FINANCE THEORY: Inter-

temporal Consumption-Saving
and Optimal Firm Investment
Decisions
Eric Zivot
Econ 422
Summer 2010
R.W.Parks/E. Zivot
ECON 422:Fisher 1

Reading

z PCBR, Chapter 1 (general overview of

PCBR
financial decision making)
z Varian, Intermediate Microeconomics: A
Modern Approach. Chapter 10,
Intertemporal Choice.
z Hirshleifer and Hirshleifer, Price Theory
and Applications, Chapter 14, The
Economics of Time.
R.W.Parks/E. Zivot
ECON 422:Fisher 2

1
 Goals of this Section

z Understand the economic principles behind

inter-temporal consumption-savings decisions
z Introduce present value concepts
z Understand the roll of financial markets for
the efficient allocation of savings and capital
investment
z Understand what determines the level of
interest rates

R.W.Parks/E. Zivot
ECON 422:Fisher 3

The Fisher Model

z Model of intertemporal choice involving
consumption
ti and d iinvestment
t t decisions.
d i i
(Named after Yale economist Irving
Fisher)
z Key Assumptions:
Two periods (generalizing to many future
periods is straightforward).
Perfect capital markets
the absence of uncertainty
R.W.Parks/E. Zivot
ECON 422:Fisher 4

2
 I. Intertemporal Exchange
Model: Outline

A Objects of choice
A. choice, endowments and
trade opportunities, preferences
B. Individual optima and comparative
statics
C. Market
C a e e exchange
c a ge equ
equilibrium
b u a and
d the
e
determination of interest rates.

R.W.Parks/E. Zivot
ECON 422:Fisher 5

Objects of choice
z What is the consumer choosing?
z One of the many possible Consumption
Streams
z A consumption stream is a sequence of time
dated consumption, for the present and for
the future; e.g. (C0,C1)
C0 is the standard of living or consumption level
for period 0 (the present)
C1 is the standard of living or consumption level
for period 1 (the future)
R.W.Parks/E. Zivot
ECON 422:Fisher 6

3
 Representing a Consumption Stream

R.W.Parks/E. Zivot
ECON 422:Fisher 7

Consumer Preferences:
Basic Assumptions

z Consumers are able to choose between

alternative consumption streams.
z Choices are consistent (transitive)
z They prefer more consumption to less; i.e.,
they prefer higher standards of living to lower.
z C
Consumers choose
h th
the mostt preferred
f d
consumption stream among those attainable.

R.W.Parks/E. Zivot
ECON 422:Fisher 8

4
 Ways to Represent
Consumer Preferences

z Simple ranking of consumption choices

z Utility function, U(C0, C1)
z Indifference curves: level sets of utility
function
Combinations of C0 and C1 such that utility
is constant (doesnt change)
downward sloping, non intersecting, and
convex shape
R.W.Parks/E. Zivot
ECON 422:Fisher 9

Utility Function, U(C0,C1)

z The utility function gives an index value for
eachh consumptionti stream.
t
z The utility function value ranks consumption
streams
z The marginal rate of substitution, MRS, gives:
slope of an indifference curve at a point.
the rate at which a consumer is willing to exchange
future consumption for present consumption, (while
maintaining the same level of satisfaction.)

R.W.Parks/E. Zivot
ECON 422:Fisher 10

5
 Characteristics of preferences over
consumption streams

z Present oriented
z Future oriented
z High degree of substitutability
z Low degree of substitutability

R.W.Parks/E. Zivot
ECON 422:Fisher 11

Examples of Utility Functions

U (C0 , C1 ) = C01/ 2C11/ 2

U (C0 , C1 ) = C02 / 3C11/ 3
U (C0 , C1 ) = C01/ 3C12 / 3

R.W.Parks/E. Zivot
ECON 422:Fisher 12

6
 From utility function to MRS
z Utility function or index U=U(C0,C1)
z M i l utility
Marginal tilit ttells
ll us th
the rate
t att which
hi h utility
tilit
changes when we change C0, holding C1
fixed or when we change C1, holding C0 fixed.
z U0=U/C0 = partial derivative (derivative
holding C1 fixed) of U with respect to C0
z U1=U/C
U/C1 = partialti l d
derivative
i ti (d (derivative
i ti
holding C0 fixed) of U with respect to C1

R.W.Parks/E. Zivot
ECON 422:Fisher 13

From utility function to MRS

z Total derivative of utility function:

dU = U 0 dC0 + U1dC1
z For changes along a given IC, utility stays
constant (dU = 0):

0 = U 0 dC0 + U1dC1
z Solve for slope dC1/dC0:
d C1 U
= 0 = MRS
dC0 U1
R.W.Parks/E. Zivot
ECON 422:Fisher 14

7
 Consumer Endowments
z Consumers endowment is a claim to
goods and services in the present and
in the future.
z (Y0,Y1) represents the consumers
endowment
Yi is the endowment in the ith p
period.

