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Varian Chapter10 Intertemporal Choice PDF
Varian Chapter10 Intertemporal Choice PDF
1
Future Value Present Value
• Suppose you can pay now to obtain $1
• Given an interest rate r the future value at the start of next period.
one period from now of $1 is • What is the most you should pay?
FV = 1 + r . • $1?
• No. If you kept your $1 now and saved
• Given an interest rate r the future value
it then at the start of next period you
one period from now of $m is
would have $(1+r) > $1, so paying $1
FV = m( 1 + r ). now for $1 next period is a bad deal.
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The Intertemporal Choice
Present Value
• E.g., if r = 0.1 then the most you should
Problem
pay now for $1 available next period is • Let m1 and m2 be incomes received in
periods 1 and 2.
1
PV = = $0 ⋅ 91. • Let c1 and c2 be consumptions in periods 1
1+ 0⋅1 and 2.
• And if r = 0.2 then the most you should
pay now for $1 available next period is • Let p1 and p2 be the prices of consumption
in periods 1 and 2.
1
PV = = $0 ⋅ 83.
1+ 0⋅ 2
3
The Intertemporal Budget The Intertemporal Budget
Constraint c2 Constraint
• Suppose that the consumer chooses not So (c1, c2) = (m1, m2) is the
to save or to borrow. consumption bundle if the
consumer chooses neither to
• Q: What will be consumed in period 1?
save nor to borrow.
• A: c1 = m1.
• Q: What will be consumed in period 2? m2
• A: c2 = m2.
0 c1
0 m1
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The Intertemporal Budget The Intertemporal Budget
Constraint Constraint
c2
the future-value of the income
c2 ( c1 , c 2 ) = ( 0 , m 2 + ( 1 + r )m1 )
m2 + m2 +
endowment is the consumption bundle when all
( 1 + r )m1 ( 1 + r )m1 period 1 income is saved.
m2 m2
0 c1 0 c1
0 m1 0 m1
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The Intertemporal Budget The Intertemporal Budget
Constraint Constraint
c2 ( c1 , c 2 ) = ( 0 , m 2 + ( 1 + r )m1 ) c2 ( c1 , c 2 ) = ( 0 , m 2 + ( 1 + r )m1 )
m2 ++ m2 +
is the consumption bundle when all is the consumption bundle when
( 1 + r )m1 period 1 income is saved. ( 1 + r )m1 period 1 saving is as large as possible.
m
( c1 , c 2 ) = m1 + 2 ,0
the present-value of
1+r
m2 m2 is the consumption bundle
the income endowment
when period 1 borrowing
is as big as possible.
0 0
0 m1 m 2 c1 0 m1 m 2 c1
m1 + m1 +
1+ r 1+ r
0
slope intercept m1 +
1+ r
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The Intertemporal Budget The Intertemporal Budget
c2 Constraint Constraint
c 2 = − ( 1 + r ) c 1 + m 2 + ( 1 + r )m1 . ( 1 + r ) c 1 + c 2 = ( 1 + r )m1 + m 2
m2 +
(1 + r)m1 slope = -(1+r) is the “future-valued” form of the budget
Sa
vi constraint since all terms are in period 2
n g values. This is equivalent to
c2 m2
Bo c1 + = m1 +
m2 rro 1+r 1+r
w which is the “present-valued” form of the
in
g constraint since all terms are in period 1
0
0 m1 m 2 c1 values.
m1 +
1+ r
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Intertemporal Choice Intertemporal Choice
• Similarly, maximum possible expenditure • Finally, if c1 units are consumed in period
in period 1 is 1 then the consumer spends p1c1 in period
m 1, leaving m1 - p1c1 saved for period 1.
m1 + 2
1+r Available income in period 2 will then be
so maximum possible consumption in
period 1 is so m2 + ( 1 + r )( m1 − p1c1 )
m + m 2 / (1 + r )
c1 = 1 . p 2c 2 = m 2 + ( 1 + r )( m1 − p1c 1 ).
p1
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Price Inflation Price Inflation
• Define the inflation rate by π where • We lose nothing by setting p1=1 so that
p2 = 1+ π .
p1 ( 1 + π ) = p 2 .
• Then we can rewrite the budget constraint
• For example,
π = 0.2 means 20% inflation, and p 1c 1 +
p2
c 2 = m1 +
m2
1+r 1+r
π = 1.0 means 100% inflation. as
1+π m2
c1 + c 2 = m1 +
1+r 1+r
9
Real Interest Rate Real Interest Rate
1+r
− (1 + ρ ) = − r 0.30 0.30 0.30 0.30 0.30
1+π
gives
r−π π
ρ= . 0.0 0.05 0.10 0.20 1.00
1+ π
For low inflation rates (π ≈ 0), ρ ≈ r - π . r - π 0.30 0.25 0.20 0.10 -0.70
For higher inflation rates this
approximation becomes poor.
ρ 0.30 0.24 0.18 0.08 -0.35
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Comparative Statics Comparative Statics
c2 1+r c2 1+r
slope = − ( 1 + ρ ) = − slope = − ( 1 + ρ ) = −
1+π 1+π
The consumer borrows. A If the consumer borrows then
fall in the inflation rate or borrowing and welfare are
a rise in the interest rate increased by a lower
“flattens” the interest rate or a
m2/p2 budget constraint. m2/p2 higher inflation
rate.
0 c1 0 c1
0 m1/p1 0 m1/p1
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Valuing Securities Valuing Bonds
• The PV of $m1 paid 1 year from now is
m1 / ( 1 + r ) • A bond is a special type of security that
pays a fixed amount $x for T years (its
• The PV of $m2 paid 2 years from now is
maturity date) and then pays its face value
m2 / ( 1 + r ) 2 $F.
• The PV of $m3 paid 3 years from now is
• What is the most that should now be paid
m3 / ( 1 + r ) 3 for such a bond?
• The PV of the security is therefore
m1 / ( 1 + r ) + m2 / ( 1 + r ) 2 + m 3 / ( 1 + r ) 3 .
x x x F
PV = + +Κ + + .
1 + r (1 + r ) 2 T−1
(1 + r ) (1 + r ) T
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Valuing Bonds Valuing Consols
$100,000 $100,000 $100,000 • A consol is a bond which never terminates,
PV = + +Κ +
1 + 0 ⋅ 1 (1 + 0 ⋅ 1) 2
(1 + 0 ⋅ 1)10 paying $x per period forever.
• What is a consol’s present-value?
= $614,457
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Valuing Consols
E.g. if r = 0.1 now and forever then the
most that should be paid now for a
console that provides $1000 per year is
x $1000
PV = = = $10,000.
r 0⋅1
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