Intertemporal Choice

Question 1

What is the intertemporal choice?

Answer 1

• People often receive income in ‘lumps’ (monthly salary), how is this spread over periods?
• M1 and M2 denote two periods, where M1 is the income received in the immediate timeframe, and M2 is income that will be received in the future

Question 2

Explain the intertemporal budget constraint

Answer 2

• c1 + c2/(1+r) = m1 + m2/(1+r)
• The present value (x-intercept) is m1 + m2/(1+r)
• The future value (y-intercept) is m2 + m1*(1+r)
• Lenders are on the left of the (m1,m2) point, whilst borrowers are on the right

Question 3

What is the equation for the real interest rate?

Answer 3

• Real IR = i - π / 1 + π

Question 4

What do borrowers/lenders prioritise (c1 Vs m1)?

Answer 4

• Borrowers: c1>m1
• Lenders: c1<m1

Question 5

If IR rise, what happens to lenders and borrowers?

Answer 5

• Lenders are better off, and borrowers are worse off
• Increasing the IR pivots the budget constraints around the endowment to a steeper position
• Consumption bundle lies on a higher indifference curve for lenders and lower I.C. for borrowers
• People will move away from borrowing to lending, from spending to saving

Question 6

Explain the Future value (Y-intercept)

Answer 6

• This is only an estimate
• The future value is the value of the next period of $1 saved
• Given interest rate r, the future value from this $m = m (1+r)

Question 7

Explain the Present value (X-intercept)

Answer 7

• If you could pay $1 for money now, you wouldn’t pay for as (1+r)>1
• You would require a PV of m = 1 / (1+r) as r is inversely related to consumption