m

m


  m


 m

 
INTERTEMPORAL CHOICE
„ Want to consider the effect of the interest rate +
possibility of saving and borrowing on the level of
consumption.
„ ASSUMPTIONS:
! Jou live for two periods, 1 and 2.
! Overall you consume the net amount available to
you.
! Jou receive an income at the start of the first period,
M1, and at the start of the second period M2, and
!
 !
! 

     

!


 
  
 .
! There is a perfectly competitive capital market which
sets the interest rate ¶r· ë used for both borrowing and
saving.
INTERTEMPORAL CHOICE
„ If you forgo all your current consumption save your
entire income, in the next period you will have the net
future value of your total wealth, M1 + M2:
! C2 = M2 + (1+r)(M1 ² C1)
! (1+
1+
(1+m1+më 
 


  

„ Conversely, if you forgo all your consumption in the
next period, you will have the net present value of
your total wealth.
! C1 = M1 + [1/(1+r)].(M2 ² C2)
!
1+
(1+m1+m(1+ ë 



 
 


„ uor more than 2 periods, the equations look the same,

except it·s [Mt / (1+r)t-1] or Mt(1+r)t-1 depending.
INTERTEMPORAL CHOICE
C2
„ The difference between a
SAVER and a BORROWER
can be seen
diagrammatically.
„ A consumer is given an
initial endowment of M1 C2··
and M2 in their respective
periods.
„ The BLUE indifference M2
curve is for a BORROWER.
! He chooses to consume
beyond his initial endowment
and thus consumes C1 > M1, C2·
but C2 < M2.
„ The RED indifference curve
is for a SAVER. C1·· M1 C1· C1
! He chooses to consume less
than his initial endowment,
C1 < M1, and C2 > M2
INTERTEMPORAL CHOICE
„ How does a consumer therefore change his
consumption with respect to a change in the interest
rate?
„  

   
1
(i.e., a rise in the interest rate is akin to a rise in P1
due to a higher opportunity cost).
„ Therefore, we can




!
 
 to analyse the effect:
 a = a
= a

  Îm a
a

a =
a 
=m a
„ Where C1h(.) and C1(.) are the Hicksian and
Marshallian demand functions respectively.
„ 



  



 
 !

 



 
 
 
(m1
1
INTERTEMPORAL CHOICE
„ If:
„ (m1
1 !



"
! The entire expression will be negative, thus a rise in
¶r· will be met with a fall in ¶C1·.
! The Borrower will STAJ a borrower.

„ (m1
1#!




! The overall sign of the expression is indeterminate.
! If the income effect is of sufficient magnitude then a
saver may SWITCH to becoming a borrower.
TIME ALLOCATION
„ The problem of time allocation is that the
consumer faces TWO constraints:
! Budget constraint.
! TIME constraint (only so many hours in which to
consume).

„ Therefore we can derive the uULL budget

constraint by combining the above two
constraint:
! Constraint 1: 1x1+x++x + x
! Constraint 2: 1x1+x++x m+
„ Where ti is the time it takes to consume xi and
¶N· is the number hours worked, and M is non-
wage income (w = wage).
TIME ALLOCATION
„ We then combine the two constraints:
! p1x1 + p2x2 + ... + pnxn = M + [Tmax ² t1x1 ² t2x2 -
... ² tnxn].w
! (1+1x1+(+x++( +x m+
x
! This is the uULL budget constraint.
„ M + Tmax is the consumer·s uULL income.
„ (pi + wti) is the uULL price for good xi.

„ In the 2-good case 



 
  

 
x
 (





 (


TIME ALLOCATION
„ To find the utility maximising level of
consumption of goods, solve via the standard
method.
„ The MRS should = the ratio of uULL prices.

„ Once we have the optimal quantities (a vector

X*), we can derive:
!   
  

 ë TX*
!  
   ë Tmax ² TX* = N*
! "ë N*w