Intertemporal choice: Imagine a consumer lives for two periods. In the first per

Question

Intertemporal choice: Imagine a consumer lives for two periods. In the first period she receives M1 and in the second time period she receives M2. Any income that is not consumed in the first period can be saved in a bank account, which pays interest r on each dollar and can be used for consumption in the next period, i.e. you put $1 in the bank you get $1(1 + r) back tomorrow. Also assume, that an individual can borrow money at rate r against future income, i.e. if you want $1 today you have to pay back $1(1 + r) in period 2.

The consumer decides how much of her income to consume in each period. Call consumption in period 1, C1 and consumption in period 2, C2.

Carefully explain how consumption in both periods reacts to changes in the level r and why the direction you have described makes intuitive sense.

Explanation / Answer

This question is a gross over-simplification of reality because it doesn't take into account how prices change over time and how price changes (i.e. inflation/deflation) is tied to the prevelant interest rates. That said, let's answer the actual question. Begin by considering two extreme cases: the first where the interest rate is zero and the other where the interest rate is 100%. In the case where the interest rate is zero, the consumer will borrow against the entirety of their 2nd paycheck and spend it in the first period because there is no incentive not to. Similarly, if the interest rate is 100%, the consumer maximizes their total consumption by saving all their money in the first period (C1=0) and spending it all in the second (C2=2M1+M2) So as r decreases, C1 will increase and as r increases C1 will decrease.

Related Questions

Navigate

• Browse (All)
• Browse I
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.