Intertemporal Choice

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?
Present and Future Values

 Begin with some simple financial arithmetic.

 Take just two periods; 1 and 2.
 Let r denote the interest rate per period.
Future Value

 E.g., if r = 0.1 then Rs.100 saved at the start of period 1 becomes Rs110 at
the start of period 2.
 The value next period of Rs1 saved now is the future value of that unit of
money.
Future Value

 Given an interest rate r the future value one period from now of Rs1 is

FV  1  r.
 Given an interest rate r the future value one period from now of Rsm is

FV  m(1  r ).
Present Value
 Suppose you can pay now to obtain Rs1 at the start of next period.
 What is the most you should pay?
 Rs1?
 No. If you kept your Rs1 now and saved it then at the start of next
period you would have Rs(1+r) > Rs1.
 Q: How much money would have to be saved now, in the present,
to obtain Rs1 at the start of the next period?
 A: Rs m saved now, becomes Rs m(1+r) at the start of next period,
so we want the value of m for which
m(1+r) = 1
That is, m = 1/(1+r),
the present-value of Rs1 obtained at the start of next period.
Present Value
 The present value of Rs1 available at the start of the next period
𝟏
is 𝑷𝑽 =
𝟏+𝒓
 And the present value of Rs. m available at the start of the next period is
𝒎
 𝑷𝑽 =
𝟏+𝒓
 E.g., if r = 0.1 then the most you should pay now for Rs.
1 available next period is is 𝑷𝑽 =
𝟏
=0.91
𝟏+.𝟏
 And if r = 0.2 then the most you should pay now for Rs. 1
available next period is
𝟏
 𝑷𝑽 = =0.833
𝟏+.𝟐
 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.
 Let p1 and p2 be the prices of consumption in periods 1 and 2.
 The intertemporal choice problem:
Given incomes m1 and m2, and given consumption prices p1 and p2, what is the
most preferred intertemporal consumption bundle (c1, c2)?
 For an answer we need to know:
 the intertemporal budget constraint
 intertemporal consumption preferences.

 To start, let’s ignore price effects by supposing that

p1 = p2 = Rs1
The Intertemporal Budget Constraint

 Suppose that the consumer chooses not to save or to

borrow.
 Q: What will be consumed in period 1?
 A: c1 = m1.
 Q: What will be consumed in period 2?
 A: c2 = m2.
The Intertemporal Budget Constraint
c2

m2

0 c1
0 m1
 The Intertemporal Budget Constraint

c2
So (c1, c2) = (m1, m2) is the
consumption bundle if the
consumer chooses neither to
save nor to borrow.
m2

0 c1
0 m1
The Intertemporal Budget Constraint

 Now suppose that the consumer spends nothing on consumption in period 1;

that is, c1 = 0 and the consumer saves
s1 = m1.
 The interest rate is r.
 What now will be period 2’s consumption level?
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
 𝑐2 = 𝑚2 + (1 + 𝑟) 𝑚1
 The Intertemporal Budget Constraint
c2
the future-value of the income
𝑚2 + (1 + 𝑟) 𝑚1 endowment

m2

0 c1
0 m1
 The Intertemporal Budget Constraint
c2
𝑐1 , 𝑐2 = (0, 𝑚2 + (1 + 𝑟) 𝑚1 )`
𝑚2 + (1 + 𝑟) 𝑚1
is the consumption bundle when all
period 1 income is saved.

m2

0 c1
0 m1
The Intertemporal Budget Constraint

 Now suppose that the consumer spends everything possible on consumption in

period 1, so c2 = 0.
 What is the most that the consumer can borrow in period 1 against her period
2 income of m2?
 Let b1 denote the amount borrowed in period 1.
The Intertemporal Budget Constraint

 Only m2 will be available in period 2 to pay back b1 borrowed in period 1.

 So b1(1 + r ) = m2.
 That is, b1 = m2 / (1 + r ).
 So the largest possible period 1 consumption level is
The Intertemporal Budget Constraint

 Only $m2 will be available in period 2 to pay back $b1 borrowed in period 1.
 So b1(1 + r ) = m2.
 That is, b1 = m2 / (1 + r ).
 So the largest possible period 1 consumption level is
𝑚2
 𝑐1 = 𝑚1 +
1+𝑟
The Intertemporal Budget Constraint
c2
m2  (c1 , c2 )  0, m2  (1  r )m1 
(1  r )m1 is the consumption bundle when all
period 1 income is saved.

m2 the present-value of
the income endowment

0 m2c1
0 m1 m1 
1 r
The Intertemporal Budget Constraint
c2
m2  (c1 , c2 )  0, m2  (1  r )m1 
(1  r )m1 is the consumption bundle when
period 1 saving is as large as possible.


