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 $100 saved
at the start of period 1 becomes
$110 at the start of period 2.
The value next period of $1
saved now is the future value of
that dollar.
Future Value
Given an interest rate r the
future value one period from now
of $1 is
FV  1  r.
Given an interest rate r the
future value one period from now
of $m FisV  m ( 1  r ).
 Present Value
Suppose you can pay now to obtain
$1 at the start of next period.
What is the most you should pay?
$1?
No. If you kept your $1 now and
saved it then at the start of next
period you would have $(1+r) > $1,
so paying $1 now for $1 next period
is a bad deal.
 Present Value
Q: How much money would have to be
saved now, in the present, to obtain
$1 at the start of the next period?
A: $m saved now becomes $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 $1 obtained at
the start of next period.
 Present Value
The present value of $1 available
at the start of the next period is
1
PV  .
1r
And the present value of $X
available at the start of the next
period is X
PV  .
1 r
 Present Value
E.g.,if r = 0.1 then the most you
should pay now for $1 available
next period is 1
PV   $0 91.
1  0 1
And if r = 0.2 then the most you
should pay now for $1 available
next period is 1
PV   $0 83 .
1  0 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
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.
The Intertemporal Budget
Constraint
To start, let’s ignore price effects
by supposing that

p1 = p2 = $1.
 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
c2 Constraint

m2

0 c1
0 m1
 The Intertemporal Budget
c2 Constraint
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.
Savingsplus 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
 The Intertemporal Budget
Constraint
Period 2 income is m2.
Savingsplus 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
c 2  mis2  ( 1  r ) m 1
expenditure
 The Intertemporal Budget
c2 Constraint
m2 
the future-value of the income
endowment
( 1  r )m1

m2

0 c1
0 m1
 The Intertemporal Budget
c2 Constraint
( c 1 , c 2 )  0 , m 2  ( 1  r ) m 1 
m2 
is the consumption bundle when all
( 1  r )m1 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 levelmis2
c 1  m1 
1r
 The Intertemporal Budget
c2 Constraint
( c 1 , c 2 )  0 , m 2  ( 1  r ) m 1 
m2 
is the consumption bundle when all
( 1  r )m1 period 1 income is saved.

m2 the present-value of
the income endowment

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










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

m2

0
0 m1 m 2 c1
m1 
1r
 The Intertemporal Budget
c2 Constraint
c 2   ( 1  r ) c 1  m 2  ( 1  r )m 1 .
m2 
(1  r)m1 Sa slope = -(1+r)
vi
ng

Bo
m2 rro
wi
ng
0
0 m1 m 2 c1
m1 
1r
 The Intertemporal Budget
Constraint
( 1  r ) c 1  c 2  ( 1  r )m 1  m 2
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.
Comparative Statics
( increase in r)
If c1< m1 the person is a lender.
If c1> m1 the person is a
borrower.
The budget line will be steeper
with rise in r.
If the person is a lender he will
continue to remain a lender.
Theory of revealed
preference
 Theory of revealed preference:-
 Suppose we observe the demands (consumption
choices) that a consumer makes for different
budgets. This reveals information about the
consumer’s preferences. We can use this
information to :-
◦ Test the behavioral hypothesis that a consumer
chooses the most preferred bundle from those
available.
◦ Discover the consumer’s preference relation.
◦ So here we are coming from
choice to preference
Revealed preference
Study of revealed preference in
little detail.
If a person is a borrower and r
decreases what will be the effect?
He will remain a borrower .
How to explain this by RPT??
 Initial borrower and r
decreases He has rejected
the shaded
C2

portion in favor
of a and still a
is affordable.
So now if he
choses from
b
a shaded portion
that will be
1+r

violation of
C1
WARP.
Revealed preference
Study of revealed preference in
little detail.
If a person is lender and r
decreases what will be the effect?
How to explain this by RPT??
 Initially lender but r
decreases He was initially
at L. Now he
C2

can be either at
S ( though
S L
earlier rejected
in favor of L,
but now L is not
T available) or at
T.
1+r

C1
Revealed preference
Study of revealed preference in
little detail.
If a person is a borrower and r
increases what will be the effect?
How to explain this by RPT??
 Initially Borrower and r
increases
He was initially
at T. Now he
C2

can be either at
S ( though
L earlier rejected
in favor of T,
S but now T is not
T available) or at
L.
C1
Revealed preference
Study of revealed preference in
little detail.
If a person is a Lender and r
increases what will be the effect?
How to explain this by RPT??
 Lender and increase in r
He was initially at L
Now if he become
C2

borrower that is
choses like S it is
already rejected
L earlier in favour of
S Still L is available s
T he cannot chose S
So lender remains
lender.
C1
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?
2  ( 1 expenditure
Maximummpossible r )m 1
in
period 2 is
m 2  ( 1  r )m1
so maximum possible
c 2 in period 2 is
consumption .
p2
Intertemporal Choice
Similarly,
maximum possible
expenditure in period 1 is
m2
m1 
1r
so maximum possible
consumption in period 1 is
m1  m 2 / ( 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
m be
 ( 1  r )( m  p c )
2 1 1 1

pso
2 c 2  m 2  ( 1  r )( m 1  p 1 c 1 ).
 Intertemporal Choice
p 2 c 2  m 2  ( 1  r )( m 1  p 1 c 1 )
rearranged is
( 1  r )p 1c 1  p 2 c 2  ( 1  r )m 1  m 2 .
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
p 1c 1  c 2  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
c2
( 1  r )m1  m 2
p2

m2/p2

0 c1
0 m1/p1
 The Intertemporal Budget
Constraint
c2
( 1  r )m1  m 2
p2

m2/p2

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

m2/p2

0 c1
0 m1/p1
m1  m 2 / ( 1  r )
p1
 The Intertemporal Budget
Constraint
c2 ( 1  r )p 1c 1  p 2 c 2  ( 1  r )m 1  m 2
( 1  r )m1  m 2
p2 p1
Sa
vi Slope =  ( 1  r )
ng p2

Bo
m2/p2 rro
wi
ng
0 c1
0 m1/p1
m1  m 2 / ( 1  r )
p1
Price Inflation
Define the inflation rate by 
where
p1 (1   )  p 2 .

