Intertemporal Choice

Dr. Leon Vinokur

ECN 111 – Microeconomics 1
Lecture 5

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 Aims & Objectives
Aim: Understand how we can expand the
models we have so far to consider choice
over time
Objectives:
• Define the budget constraint
• Define the preferences
• Derive the optimal choice
• Discover if a lender or borrower

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 Question:
Would you rather earn $70,000 a year now or
$70,000 a year in 1900?

1. $70000 a year now

2. $70000 a year in 1900

Putting Pay in Perspective: Tim Harford,

The Financial Times, Nov 26, 2010

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 Intertemporal Choice
• Persons often receive income in “lumps”; e.g.
monthly salary.
• How is a lump of income spread over the
following month (saving now for consumption
later)?
• Or how is consumption financed by borrowing
now against income to be received at the end
of the month?

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The Intertemporal Choice Problem
• Let m1 and m2 be incomes received in periods
1 and 2.
• Let c1 and c2 be consumptions in periods 1
and 2.

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INTERTEMPORAL BUDGET CONSTRAINT

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Intertemporal Budget Constraint with Interest
Rate = 0 and No Borrowing
• Assume that prices of consumption in each period are
constant at one.

The consumer has two choices:

1. Consume m1 and m2 in periods 1 and 2, respectively
(no savings).
2. Saving some of the period 1 income to spend in
period 2.
• This budget constraint is depicted in the following
diagrams.
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The Intertemporal Budget Constraint (No
Borrowing and r = 0)
c2

m2

0 c1
0 m1

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The Intertemporal Budget Constraint (No
Borrowing and r = 0)
c2
So (c1, c2) = (m1, m2) is the
consumption bundle if the
consumer chooses neither to
save nor to borrow.
m2 Endowment

0 c1
0 m1

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 The Intertemporal Budget Constraint (No
Borrowing and r = 0)
c2
m1+m2 Budget Line; slope = -1 (still
ratio of prices)

m2 Endowment

0 c1
0 m1

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 The Intertemporal Budget Constraint
• Now let us allow there to be both saving and
borrowing.
• The interest rate is r.
• Now suppose that the consumer spends nothing
on consumption in period 1; that is, c1 = 0 and
the consumer saves
s1 = m1.
• What now will be period 2’s consumption level
(y-intercept)?
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The Intertemporal Budget Constraint
• Period 2 income is m2.
• Savings plus interest from period 1 sum to
(1 + r )m1.
• So total income available in period 2 is
m2 + (1 + r )m1.
• So period 2 consumption expenditure is
c 2  m2  (1  r )m1

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The Intertemporal Budget Constraint
c2

Endowment
m2

0 c1
0 m1

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 The Intertemporal Budget Constraint
c2
m2 
This intercept is the future value of income
(1  r )m1

Endowment
m2

0 c1
0 m1

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 The Intertemporal Budget Constraint
c2
m2 
This intercept is the future value of income
(1  r )m1

Endowment
This intercept is the
m2
present value of
income
0
0 m1 m  m2 c1
1
1r
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 The Intertemporal Budget Constraint
• The Future Value Of Income:
– Y-intercept
– Maximum amount of second period consumption.

• The Present Value of Income:

– X-intercept
– Amount of money in period 1 that would generate the
same budget set as the endowment
– Maximum amount of period 1 consumption possible.
– Note that you have to be able to pay back everything you
borrow, with interest.
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 The Intertemporal Budget Constraint
c2
m2  c2  (1  r )c1  m2  (1  r )m1.
(1  r)m1 Sa
vi
ng slope = -(1+r)
Bo
m2 rro
wi
ng
0
0 m1 m2 c1
m1 
1r
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 Slope of Intertemporal Budget Constraint