( c1 , c 2 )   m1 
m2 
,0
 1r 
m2 is the consumption bundle
when period 1 borrowing
is as big as possible.
0
0 m1 m2 c1
m1 
1r
The Intertemporal Budget Constraint

 Suppose that c1 units are consumed in period 1. This costs c1 and leaves m1-
c1 saved. Period 2 consumption will then be

c2  m2  (1  r )( m1  c1 )
c2  (1  r )c1  m2  (1  r )m1 .
slope
intercept
The Intertemporal Budget Constraint
c2
m2  (c1 , c2 )  0, m2  (1  r )m1 
is the consumption bundle when
(1  r )m1
period 1 saving is as large as possible.

( c1 , c 2 )   m1 
m2 
,0
 1r 
m2 is the consumption bundle
when period 1 borrowing
is as big as possible.
0
0 m1 m2 c1
m1 
1r
The Intertemporal Budget Constraint
c2
c2  (1  r )c1  m2  (1  r )m1 .
m2 
( 1  r)m1
slope = -(1+r)

m2

0
0 m1 m2 c1
m1 
1r
The Intertemporal Budget Constraint
c2
m2 
c2  (1  r )c1  m2  (1  r )m1 .
( 1  r)m1
slope = -(1+r)

m2

0
0 m1 m2 c1
m1 
1r
The Intertemporal Budget Constraint
(1  r )c1  c2  (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.
The Intertemporal Budget Constraint

 Now let’s add prices p1 and p2 for consumption in periods 1 and 2.

 How does this affect the budget constraint?
Intertemporal Choice
 Given her endowment (m1,m2) and prices p1, p2 what intertemporal
consumption bundle (c1*,c2*) will be chosen by the consumer?
 Maximum possible expenditure in period 2 is
so maximum possible consumption in period 2 is

m2  (1  r )m1
m2  (1  r )m1
c2  .
p2
 Intertemporal Choice
 Similarly, maximum possible expenditure in period 1 is
m2
m1 
1 r

 so maximum possible consumption in period 1 is

m1  m2 /(1  r )
c1  .
p1
 Intertemporal Choice
 Finally, if c1 units are consumed in period 1 then the consumer spends p1c1 in
period 1, leaving m1 - p1c1 saved for period 1. Available income in period 2
will then be

so
m2  (1  r )( m1  p1c1 )

p2 c2  m2  (1  r )( m1  p1c1 ).
Intertemporal Choice

p2 c2  m2  (1  r )( m1  p1c1 )

rearranged is
(1  r ) p1c1  p2 c2  (1  r )m1  m2 .

This is the “future-valued” form of the

budget constraint since all terms are
expressed in period 2 values. Equivalent
to it is the “present-valued” form
p2 m2
p1c1  c2  m1 
1 r 1 r
where all terms are expressed in period 1
values.
The Intertemporal Budget Constraint
c2

m2/p2

0 c1
0 m1/p1
The Intertemporal Budget Constraint
(1  r )m1  m2 c2
p2

m2/p2

0 c1
0 m1/p1
The Intertemporal Budget Constraint
(1  r )m1  m2 c2
p2

m2/p2
m1  m2 / (1  r )
0 c1 p1
0 m1/p1
The Intertemporal Budget Constraint
c2
(1  r ) p1c1  p2 c2  (1  r )m1  m2
(1  r )m1  m2
p2 p1
Slope =  (1  r ) p
2

m2/p2

0 c1
0 m1/p1
m1  m2 / (1  r )
p1
The Intertemporal Budget Constraint
c2 (1  r ) p1c1  p2 c2  (1  r )m1  m2
(1  r )m1  m2
p2
p1
 (1  r )
Slope = p2

m2/p2

0 c1
0 m1/p1
m1  m2 / (1  r )
p1
Price Inflation

 Define the inflation rate by p where

p1 (1  p )  p2 .
 For example,

p = 0.2 means 20% inflation, and

p = 1.0 means 100% inflation.
Price Inflation

 We lose nothing by setting p1=1 so that p2 = 1+ p.

 Then we can rewrite the budget constraint

p2 m2
as p1c1  c2  m1 
1 r 1 r
1 p m2
c1  c2  m1 
1 r 1 r
Price Inflation
1 p m2
c1  c2  m1 
1 r 1 r
rearranges to
1 r  m1 
c2   c1  (1  p )  m2 
1 p 1 r 

so the slope of the intertemporal budget

constraint is 1 r
 .
1 p
Price Inflation
 When there was no price inflation (p1=p2=1) the slope of the budget constraint was -
(1+r).

 Now, with price inflation, the slope of the budget constraint is -(1+r)/(1+ p). This
can be written as
1 r
 (1  r )  
r is known as the real interest rate. 1 p
 If you save Rs. I unit today you get Rs. (1+r) in next period. In real terms it is
(𝟏+𝒓)
equivalent to (𝟏+𝝅) where p1 =1 and p2=1+ 𝝅.