For example,
 = 0.2 means 20% inflation,
and
 = 1.0 means 100% inflation.
Price Inflation
We lose nothing by setting p1=1
so that p2 = 1+  .
Then we can rewrite the budget
constraint
p2 m2
p 1c 1  c 2  m1 
1r 1r
asc  1   c  m  m 2
1 2 1
1r 1r
 Price Inflation
1 m2
c1  c 2  m1 
1r 1r

so the slope of the intertemporal budget

constraint is 1 r
 .
1 
 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+ ). This can be written as
1r
 (1   )  
1
 is known as the real interest rate.
 Real Interest Rate
1r
 (1   )  
1
gives
r 
 .
1
For low inflation rates ( 0),  r -  .
For higher inflation rates this
approximation becomes poor.
Real Interest Rate
r 0.30 0.30 0.30 0.30 0.30

 0.0 0.05 0.10 0.20 1.00

r -  0.30 0.25 0.20 0.10 -0.70

 0.30 0.24 0.18 0.08 -0.35

Comparative Statics
The slope of the budget constraint
is
1 r
 (1   )   .
1 
The constraint becomes flatter if
the interest rate r falls or the
inflation raterises (both
decrease the real rate of interest).
Comparative Statics
c2 1r
slope =  ( 1   )  
1

m2/p2

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

m2/p2

0 c1
0 m1/p1
Comparative Statics
c2 1r
slope =  ( 1   )  
1
The consumer saves.

m2/p2

0 c1
0 m1/p1
Comparative Statics
c2 1r
slope =  ( 1   )  
1
The consumer saves. An
increase in the inflation
rate or a decrease in
the interest rate
m2/p2 “flattens” the
budget
constraint.
0 c1
0 m1/p1
Comparative Statics
c2 1r
slope =  ( 1   )  
1
If the consumer saves then
saving and welfare are
reduced by a lower
interest rate or a
m2/p2 higher inflation
rate.
0 c1
0 m1/p1
Comparative Statics
c2 1r
slope =  ( 1   )  
1

m2/p2

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

m2/p2

0 c1
0 m1/p1
Comparative Statics
c2 1r
slope =  ( 1   )  
1
The consumer borrows.

m2/p2

0 c1
0 m1/p1
Comparative Statics
c2 1r
slope =  ( 1   )  
1
The consumer borrows. An
increase in the inflation rate or
a fall in the interest rate
“flattens” the
m2/p2 budget constraint.

0 c1
0 m1/p1
Comparative Statics
c2 1r
slope =  ( 1   )  
1
If the consumer borrows then
borrowing and welfare are
increased by a lower
interest rate or a
m2/p2 higher inflation
rate.
0 c1
0 m1/p1
 Valuing Securities
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?
 Valuing Securities
Thesecurity is equivalent to the
sum of three securities;
◦ the first pays only $m1 at the end of
year 1,
◦ the second pays only $m2 at the end
of year 2, and
◦ the third pays only $m3 at the end of
year 3.
 Valuing Securities
The PV of $m1 paid 1 year from now is
m 1 / (1  r )
The PV of $m2 paid 2 years from now is
2
m 2 / (1  r )
The PV of $m3 paid 3 years from now is

m 3 / (1  r ) 3
The PV of the security is therefore

m 1 / (1  r )  m 2 / (1  r ) 2  m 3 / (1  r ) 3 .
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 $x $x … $x $F
-Value 1  r (1  r ) 2 (1  r ) 3 (1  r )T  1 (1  r )T

x x x F
PV      .
1  r (1  r ) 2 (1  r )T  1 (1  r )T
Valuing Bonds
Suppose you win a State lottery.
The prize is $1,000,000 but it is
paid over 10 years in equal
installments of $100,000 each.
What is the prize actually worth?
 Valuing Bonds
$100, 000 $100, 000 $100, 000
PV    
1  0 1 ( 1  0 1) 2 ( 1  0 1) 10

 $614, 457

is the actual (present) value of the prize.

Valuing Consols
A consol is a bond which never
terminates, paying $x per period
forever.
What is a consol’s present-value?
Valuing Consols
End of
1 2 3 … t …
Year
Income
$x $x $x $x $x $x
Paid
Present $x $x $x … $x …
-Value 1  r ( 1  r ) 2
( 1  r ) 3
(1  r )t

x x x
PV      .
1  r (1  r ) 2 t
(1  r )
 Valuing Consols
x x x
PV    
1  r (1  r ) 2 (1  r ) 3
1  x x 
 x    
1r  1  r (1  r ) 2 
1

1r
 x  PV . Solving for PV gives
x
PV  .
r
 Valuing Consols
E.g. if r = 0.1 now and forever then the
most that should be paid now for a
console that provides $1000 per year is
x $1000
PV    $10, 000 .
r 0 1