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c2 = m2 + (1+r)m1
1:
r)m1
m2 +(1+r)m1 = intercept
(1 + r)c1 + c2 = (1 + r)m1 + m2
o
o
C1 + c2/(1 + r) = m1 + m2/(1+r)
o PV form of constraint (period 1 values)
Adding prices
How does it affect budget constraint?
Endowment (m1,m2) and prices (p1,p2) what intertemporal bundle (c1*,c2*) qill be
chosen?
o Max possible expenditure in period 2:
M2 + (1 + r)m1
o Max possible consumption in period 2:
C2 = [m2 + (1+r)m1]/p2
o Max possible expenditure in period 1:
M1 + m2/(1+r)
o Max possible consumption in period 1:
C1 = [m1 + m2/(1+r)]/p1
C1 units consumes in period 1 spends p1c1 in period 1 leaving m1 p1c1 for period 2
o Available income in period 2:
m2 + (1+r)(m1-p1c1)
p2c2 = m2 + (1+r)(m1-p1c1)
o Rearranged:
(1+r)p1c1= (1+r)m1 + m2 FV form of budget constraint
p1c1 + [p2/(1+r)]c2 = m1 + m2(1+r) PV
Future Value Budget Constraint
Price
Inflation
Inflation rate p1(1 + ) = p2
P1 = 1 p2 = 1 +
can rewrite budget constraint
p1c1 + [p2/(1+r)]c2 = m1 + m2(1+r)
to
c1 + [(1+)/(1+r)]c2 = m1 + m2/(1+r)
rearrange
Comparative Statics
slope of budget constraint
-(1+p) = - (1+r)/(1+)
constraint becomes flatter if:
o interest rate r falls
o inflation rate rises
both decreased the real rate of interest p
p = (r )/(1 + )
Life-Cycle Model
Budget Line
Co = consumption in period o
Mo = income in period o
i interet rate
right side of equiation FV of income stream
left side FV of consumption bundle
slope = -(1+i) = opp cost
Co(1 + i) + C1 = Mo(1 + i) + M1 FV
Co + C1/(1+i) = Mo + M1/(1+i) PV
Co = Mo, C1 = M1 endowment
As i increases budet line pivots on endowment