Intertemporal Choice

Persons often receive monthly salary,

not daily salary.
How is the monthly income spent
over the whole month (e.g., saving
now for consumption later)?
Or, how is consumption financed by
borrowing now against income to be
received next period/month?
 Present and Future Values

Take just two periods, for example:

period 1 and period 2

Let r denote the interest rate per

period.
 Future Value

If r = 0.1, then $100 saved in period 1

becomes $110 in period 2.

The value next period of $1 saved

now is the future value (FV) of that
dollar.
 Future Value
Given interest rate r, the future value
one period from now of $1 is
FV = 1 + r.
Given interest rate r, the future value
one period from now of $m is
F V = m ( 1 + r ).
 Present Value
Q: How much money would have to be
saved now, in the present, to obtain $1 in
next period?
A: $m saved now becomes $m(1+r) at the
start of next period, so the value of m for
which m(1+r) = 1 is:
m = 1/(1+r),
the present value (PV) of $1 at the start of
next period.
 Present Value
The present value of $1 available in next
period is:
1
PV = .
1+r
And the present value of $m available in
next period is:
m
PV = .
1+r
 Present Value
E.g., if r = 0.1 then the most you
should pay now for $1 in next period
is: 1
PV = = $0  91.
1+ 01
And if r = 0.2 then the most you
should pay now for $1 in next period
is: 1
PV = = $0  83 .
1+ 02
 The Intertemporal Choice
Let m1 and m2 be incomes/endowments
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

The intertemporal choice problem:

Given incomes (m1, m2) and prices (p1, p2),
what is the most preferred intertemporal
consumption bundle (c1, c2)?

We need to know:
– intertemporal budget constraint
– intertemporal consumption preferences
The Intertemporal Budget Constraint

Let’s start by assuming 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 Constraint
c2
So (c1, c2) = (m1, m2) is the
consumption bundle if the
consumer chooses neither
to save nor to borrow.

m2

0 c1
m1
The Intertemporal Budget Constraint

Now suppose that the consumer

spends nothing on consumption in
period 1; that is, c1=0, and saves s1=m1.

Let the interest rate be r.

What will then 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:

c 2 = m 2 + ( 1 + r )m 1
 The Intertemporal Budget Constraint
c2
FV of income endowment
m2 +
( 1 + r )m1 ( c 1 , c 2 ) = ( 0 , m 2 + ( 1 + r )m 1 )
is the consumption bundle when all
period 1 income is saved.

m2

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:

m2
c 1 = m1 +
1+r
The Intertemporal Budget Constraint
c2

m2 +
( c 1 , c 2 ) = ( 0 , m 2 + ( 1 + r )m 1 )
( 1 + r )m1
is the consumption bundle when all
period 1 income is saved.

m2
PV of income endowment

c1
0 m1 m1 +
m2
1+r
 The Intertemporal Budget Constraint
c2
( c 1 , c 2 ) = ( 0 , m 2 + ( 1 + r )m 1 )
is the consumption bundle when
m2 +
( 1 + r )m1 period 1 saving is as large as possible.

( c 1 , c 2 ) =  m 1 +
m2 
,0
 1+r 
is the consumption bundle
m2 when period 1 borrowing
is as big as possible.

c1
0 m1 m1 +
m2
1+r
The Intertemporal Budget Constraint
Suppose that c1 are consumed in period 1.
This 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 Constraint
c2
m2 +
(1 + r)m1 c 2 = − ( 1 + r ) c 1 + m 2 + ( 1 + r )m 1 .
slope = - (1+r)

m2

0 c1
0 m1 m1 +
m2
1+r
The Intertemporal Budget Constraint

c2
c 2 = − ( 1 + r ) c 1 + m 2 + ( 1 + r )m 1 .
m2 +
(1 + r)m1

m2

c1
0 m1 m1 +
m2
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.

c2 m2
c1 + = m1 +
1+r 1+r
is the present-valued form of the
constraint since all terms are in period 1
values.
The Intertemporal Budget Constraint

Now, let the consumption prices

in the two periods be p1 and p2.