• Slope = -(1+r)
• It is (still) the ratio of the price of the good on the x-
axis to that on the y-axis.
• Says that the price of consumption in period 1 is
(1+r).
• Does this make sense?
• The cost to consuming $1 in period 1 is that which
you have to give up in period 2, i.e. $1 of
consumption plus the interest you can earn.
– Makes sense if you think about it in terms of opportunity
costs. 18
 What is the equation of the Intertemporal
Budget Constraint?
• Consider a consumer who decides to be a
saver. What is his period 2 consumption equal
to?
c2  m2   m1  c1   r  m1  c1   m2   1  r   m1  c1 

savings Interest on savings

Can rearrange terms to get:
 1  r  c1  c2   1  r  m1  m2
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The Intertemporal Budget Constraint
( 1  r ) c1  c 2  ( 1  r )m1  m2
is the “future-valued” form of the budget
constraint since all terms are in period 2
values. This is equivalent to
c2 m2
c1   m1 
1r 1r
which is the “present-valued” form of the
constraint since all terms are in period 1
values.

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 Future versus Present Valued Budget
Constraint
• These are just different equations for the
SAME budget constraint.
• Future Valued – all period 1 values are
multiplied by (1 + r)
– What are these values worth in period 2?
• Present valued – all period 2 values are
discounted by (1 + r)
– What are these values worth in period 1?

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Review Question: The future value of income
is …
1. m2 + (1 + r)m1 0%
2. m2 /(1 + r) + m1 0%
3. m2 + (1 + r)m1 = c2 + (1 + r)c1 0%
0%
4. None of the above

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Preferences for Consumption

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 Perfect Substitutes
• If the consumer’s preferences for
consumption over time could be characterized
as perfect substitutes, then the slopes of the
indifferent curves would be -1.
– (assuming 1 for 1 substitution)
• This person doesn’t care whether he
consumes today or tomorrow.
• MRS between today and tomorrow is -1.

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 Perfect Complements
• Consumer wants to consume equal amounts
today and tomorrow (assuming ratio of 1:1)
• Unwilling to substitute consumption from one
period to another

• Well behaved preferences are somewhere in the

middle. Most typical. Willing to substitute some
amount of consumption today for consumption
tomorrow.
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Inflation

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 Price Inflation
• When there was no price inflation (p1=p2=1) the slope
of the budget constraint was -(1+r).
• Inflation rate, , is the rate at which prices grow.
• With price inflation, the slope of the budget constraint
is -(1+r)/(1+ p).
• This is still the price of period 1 consumption over the
price of period 2 consumption.
– But period 2 price is now 1 + inflation.
• This can be written as
1r
 (1   )  
1 
r is known as the real interest rate. 27
 Price inflation ctd.
• Let
  m1 and m2 denote the real incomes in the
two periods. The intertemporal b.c. is

• The inflation rate is given by: (1+ p)= p2/p1.

Hence, dividing across by p1:

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• The
  budget constraint is now:

• The slope of the budget constraint is

1 r
(1   )   .
1 
• How do consumption patterns change when
interest rates or inflation change?
• Note that the constraint becomes flatter if the
interest rate r falls or the inflation rate p rises
(both decrease the real rate of interest). 29
 The Budget Constraint with Inflation
c2 1r
slope =  (1   )  
 𝑚 2+ 1+𝑟 𝑚 1 1 
1+𝜋

m2

0 m2
0 m1 m1  c1
1 
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 Identifying Borrowers and Savers
• Before we turn to the comparative statics (i.e.
how consumption changes when interest rates
or inflation change), it is important that we
can identify what a borrower and saver look
like.
• Borrower: Chooses bundle such that c1>m1
• Saver or Lender (lending to period 2): Chooses
bundle such that c1<m1

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c2 1r
slope =  (1   )  
1 

m2

0 c1
0 m1

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 c2 1r
slope =  (1   )  
1 
The consumer saves.

m2

0 c1
0 m1

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c2 1r
slope =  (1   )  
1 

m2

0 c1
0 m1

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 c2 1r
slope =  (1   )  
1 
The consumer borrows.

