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The Fisher Model
z Model of intertemporal choice involving

FINANCE THEORY consumption and investment decisions.
(Named after Irving Fisher)
z Key Assumptions:
THE FISHER MODEL » Two periods (generalizing to many future
periods is straightforward).
» Perfect capital markets
» the absence of uncertainty
© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot
ECON 422:Fisher 1 ECON 422:Fisher 2
I. Intertemporal Exchange
Model: Outline Objects of choice
z What is the consumer choosing?
A. Objects of choice, endowments and z One of the many possible “Consumption
trade opportunities, preferences Streams”
B. Individual optima and comparative z A consumption stream is a sequence of time
statics dated consumption, for the present and and
for the future. e.g. (C0,C1)
C. Market exchange equilibrium and the
» C0 is the standard of living or consumption level
determination of interest rates. for period 0 (the present)
» C1 is the standard of living or consumption level
for period 1 (the future)
1
Representing a Consumption Consumer Preferences:
Stream 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 Consumers choose the most preferred
consumption stream among those attainable.

Ways to Represent
Consumer Preferences Utility Function, U(C0,C1)
z The utility function gives an index value for
a. Simple ranking of consumption choices each consumption stream.
b. Indifference curves z The utility function value ranks consumption
» downward sloping, non intersecting, and streams
convex shape. z The marginal rate of substitution, MRS, gives:
c. Utility function, U(C0,C1) » 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.)
» MRS= - U0/U1 where Ui is the marginal utility of
consumption in the ith period.
2
Example: Preferences Characteristics of preferences
z Sketch indifference curves for a person who has a z Present oriented

high MRS (when measured at points of equal present
and future consumption) and for a person who has a z Future oriented
low MRS (at points of equal consumption through
z High degree of substitutability
time).
z Sketch indifference curves for someone with a high z Low degree of substitutability
but not perfect degree of substitutability between
present and future consumption and for someone
with low substitutability. (again measured at points of
equal consumption through time.)

From utility function to MRS

From utility function to MRS (continued)
z Utility function or index U=U(C0,C1)

z When C0 and C1 change, the change in utility
is the sum of the changes in C0 and C1, each
z Marginal utility tells us the rate at which utility
changes when we change C0, holding C1 fixed. multiplied by their marginal utilities
z U0=ΔU/ΔC0 (holding C1 fixed)
dU = U 0dC0 + U1dC1
But for changes along a given
∂U
U0 = the partial derivative of U with respect to C0 indifference curve, dU = 0
∂ C0
The partial derivative holds constant other variables. dC1 U
Solve to get = − 0 = MRS
© R.W.Parks/E. Zivot
dC0 U1
3
Consumer opportunities: Consumer’s Endowment:
Endowments Interpretation
z Consumer’s endowment is a claim to z The endowment might represent income that

goods and services in the present and is expected in each of the two periods, from
in the future. wages, from a pension trust, etc.
z The consumer can always choose a
z (Y0,Y1) represents the consumer’s
consumption stream equal to the endowment,
endowment but there may be other opportunities as well.
» Yi is the endowment in the ith period. e.g.through storage or by borrowing or
lending.

Consumer Endowments Storage

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

4
Consumer’s Budget
Market Exchange: Borrowing
Constraint: Lending
or Lending
z The consumer can borrow or lend z If the consumer does not consume the
consumption claims between periods entire present endowment, he or she
z Must be consistent with the endowment, i.e. can lend the amount (Y0 - C0) = S0.
you can’t borrow more than you can repay.
z This loan will be repaid with interest r
No uncertainty, lender knows your capacity.
z The real interest rate = r. z Future consumption will be
z What consumption streams are possible? C1 = Y1 + (1+r)(Y0 - C0).

