Flashcards in A Theory of Intertemporal Choice Deck (28):
What is an IBC?
Intertemporal budget constraint
What's the IBC for year one?
C1 = W1 + Y1d - S1
What's the IBC for year two?
C2 = Y1d + (1 + r) S1
How can we combine IBC for year 1 and two to get C2?
C2 = (1 + r) (W1 + Y1d - C1) + Y2d
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.
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.
What does C1 + C2/(1+r) denote?
The present-value of lifetime consumption.
What does W1 + Y1d + Y2d/(1+r) denote?
The present-value of lifetime wealth and income, or "lifetime resources".
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.
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)
What does the slope of an intertemporal indifference curve represent?
The intertemporal MRS between consumption at each period.
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.
When is the MRS high?
When C1/C2 is small.
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.
When is the MRS low?
When C1/C2 is large.
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.
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)
What is MRS at the optimal level?
MRS = -(1 + r)
What is one purpose of the intertemporal choice model?
To help us understand how consumers decide on their consumption and saving levels.
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.
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.
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.
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).
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.
What is the increase in period 1 opportunity cost due to increased interest rates called?
The substitution effect.
What are the two opposite effects of an increase in interest rates?
Is the substitution or wealth effect stronger?
It depends on the consumer's indifference curve.