m2

0 c1
0 m1

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 Example
• Consider an individual with m1=500, m2=700,
r=10%, inflation = 0, and U(c1,c2) = c1 + c2.
• What is the future-valued budget constraint?
• What does the budget constraint look like?
Make sure to label intercepts.
• What do the indifference curves look like?
• What is this individual’s optimal consumption
bundle?
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Comparative statics with changes in inflation
and interest rate

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 Comparative Statics
c2 1r
slope =  (1   )  
m2  1 
( 1   )m1

m2

0 m2 c
0 m1 m1  1
1 
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 Comparative Statics
c2 1r
slope =  (1   )  
m2 
1 
( 1   )m1 The consumer saves.

m2

0 m2 c
0 m1 m1  1
1 
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 Comparative Statics
c2 1r
slope =  (1   )  
m2 
1 
( 1   )m1 The consumer saves. An
increase in the inflation
rate or a decrease in
the interest rate
m2 “flattens” the
budget
constraint.
0 m2 c
0 m1 m1  1
1 
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 Comparative Statics
c2 1r
slope =  (1   )  
m2 
1 
( 1   )m1 If the consumer saves, then
saving and welfare are
reduced by a lower
interest rate or a
m2 higher inflation
rate.
0 m2 c
0 m1 m1  1
1 
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 Comparative Statics
c2 1r
slope =  (1   )  
m2 
1 
( 1   )m1

m2

0 m2 c
0 m1 m1  1
1 
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 Comparative Statics
c2 1r
slope =  (1   )  
m2 
1 
( 1   )m1

m2

0 m2 c
0 m1 m1  1
1 
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 Comparative Statics
c2 1r
slope =  (1   )  
m2 
1 
( 1   )m1 The consumer borrows.

m2

0 m2 c
0 m1 m1  1
1 
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 Comparative Statics
c2 1r
slope =  (1   )  
m2 
1 
( 1   )m1 The consumer borrows. A
rise in the inflation rate or
a decrease in the interest
rate “flattens” the
m2
budget constraint.

0 m2 c
0 m1 m1  1
1 
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 Comparative Statics
c2 1r
slope =  (1   )  
m2 
1 
( 1   )m1 If the consumer borrows then
borrowing and welfare are
increased by a lower
m2 interest rate or a
higher inflation
rate.
0 m2 c
0 m1 m1  1
1 
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 Example (continued)
• Recall: m1=500, m2=700, r=10%, inflation = 0,
and U(c1,c2) = c1 + c2.
• How does this individual’s optimal bundle
change if the interest rate increases to 20%?
• What happens to borrowing/saving?
• What happens to utility?

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 Present Value (more generally)
• What is the value of a stream of income or
consumption in terms of today’s dollars?
• Every period, money grows in value by (1+r).
• $1 invested today will become $(1+r) by the
next period.
• During the next period, $(1+r) is invested and
becomes $(1+r)2.

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 Present Value (continued)
• So, the present value of a stream of income,
for instance, is:
x0 x1 x2 xT
PV      .
 1  r   1  r  (1  r ) (1  r )
0 1 2 T

• When would you have the first term?

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 Valuing Bonds
• A bond is a special type of security that pays a
fixed amount $x for T years (its maturity date)
and then pays its face value $F.
• What is the most that should now be paid for
such a bond?

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 Valuing Bonds

x x x F
PV     .
1  r (1  r ) 2 T 1 T
(1  r ) (1  r )

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Lecture Highlights:
1. The concepts of future and present value
2. How to construct and interpret an intertemporal budget
constraint
3. The meaning of its slope and the vertical and horizontal intercepts
4. The effect of changes in interest rate and in inflation on the
optimal intertemporal choice of the agent.
5. What would be the optimal choice over time if:
- Cobb Douglas Preferences
- Complement Preferences
- Substitute Preferences

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