R.W.Parks/E. Zivot
ECON 422:Fisher 15

Consumers Endowment:
Interpretation

z The endowment might represent income that

is expected in each of the two periods, from
wages, from a pension trust, etc.
z The consumer can always choose a
consumption stream equal to the endowment,
but there may be other opportunities as well;
e.g., through storage or by borrowing or
lending.

R.W.Parks/E. Zivot
ECON 422:Fisher 16

8
 Consumer Endowments

R.W.Parks/E. Zivot
ECON 422:Fisher 17

Storage
Some of the present endowment is saved and stored
for consumption in the next period.

R.W.Parks/E. Zivot
ECON 422:Fisher 18

9
 Market Exchange: Borrowing
or Lending
z The consumer can borrow or lend
consumption claims between periods
z Must be consistent with the endowment, i.e.
you cant borrow more than you can repay.
No uncertainty, lender knows your capacity.
z The real interest rate = r; e.g.,
e g r = 0.10
0 10 or 10%
z What consumption streams are possible?

R.W.Parks/E. Zivot
ECON 422:Fisher 19

Consumers Budget
Constraint: Lending

z If the consumer does not consume the

entire present endowment, he or she
can lend the amount (Y0 - C0) = S0.
z This loan will be repaid with interest r
z Future
u u e co
consumption
su p o will be
C1 = Y1 + (1+r)(Y0 - C0).

R.W.Parks/E. Zivot
ECON 422:Fisher 20

10
 Consumers Budget
Constraint: Borrowing

z To consume more than the present

endowment the consumer must borrow
(C0 - Y0).
z The loan must be repaid with interest
z Future
u u e co
consumption
su p o will be
C1 = Y1 - (1+r)(C0 - Y0).
z Changing signs: C1 = Y1 + (1+r)(Y0 - C0)

R.W.Parks/E. Zivot
ECON 422:Fisher 21

Consumers Budget Constraint

z C1 = Y1 + (1+r)(Y0 - C0)
Covers both lending and borrowing
because (Y0 - C0) changes sign.
z Rewrite as:
C1 = (1+r)Y0 + Y1 - (1+r) C0 or as
C1 Y
C0 + = Y0 + 1
1+ r 1+ r

R.W.Parks/E. Zivot
ECON 422:Fisher 22

11
 Wealth
z What is the maximum present
consumption
ti th
thatt can b
be obtained
bt i d with
ith
a given endowment, when we leave no
resources for the future?
z Set the C1 variable to zero in the budget
constraint and solve for C0:
C0 = Y0 + Y1/(1+r) = W

R.W.Parks/E. Zivot
ECON 422:Fisher 23

Interpreting the Budget Constraint

C1 Y
C0 + = Y0 + 1 = W
1+ r 1+ r
Let C0 denote consumption today in todays $
=> P0,0 = 1
Define P0,1 = 1/(1 + r) = price today of $1 to be
received in period 1 = present value of $1
Re-interpretation of budget constraint in terms
of present value:

P0,0C0 + P0,1C1 = P0,0Y0 + P0,1Y1 = W

R.W.Parks/E. Zivot
ECON 422:Fisher 24

12
 Budget Constraint and Wealth

R.W.Parks/E. Zivot
ECON 422:Fisher 25

Budget Constraint and Wealth

z Consumers can attain (choose) any

point on or inside the budget line.
z The line goes through the endowment
point (Y0,Y1) ,has slope -(1+r).
z The
e horizontal
o o a intercept
e cep ggives
es the
e
consumer's wealth, W.

R.W.Parks/E. Zivot
ECON 422:Fisher 26

13
 Class Exercise
z Person has endowment
(y0,y
y1)=(10,000,11,000)
)=(10 000 11 000)
z Real interest rate is r=.10
z Find the persons wealth
z Find the future value of the endowment
z Write an equation for the budget
constraint. Sketch it, i.e. indicate slope,
intercepts.

R.W.Parks/E. Zivot
ECON 422:Fisher 27

The Consumer Optimum: Maximize Utility

s.t. Intertemporal Budget Constraint
C1

C*
C1*

E
y1

0 C0* y0
C0

z This person saves S0 = Y0 - C0* and lends it

z Repayment with interest is (Y0 C0*)(1+r)
z Y1 + (Y0 C0*)(1+r) = C1* the persons future
consumption R.W.Parks/E. Zivot
ECON 422:Fisher 28

14
 Characteristics of the optimum
z The optimum consumption stream
(C0*,C
* C1*) must satisfy:
z The budget constraint C0 + C1/(1+r) = W
or C1 = (1+r)y0 + y1 - (1+r)C0
z Slope of IC = MRS = -U0/U1 =
-(1+r) = slope of BC

R.W.Parks/E. Zivot
ECON 422:Fisher 29

Example
U = C00.5C10.5 (a specific utility function)
U0 C
MRS = = 1
U1 C0
C1 Y
(1) C0 + = W = Y0 + 1
1+ r 1+ r
C
(2) MRS = 1 = (1 + r ) = slope of B.C.
C0
Solve for C0 ,C1 in terms of r,W (or r, Y0 , and Y1 )
R.W.Parks/E. Zivot
ECON 422:Fisher 30