Consumer’s Budget Consumer’s Budget

Constraint: Borrowing Constraint
z C1 = Y1 + (1+r)(Y0 - C0)
z To consume more than the present » Covers both lending and borrowing
endowment the consumer must borrow because (Y0 - C0) changes sign.
(C0 - Y0). z Rewrite as:
z The loan must be repaid with interest
C1 = (1+r)Y0 + Y1 - (1+r) C0 or as
z Future consumption will be
C1 Y1
C1 = Y1 - (1+r)(C0 - Y0). C0 + = Y0 + =W
z Changing signs: C1 = Y1 + (1+r)(Y0 - C0) (1 + r ) (1 + r )

5
Budget Constraint and
Wealth Wealth
Budget Constraint:
C1
C1=(1+r)Yo+Y1-(1+r)Co
z What is the maximum present
consumption that can be obtained with Wealth:
W=Yo + Y1/(1+r)
a given endowment, when we leave no
resources for the future?
. (Yo,Y1)
z Set the C1 variable to zero in the budget
constraint and solve for C0:
C0 = Y0 + Y1/(1+r) = W
0 W Co

Budget Constraint and Wealth Class Exercise
z Person has endowment

z Consumers can attain (choose) any » (y0,y1)=(10000,11000)
point on or inside the budget line. z Real interest rate is r=.10
z The line goes through the endowment z Find the person’s wealth
point (Y0,Y1) ,has slope -(1+r). z Find the future value of the endowment
z The horizontal intercept gives the z Write an equation for the budget
consumer's wealth, W. constraint. Sketch it, i.e. indicate slope,
intercepts.
6
The Consumer Optimum Characteristics of the optimum
C1
z The optimum consumption stream

C*
(C0*,C1*) must satisfy
C1*
E
y1
1. the budget constraint
0 C0* y0
C0
C0+C1/(1+r)=W
z This person saves S0=y0-C0* and lends it or C1=(1+r)y0+y1-(1+r)C0 and
z Repayment with interest is C1*-y1

2. slope of IC = MRS = -U0/U1 = -(1+r) = slope of BC
z y1+(C1*-y1)=C1* the person’s future
consumption © R.W.Parks/E. Zivot © R.W.Parks/E. Zivot
Mathematical Example
U=U(C0,C1) The solution:
U = C00.5C10.5 (a specific utility function) C1 = C0 (1 + r ) from 2)
U0 C
MRS = − =− 1 Substitute into 1):
U1 C0
C (1 + r )
1)C0 +
C1
= W = Y0 + 1
Y C0 + 0 =W
1+ r 1+ r 1+ r
C
2) MRS = − 1 = −(1 + r ) = slope of B.C. 2C0 = W
C0
1 1
Solve for C0 ,C1 in terms of r,W (or r, Y0 , and Y1 )
C0* = W C1* = W (1 + r )
2 2
7
See example Spreadsheet Formal Optimization Problem
econ422Utility.xls on class notes
page for numerical example m ax U ( C 0 , C 1 ) su b ject to
C 0 ,C 1
using Excel
C1 Y1
C0 + = Y0 +
1+ r 1+ r

Solution Using Lagrange Solution Using Lagrange Multipliers

Multipliers Step 3: Maximize Lagrangian function
Step 1: Put constraint in homogeneous form
max L(C0 , C1 , λ )
C0 ,C1 ,λ
C1 C1
C0 + = W ⇒ C0 + −W = 0 First order conditions
(1 + r ) (1 + r )
∂ L (C 0 , C 1, λ )
= 0
Step 2: Form the Lagrangian function ∂C 0
∂ L (C 0 , C 1, λ )
⎡ C ⎤ = 0
L(C0 , C1 , λ ) = U (C0 , C1 ) + λ ⎢C0 + 1 − W ⎥ ∂C1
⎣ 1+ r ⎦
∂ L (C 0 , C 1, λ )
= 0
∂λ
8
Comparative Statics for
Borrowers vs. Lenders the Fisher Exchange Model
z Individuals with strong preferences z What happens to the consumer optimum

toward future consumption will be when the constraint changes?
lenders » Start with an original optimum
z Individuals with strong preferences
» Change something
toward current consumption will be » Find the new optimum
borrowers » Compare it with the original
z In this model we can change:
(a)The endowment or (b)the interest rate
Effect of a Wealth Change Comparative Statics:

with Fixed r Increase in Interest Rate r for a Lender
C1
C1 Bc
If the change from B1 to B2 is
B2 done in two steps, first from B1 to
Bc, then from Bc to B2, we see
B B1 that the new optimal
consumption must be above and
A to the right of Cc.
Cc The new consumption stream
must have more C1 than
originally, but C0 may either
C* increase or decrease.
0 W1 W2 C0 C1*
z With wealth W1, the optimum is at A

