Flashcards in A Theory of Intertemporal Choice Deck (28):

1

## What is an IBC?

### Intertemporal budget constraint

2

## What's the IBC for year one?

### C1 = W1 + Y1d - S1

3

## What's the IBC for year two?

### C2 = Y1d + (1 + r) S1

4

## How can we combine IBC for year 1 and two to get C2?

### C2 = (1 + r) (W1 + Y1d - C1) + Y2d

5

## What does promising to pay $(1+r) at period 2 allow one to do today?

### A promise to pay $(1+r) at period 2 allows one to increase consumption by $1 through borrowing and is thus equivalent to receiving $1 today.

6

## What does receiving an extra $1 today allow one to do in period 2?

### Receiving an extra $1 today allows you to increase consumption by $(1+r) tomorrow through saving and is thus the same as a promise to give $(1+r) tomorrow.

7

## What does C1 + C2/(1+r) denote?

### The present-value of lifetime consumption.

8

## What does W1 + Y1d + Y2d/(1+r) denote?

### The present-value of lifetime wealth and income, or "lifetime resources".

9

## What can the IBC be interpreted as with respect to present values?

### The IBC can be interpreted as imposing an equality between the PV of consumption and the PV of lifetime resources.

10

## Which equation expresses the equality between the PV of consumption and the PV of lifetime resources?

### C1 + C2 / (1 + r) = W1 + Y1d + Y2d / (1 + r)

11

## What does the slope of an intertemporal indifference curve represent?

### The intertemporal MRS between consumption at each period.

12

## What does the intertemporal MRS represent?

### How many units of period 2 consumption one is willing to give up in order to increase consumption by one unit at period 1.

13

## When is the MRS high?

###
When C1/C2 is small.

14

## What does a high MRS represent?

### When consumption at period 2 is high in relation to period 1 consumption, one is willing to give up a lot of period 2 consumption in order to increase period 1 consumption by one unit.

15

## When is the MRS low?

### When C1/C2 is large.

16

## What does a low MRS represent?

### When consumption at period 2 is low in relation to period 1 consumption, one is willing to give up only a little of period 2 consumption in order to increase period 1 consumption by one unit.

17

## What's the consumer's optimal choice of consumption and saving?

###
The welfare maximizing choice of consumption levels C1* and C2*.

(Maximization problem where IIC is tangent to IBC)

18

## What is MRS at the optimal level?

### MRS = -(1 + r)

19

## What is one purpose of the intertemporal choice model?

### To help us understand how consumers decide on their consumption and saving levels.

20

## What happens if there is an increase in present income?

### An increase in present income results in an increase in lifetime resources and therefore induces a shift of the budget constraint line to the right.

21

## What is consumption smoothing?

### When an Increase in the income level at one period induces the consumer to increase her consumption levels at both periods.

22

## What's the first consequence of an increase of the interest rate?

### With higher interest rate, savers can increase their consumption levels at both periods through consumption smoothing.

23

## What is consumption smoothing due to increase interest rates called and how does it work?

### The wealth effect of a higher interest rate (analogous to the effect of an increase in period 1 income).

24

## What's the second consequence of an increase of the interest rate?

###
With a higher return to saving, the opportunity cost of consumption at period 1 increases.

This induces consumers to lower present consumption in return for more consumption tomorrow.

25

## What is the increase in period 1 opportunity cost due to increased interest rates called?

### The substitution effect.

26

## What are the two opposite effects of an increase in interest rates?

###
-Substitution effect

-Wealth effect

27

## Is the substitution or wealth effect stronger?

### It depends on the consumer's indifference curve.

28