).

Graphically we (1+r) at point B suggests

what can be consumed in future if

individual does not consume at all in first

period. Similarly we at point A states

what can be consumed currently if

nothing is left for future. So, BA provides

the budget constraint while consumer

need to decide from choices below the

specified line. Whereas point E refers to Figure 1: Lifetime Budget Constraint

endowment where all available income is wholly consumed in both periods and nothing is

saved. Any leftward movement from point E to B reflects savings and rightward movement

from point E to A reflects dissaving.

Increase in Interest Rate

Considering the increase in real interest rate on optimised consumption decision. Increase in

interest rate imply that the rental price of money has increased in first period relatively to

second period. This increase in interest rates provides an incentive to substitute current

consumption with the future consumption. So, ultimately intertemporal substitution effect

encourage consumer to reduce current

consumption hence savings are initiated as

income in the second period has more value than

current period. Graphically with increase in

interest rate the budget constraint line becomes

steeper and its slope also increases. Movement

in budget constraint is clockwise through the

Figure 2: Increase in Interest Rate
endowment point.

Increase in Interest Rate for a Lender (Substitution, Income and Total Effect)

Figure 3: Increase in Interest Rate for a Lender

In an optimised consumer choice with real interest rate at r1, consumer who is a lender with

higher level indifference curve chooses point A (Bishop, et al., 2010). Now with increased

interest rate at R2, individual choose point B at we2 budget line. With the increased interest

rate consumer substitute current consumption with future consumption whereas on

indifference curve the movement is specified from point A to D. So, substitution discourages

current consumption and boosts savings with incentive of increased future consumption.

Since consumer have higher level indifference curve at new budget line which indicates

higher income in both periods encouraging consumption in current and in future period too.

Though increased consumption lead to dissaving in the first period. The overall effect on

current consumption is dubious as substitution effect discourages and income effect

encourages consumption in first period. Similarly savings are also conflicting as substitution

effect produces savings while income effect causes dissaving.

Increase in Interest Rate for a Borrower (Substitution, Income and Total Effect)

Figure 4: Increase in Interest rate for Borrower

Consumer with budget constraint tangent to lower level indifference curve choose point A for

optimum consumption decision at real interest rate at r1. Point A rightwards to endowment at

E shows that the consumer is a borrower with dissaving. Increase in interest rate at r2 forces

consumer to choose point B and reduces opportunity cost of the borrower. With the increased

interest rate consumer substitutes his current consumption with second period consumption

from point A to D. Since borrowing and consumption has become costly in the first period,

the borrower attempts to decrease current consumption leading to increased savings. Steeper

budget constraint line with reduced indifference capacity, consumer’s income cut down from

point D to B. Wilted income then effects as decreasing consumption and increasing savings

in current period. So, the overall effect is visible as substitution and income effect both

contain consumption and encourage savings.

It is evident that Increase in interest rate reduces current consumption and provide incentives

for future consumption (Mankiw, 2011). Besides outcomes related to interest rate are

influenced by multiple factors such as income effect, slope of budget constraint, substitution

effect, and also the level and shape of indifference curve. So, predicting precise effect truly

rely on preferences and choices.

References

Attanasio, O., 1999. Handbook of Macroeconomics. Vol. 1 ed. North Holland: Elsevier.

Bishop, M., Press, A. & Tauber, T., 2010. Economics. London: The Economist.

Blundell, R., Browning, M. & Meghir, C., 1994. Consumer Demand and the Lifetime

Allocation of Consumption. Review of Economic`Studies, Volume 61, pp. 57-80.

Bowman, D., Minehart, D. & Rabin, M., 1999. Loss aversion in a consumption–savings

model. Journal of Economic Behavior & Organization, 38(2), pp. 155-178.

Gillman, M., 2011. Advanced Modern Macroeconomics. s.l.:Financial Times/ Prentice Hall.

Henderson, D. R., 2008. The concise encyclopedia of economics. Indianapolis, India : Liberty

Fund.

Mankiw, G., 2011. Principles of Macroeconomics. Sixth Edition ed. s.l.:South-Western

College Pub..

Williamson, S. D., 2005. Macroeconomics. Second Edition: Chapter 8 ed. Boston: Pearson

Addison-Wesley.