E
y1
z When the wealth increases to W2, the new optimum
is at B
0 C0* y0
z If both goods are “normal,” B must be above and to C0
the right of A.
9
Comparative Statics: Summary of Comparative Statics Results:
Increase in Interest Rate r for a Borrower Changes in the interest rate r
Results for a lender:

Variable: W C0 C1 S0 U
rA B ? A ? A
rB A ? B ? B
Results for a borrower:

Variable: W C0 C1 S0 U
rA B B ? A B
rB A A ? B A

The Market Equilibrium The Market Real Interest Rate

Interest Rate Market Borrowing & Lending Equilibrium
Aggregating over the various

consumers in the economy L
z Lenders need borrowers and vice versa provides us with the
Aggregate
z Market clearing means that there is a Supply (Lending) curve and
Aggregate Demand
match between the amount lenders (Borrowing)
want to lend with the amount borrowers curve.
r
want to borrow The intersection of these two B
curves illustrates the market
z If dissaving is just negative saving, the clearing real rate of interest r.
market clearing means that aggregate C0

saving is zero
10
Determinants of the Level of
Real Interest Rates II. Intertemporal Production
(Real Investment) and
z Societal Preferences Exchange: Outline
» The more present oriented are societal
preferences, the higher the market r A. Individual optima
– Shifts borrowing curve out
z Societal Endowments B. The Fisher Separation Theorem
» The more present oriented are societal C. Market equilibrium
endowments, the lower the market r D. Applications and examples
z Productive Opportunities [see later]
An Intertemporal Production Function Shows From Production Function to

the Relationship Between Inputs Today and
Outputs in the Future Fisher Diagram
I
Output z Reverse the production function around
the vertical axis
Q1
z Drag the origin to the endowment point
Q0
of the Fisher diagram
0 Io I1 Input
11
Production Function to Fisher Consumer-Investor Optimum
Diagram With No Financial Market
Production Function Reversed
Output
Output
Opt. R is on the transf curve
C1
and MRS=MRT
R
0 Inputs Inputs 0
C1
0 C0
Endowment point
0 Co
Investor Optimum with Consumer- Investor Optimum

Financial Market with Financial Market
Points A, B, Q, and D are attainable by Higher wealth means higher utility

C1 investing different amounts today. C1
D D Wq is the highest attainable wealth
Draw wealth lines through each point
C* is the consumer optimum
with slope -(1+r).
Which choice gives the
Q* Q*
largest wealth value?
C*
B B
A A
0 E C0 Wd Wa Wb Wq 0 E C0 Wd Wa Wb Wq

12
The Fisher Separation The Fisher Separation
Theorem Theorem (continued)
z The consumer - investor’s two-fold problem of z The choice of optimal investment can be
determining the optimal level of investment separated from the choice of optimal
and the optimal consumption stream can be consumption. i.e it does not depend on
separated into two steps: investor preferences.
» First choose the investment level that z A necessary condition for utility maximization
maximizes wealth. This choice does not is wealth maximization.
depend on preferences. z Note: The separation result depends on the
» Next determine the optimum consumption existence of a perfect capital market.
stream, based on the maximized wealth. Investors can borrow or lend at the market
rate r. © R.W.Parks/E. Zivot
Markets Resolve Differences in Markets Resolve Differences in

Preferences:Partners and Corporations Preferences:Partners and Corporations
C1
With financial markets, A and B
C1 With no financial markets, A and B can agree on the optimal
are in conflict over the optimal investment level for the firm at Qj.
investment level. b
After joint wealth is divided
b A wants the company to be at a.
UB A and B can each choose
UB B wants the company to be at b. Qj
Cb
their best consumption
streams.
Qb a
Qb a
Qa Qa Ca
P P
P/2 UA P/2 UA
0 0
Ejoint C0 Wmax/2 Ejoint Wj max C0

13
Determinants of the Level of
Development or venture capital Real Interest Rates Revisited
z Endowment (0,0).
z Knowledge about a productive opportunity.(see below) z Societal Preferences
z Access to capital market at rate r. » The more present oriented are societal preferences, the
z Apply the two period Fisher analysis and find the optimal higher the market r
consumption and optimal investment. – Shifts Borrowing curve out
Output in
future z Societal Endowments
» The more present oriented are societal endowments, the
lower the market r
– Shifts lending curve out
z Productive Opportunities
» The more productive are the opportunities for converting
present into future resources through real investment (i.e.
0
Investment today production), the higher the market r.
Real versus Nominal Relationship b/w Nominal & Real Interest