15
 The solution:
C1 = C0 (1 + r ) from (2)
Substitute into (1):
C0 (1 + r )
C0 + =W
1+ r
2C0 = W
1 1
C0* = W C1* = W (1 + r )
2 2
R.W.Parks/E. Zivot
ECON 422:Fisher 31

See example Spreadsheet

econ422Utility.xls on class notes
page for numerical example
using Excel

R.W.Parks/E. Zivot
ECON 422:Fisher 32

16
 Formal Optimization Problem

m ax U ( C 0 , C 1 ) su b ject to
C 0 , C1

C1 Y1
C0 + = Y0 + =W
1+ r 1+ r

R.W.Parks/E. Zivot
ECON 422:Fisher 33

Solution Using Lagrange

Multipliers
Step 1: Put constraint in homogeneous form

C1 C1
C0 + = W C0 + W = 0
(1 + r ) (1 + r )

Step 2: Form the Lagrangian function

C
L(C0 , C1 , ) = U (C0 , C1 ) + C0 + 1 W
1+ r

R.W.Parks/E. Zivot
ECON 422:Fisher 34

17
 Solution Using Lagrange Multipliers
Step 3: Maximize Lagrangian function
C
L(C0 , C1 , ) = U (C0 , C1 ) + C0 + 1 W
1+ r
First order conditions
L(C0 , C1 , )
= U0 + = 0
C0
L(C0 , C1 , )
= U1 + =0
C1 1+ r
L(C0 , C1 , ) C
= C0 + 1 W = 0
1+ r
R.W.Parks/E. Zivot
ECON 422:Fisher 35

Use first to conditions to solve for :

U 0 =
U1 (1 + r ) =
U0
= (1 + r )
U1

Hence, solving optimization problem gives solution

Hence
that MRS = slope of budget constraint and that the
budget constraint is satisfied.

R.W.Parks/E. Zivot
ECON 422:Fisher 36

18
 Numerical Solution: Excel Solver

z Lagrangian maximization problem can

be solved numerically using the Excel
solver add-in
z See econ422Utility.xls for example

R.W.Parks/E. Zivot
ECON 422:Fisher 37

Borrowers vs. Lenders

z Individuals with strong preferences

toward future consumption and/or those
with high initial endowments will be
lenders
z Individuals with strong preferences
toward current consumption and/or
those with high future endowments will
be borrowers
R.W.Parks/E. Zivot
ECON 422:Fisher 38

19
 Comparative Statics for
the Fisher Exchange Model

z What happens to the consumer optimum

when the constraint changes?
Start with an original optimum
Change something
Find the new optimum
Compare it with the original
z In this model we can change:
(a)The endowment or (b) the interest rate
R.W.Parks/E. Zivot
ECON 422:Fisher 39

Effect of a Wealth Change with Fixed r

C1

0 W1 W2 C0

z With wealth W1, the optimum is at A

z When the wealth increases to W2, the new optimum
is at B
z If both goods are normal, B must be above and to
the right of A.
R.W.Parks/E. Zivot
ECON 422:Fisher 40

20
 Comparative statics: Increase in r for a lender

R.W.Parks/E. Zivot
ECON 422:Fisher 41

Comparative statics: Increase in r for a lender

R.W.Parks/E. Zivot
ECON 422:Fisher 42

21
 Comparative statics: Increase in r for a lender

R.W.Parks/E. Zivot
ECON 422:Fisher 43

Summary of Comparative Statics Results:

Changes in the interest rate r

Results for a lender

Variable W C0 C1 S0 U
r ? ?

r ? ?
Results for a borrower
r ?

r ?

R.W.Parks/E. Zivot
ECON 422:Fisher 44

22
 The Market Equilibrium
Interest Rate

z Lenders need borrowers and vice versa

z Market clearing means that there is a
match between the amount lenders
want to lend with the amount borrowers
want to borrow
z If dissaving is just negative saving, then
market clearing means that aggregate
saving is zero
R.W.Parks/E. Zivot
ECON 422:Fisher 45

The Market Real Interest Rate

Market Borrowing & Lending Equilibrium

Aggregating over the various

consumers in the economy L
provides us with the
Aggregate
Supply (Lending) curve and
Aggregate Demand
(Borrowing)
curve.
r
The intersection of these two B
curves illustrates the market
clearing real rate of interest r.

S0

R.W.Parks/E. Zivot
ECON 422:Fisher 46

23
 Example

z 2 individuals A and B with utility

U(C0,C1)=(C0C1)1/2
z Endowments: A = (240,160); B = (320,
440)
z Determine
ee e equ
equilibrium
b u interest
e es rateaer
such that aggregate saving is zero

R.W.Parks/E. Zivot
ECON 422:Fisher 47

Determinants of the Level of

Real Interest Rates

z Societal Preferences
The more present oriented are societal
preferences, the higher the market r
Shifts borrowing curve out
z Societal Endowments
The more present oriented are societal
endowments the lower the market r
endowments,
Shifts lending curve out

z Productive Opportunities [see later]

R.W.Parks/E. Zivot
ECON 422:Fisher 48

24