 Thus in real terms extra you have earned over your savings of one unit is
(𝟏+𝒓) 𝒓−𝝅
 -1=𝟏+𝝅 =𝝆 = 𝒓𝒆𝒂𝒍 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕.
(𝟏+𝝅)
Real Interest Rate
1 r
 (1  r )  
1 p
gives
r p
r  .
1 p
For low inflation rates (p  0), r  r - p .
For higher inflation rates this
approximation becomes poor.
Real Interest Rate

r 0.30 0.30 0.30 0.30 0.30

p 0.0 0.05 0.10 0.20 1.00

r - p 0.30 0.25 0.20 0.10 -0.70

r 0.30 0.24 0.18 0.08 -0.35

Comparative Statics

 The slope of the budget constraint is

1 r
 (1  r )   .
1 p
 The constraint becomes flatter if the interest rate r falls or the inflation rate

p rises (both decrease the real rate of interest).

Comparative Statics
c2
slope = 1 r
 (1  r )  
1 p

m2/p2

0 c1
0 m1/p1
Preference
U= 𝒖 𝒄𝟏 + 𝛅𝒖(𝒄𝟐 ) 0< 𝛅 ≤ 𝟏
Here 𝛅 is the discount rate by which consumer is
discounting future utility.
What is the MRS?
𝒖, (𝒄𝟏 )
MRS= ,
𝜹𝒖 (𝒄𝟐 )

𝒖, (𝒄𝟏 )
Slope of the indifference curve: -
𝜹𝒖, (𝒄𝟐 )
As 𝛅, consumer becomes more impatient , the
indifference curves become steeper.
Comparative Statics
c2
slope = 1 r
 (1  r )  
1 p

m2/p2

0 c1
0 m1/p1
Comparative Statics
c2  (1  r )  
1 r
slope = 1 p

The consumer saves. Or a lender

m2/p2

0 c1
0 m1/p1
 Comparative Statics: A Fall in r

c2 1 r
 (1  r )  
slope = 1 p

The consumer saves. A

decrease in the interest
rate “flattens” the
budget constraint.

If inflation rate goes

m2/p2
up then budget line
flattens, as well as
m2/p2 0 c1
falls. 0 m1/p1
Comparative Statics: fall in r
c2 1 r
slope =  (1  r )  
1 p

If the consumer saves then

saving and welfare are
reduced by a lower
interest rate.
m2/p2

0 c1
0 m1/p1
Comparative Statics
c2  (1  r )  
1 r
slope = 1 p

m2/p2

0 c1
0 m1/p1
Comparative Statics
c2 1 r
slope = (1  r )   1 p

m2/p2

0 c1
0 m1/p1
Comparative Statics
c2  (1  r )  
1 r
slope = 1 p

The consumer borrows.

m2/p2

0 c1
0 m1/p1
Comparative Statics: A fall in r
c2  (1  r )  
1 r
slope = 1 p

The consumer borrows. A

fall in the interest rate “flattens” the
budget constraint.

m2/p2

0 c1
0 m1/p1
Comparative Statics: A fall in r
c2 1 r
slope =  (1  r )  
1 p

If the consumer borrows then

borrowing and welfare are
increased by a lower
interest
m2/p2

0 c1
0 m1/p1
Proposition: Suppose first that the consumer is a lender. Then it turns out that if interest
rate increases, the consumer must remain a lender.

◎ Qs.If the consumer is initially a lender, then his

consumption bundle is to the left of the endowment
point. Now let the interest rate increase. Is it ◎
possible that the consumer shifts to a new
consumption point to the right of the endowment?
◎ Ans. No, due to Revealed Preference theory.
◎ Because that would violate the principle of revealed
preference: choices to the right of the endowment
point were available to the consumer when he
faced the original budget set and were rejected in Slope=-(1+𝝆)
favor of the chosen point. Since the original optimal
bundle is still available at the new budget line, the
new optimal bundle must be a point outside the old
◎ budget set—which means it must be to the left of
the endowment. The consumer must remain a
lender when the interest rate increases.
There is a similar effect for borrowers: if the consumer is initially a
borrower, and the interest rate declines, he or she will remain a borrower

◎ .
Valuing Securities : Present Value for
several periods
 A financial security is a financial instrument that promises to deliver an income stream.
 E.g.; a security that pays
m1 at the end of year 1,
m2 at the end of year 2, and
m3 at the end of year 3.
 What is the most that should be paid now for this security?

m1 /(1  r )  m2 /(1  r )  m3 /(1  r ) . 2 3

Three Period Budget Constraint

 Ignoring inflation and commodity prices as constant at unity

 Suppose interest rate varies over time. Suppose, for example, that the interest earned on savings from
period 1 to 2 is r1, while savings from period 2 to 3 earn r2. Then Rs. 1 in period 1 will grow to (1+r1)(1+r2)
dollars in period 3. The present value of Rs1 in period 3 is therefore 1/(1 + r1)(1 + r2). This implies that the
correct form of the budget constraint is
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?
Valuing Bonds
End of
1 2 3 … T-1 T
Year
Income
x x x x x F
Paid
Present x
1 r
x
(1  r )2
x
(1  r )3 … x
(1  r )T 1
F
(1  r )T

-Value

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