Interest Rates Rates
Recall from Fisher Model:

MRS = ΔC1/ΔC0 = (1+r), r = real interest rate
z Fisher model uses real interest
rates. Multiplying thru by nominal price ratio P1/P0:
ΔC1/ΔC0*(P1/P0) = (1+r)*(P1/P0) = (1 + rn)
z Real interest rates indicate the rate
at which goods at one date P1 = (P0 + Δ P0) therefore: P1/P0 = (P0 + Δ P0)/P0 = 1 + inflation rate = 1 + Π
exchange for goods at another.
ΔC1/ΔC0*(P1/P0) = (1 + rn)= (1+r)*(1 + Π) Fisher Equation
z Nominal interest rates refer to the (1 + rn)= 1+r +r* Π+ Π ≈ 1+r + Π
rate at which dollars at one date
exchange for dollars at another rn ≈ r + Π
The nominal interest rate is approximately equal to the real interest rate plus the rate of
inflation
14
Global Comparison of Inflation Rates
Global Comparison of Nominal Interest Rates
(% change on year ago)
Country ST Interest Rates Country ST Interest Rates Country Consumer Price Country Consumer Price
(% p.a.) (% p.a.) Change Change
Australia 5.58% Taiwan 1.10% Australia 2.4% Taiwan 0.6%
Britain 4.13% Thailand 1..34% Britain 1.3% Thailand 2.2%
Canada 2.27% Argentina 4.94% Canada 1.2% Argentina 2.3%
Denmark 2.15% Brazil 16.30% Denmark 0.9% Brazil 6.7%
Japan 0.03% Chile 1.68% Japan -0.3% Chile 0.8%
Sweden 2.51% Columbia 7.99% Sweden 0.8% Columbia 6.3%
Switzerland 0.24% Mexico 7.56% Switzerland 0.1% Mexico 4.2%
United 1.02% Peru 2.55% United 1.7% Peru 3.4%
States States
Germany 2.09% Venezuela N/A Germany 0.9% Venezuela 21.9%
China N/A Egypt 6.89% China 2.1% Egypt 5.5%
Hong Kong 0.13% Israel 1.26% Hong Kong -1.5% Israel -2.5%
India 4.24% South Africa 8.10% India 4.3% South Africa 0.2%
Indonesia 8.18% Turkey 23.0% Indonesia 4.6% Turkey 14.3%
Malaysia 3.03% Czech Republic 2.07% Malaysia 0.9% Czech Republic 2.3%
Philippines 7.63% Hungary 12.68% Philippines 3.4% Hungary 7.1%
Singapore 0.75% Poland 5.47% Singapore 1.3% Poland 1.6%
South Korea 4.18% Russia 14.0% South Korea 3.3% Russia 10.8%
ECON
Source: 422:Fisher
The Economist, February 2004 57 ECON
Source: 422:Fisher
The Economist, February 2004 58
15

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The Fisher Model

z Model of intertemporal choice involving

z Consumers are able to choose between

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

z Sketch indifference curves for a person who has a z Present oriented

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

From utility function to MRS

z Utility function or index U=U(C0,C1)

z Consumer’s endowment is a claim to z The endowment might represent income that

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

Consumer Endowments Storage

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

z What consumption streams are possible? C1 = Y1 + (1+r)(Y0 - C0).

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

Consumer’s Budget Consumer’s Budget

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

Budget Constraint and Wealth Class Exercise

z Person has endowment

z The optimum consumption stream

z Repayment with interest is C1*-y1

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

Solution Using Lagrange Solution Using Lagrange Multipliers

z Individuals with strong preferences z What happens to the consumer optimum

Effect of a Wealth Change Comparative Statics:

z With wealth W1, the optimum is at A

Results for a lender:

Results for a borrower:

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

The Market Equilibrium The Market Real Interest Rate

Aggregating over the various

market clearing means that aggregate C0

An Intertemporal Production Function Shows From Production Function to

Investor Optimum with Consumer- Investor Optimum

Points A, B, Q, and D are attainable by Higher wealth means higher utility

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

Markets Resolve Differences in Markets Resolve Differences in

© R.W.Parks/E. Zivot © R.W.Parks/E. Zivot

Real versus Nominal Relationship b/w Nominal & Real Interest

Recall from Fisher Model:

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