How does this affect the budget

constraint?
 Intertemporal Choice
Given 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: m + ( 1 + r ) m
2 1
so maximum possible consumption in
period 2 is: m + ( 1 + r )m
c2 = 2 1.
p2
 Intertemporal Choice
Similarly, maximum possible expenditure
in period 1 is: m
m1 + 2
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 2. Available income
in period 2 will then be:
m 2 + ( 1 + r )( m 1 − p 1 c 1 )
so:

p 2c 2 = m 2 + ( 1 + r )( m 1 − p 1c 1 ).
 Intertemporal Choice
Equation above can be rearranged as:
( 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.
p2 m2
Equivalently, p 1c 1 + c 2 = m1 +
1+r 1+r

is the present-valued form.

The Intertemporal Budget Constraint
c2
( 1 + r )m1 + m 2
p2
( 1 + r )p 1c 1 + p 2c 2 = ( 1 + r )m 1 + m 2

p1
Slope = − ( 1 + r )
p2
m2/p2

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

( 1 + r )m1 + m 2
p2

m2/p2

c1
0 m1/p1 m1 + m 2 / ( 1 + r )
p1
 Price Inflation

Define the inflation rate by p where

p1 (1 + p ) = p 2 .
For example:
p = 0.2 means 20% inflation
p = 1.0 means 100% inflation.
 Price Inflation
We lose nothing by setting p1=1 so
that: p2 = 1+ p
Then we can rewrite:
p2 m2
p 1c 1 + c 2 = m1 +
1+r 1+r
as: 1+ p m2
c1 + c 2 = m1 +
1+r 1+r
 Price Inflation

So the slope of the intertemporal

budget constraint is:

1+ r
dc2/dc1 = − .
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 ) = −
1+ p
r is known as the real interest rate.
 Real Interest Rate
Hence:
r−p
r= .
1+ p

For low inflation rates (p  0)

rr-p

(But, for higher inflation rates this

approximation becomes inaccurate.)
Real Interest Rate
 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 I
c2
1+r
slope = − ( 1 + r ) = −
1+ p

m2/p2

0 c1
m1/p1
 Comparative Statics I
c2

Saver

m2/p2

c1
0 m1/p1
 Comparative Statics I
c2 1+r
slope = − ( 1 + r ) = − 1+ p
An increase in the inflation
rate or a decrease in the
interest rate “flattens” the
budget constraint.

m2/p2

0 m1/p1 c1
 Comparative Statics I
c2 If the consumer saves,
then her welfare is
reduced by a lower
interest rate or a higher
inflation rate.

m2/p2

0 c1
m1/p1
 Comparative Statics II
c2

1+r
− (1 + r ) = −
1+ p

m2/p2
Borrower

0 m1/p1 c1
 Comparative Statics II
c2 The consumer borrows.
A fall in the inflation rate
or a rise in the interest
rate “flattens” the
budget constraint.

m2/p2

0 m1/p1 c1
Comparative Statics II
c2
For a borrow, her welfare is
increased by a lower interest
rate or a higher inflation rate.

m2/p2

0 m1/p1 c1
 Valuing Securities
A financial security (證券) 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
$m3 at the end of year 3
What is the most that you should pay
now for this security?
 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:
m 2 / (1 + r ) 2
The PV of $m3 paid 3 years from now is:
m 3 / (1 + r ) 3
The PV of the security is therefore:
2 3
m 1 / (1 + r ) + m 2 / (1 + r ) + m 3 / (1 + r ) .
 Valuing Bonds
A bond (債券) 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?
x x x F
PV = + + + + .
1 + r (1 + r ) 2 (1 + r )T − 1 (1 + r )T
 Valuing Bonds

Suppose you win a lottery. The

prize is $1,000K but it is paid over
10 years in equal installments of
$100K each year.

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/Perpetuities

A consol/perpetuity (永久債券/永續年
金) is a bond which never terminates,
paying $x per period forever.

What is a consol’s present value?

 Valuing Consols

x x x
PV = + ++ +.
1 + r (1 + r ) 2 (1 + r ) t
 Valuing Consols
Solving for PV, which is the sum of
a geometric sequence:
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 .

gives: x
PV = .
r
 Valuing Consols

Example: If r = 0.1 now and forever,

then the most that should be paid now
for a console that provides $1000/year
is:

x $1000
PV = = = $10, 000 .
r 01