Advanced Monetary Theory and Policy

EPOS 2012/13

Inter-temporal consumption choices

Giovanni Di Bartolomeo
giovanni.dibartolomeo@uniroma1.it
 J.M. Keynes vs. I. Fisher
• Keynes: current consumption depends on the current
income
• Fisher: current consumption depends on the present
value of the life income
– time becomes irrelevant as the consumer can borrow
and lend
 Inter-temporal budget constraint
• The world lasts two periods

Consumption PV Income PV

The inter-temporal budget constraint shows the feasible

pair of C1 and C2.
Inter-temporal budget constraint
C2

Savings

Consumption = Income
both periods
Y2
Lending

C1
Y1
Inter-temporal budget constraint
C2

1
The slope of the budget
(1+r ) constraint -(1+r )/1

Y2

C1
Y1
 Inter-temporal preferences
C2
An indifference Higher indifference
curve indicates all curves imply higher
the C1 and C2 satisfaction.
combinations that
make consumer
indifferent among 1 The slope of the
them (equally MRS indifference curve is
the slope of the cure
happy). IC2 in that point (MRS).

IC1
C1
The marginal rate of substitution (MRS ) is the amount of C2
that the consumer may will to reduce to have now a unit more
of consumption, i.e. to increase C1.
 Optimal choice
C2
Omptimum: MRS = 1+r
The optimal basket (C1,C2) is the
highest indifference curve given the
inter-temporal budget constraint.

C1
 Income variations

If normal goods, both

C1 and C2 increase,
C2
… independently of
the if the increase of An increase inY1 or Y2
the income occurs in moves the budget up-
the first or second right.
period.

C1
 Interest rate changes

C2
An increase in r rotates the
budget around (Y1,Y2 ).

Then C1 falls and C2

increases. However, the
effects may be different … B

A
Y2

Y1 C1
 Income and substitution effect
• Income effect: if the consumer is a saver, an increase in r
raises his satisfaction, which tends to increase
consumption in both periods.
• Substitution effect: the increase in r raises the opportunity
cost of current consumption, which tends to reduce C1 and
to increase C2.
• Both effects  C2.
• But C1 increases or falls according to the prevailing effect.
 Borrowing constraints

C2 C2

unconstrained

constrained
Y2 Y2

Y1 C1 Y1 C1
 Borrowing constraints in action

C2 Non binding C2 Binding

E
D

Y1 C1 Y1 C1
 Money trasmissioni mechanism
• Money transmission mechanism:
↑M  ↓i  ↑C  ↑Y
• We can derive a sort of IS in terms of consumption

C = - s (i - pe) + Ce

• The curve is inter-temporal, we can add the natural

consumption and get

C - CN = - s (i - pe) + (Ce - CN)

 Inter-temporal IS curve
• Euler equation,
C = - s (i - pe) + Ce
• By assuming Y=C+I, with I given (if I is given Ie=I), we
can write:
C + I + G = - s (i - pe) + Ce + I + G i.e.

Y = - s r + Ye

• where r= (i - pe) is the real expected interest rate.

 A comprarison
• A) IS inter-temporal (neo classical) is
Y = - s r + Ye
• B) IS Old Keynesian (in IS/LM model prices are fix i=r)
Y=-sr+A
• Given Ye and A are mathematically equal (same
relation).
• But economically different!!!
 Old Keynesian vs. New Keynesian
• Both relationships
A) Y = - s r + Ye (IS inter temporal NC/NK)
B) Y = - s r + A (IS Old Keynesian, IS/LM)
• imply I=S equilibrium in the good market, but the
adjustment mechanism is different
• In A, after a change in r, savings (S) adjust; in B, (I)
investments adjust:
A) Dr=>DS (DC) =>DY
B) Dr=>DI=>DY (indirectly by the Keynesian multiplier,
DY=>DC=>DY)
 New Keynesian inter-temporal IS curve
• Define the output gap as: Xt = Yt - YtN
• Take the Euler equation (in Y)
Yt = - s rt + Yt+1e
• Subtract the natural output
Yt - YtN = - s rt + Yt+1e - YtN
• Assuming that the natural output is stochastic
YNt+1 = YNt + at+1
• Where a is a productivity shock (TFP). Then
Yt - YtN = - s rt + Yt+1e - YNt+1 + at+1
• It follows:
Xt = - s rt + Xt+1e + at+1
 Households in a DSGE model
• Maximise present discounted value of expected utility
from now until infinite future, subject to budget constraint

• Households characterised by
utility maximisation
consumption smoothing
 Households
• We show household consumption behaviour in a
simple two-period deterministic example with no
uncertainty

initial wealth W0
consumption C0 and C1
prices p0 and p1
nominal interest at rate i0 on savings from t0 to t1

• Result generalises to infinite horizon stochastic

problem with uncertainty
 Household utility

C
1 max U (C )  U (C )
C0 0 1

dU  0  U ' (C )dC  U ' (C )dC

0 0 1 1

dC1 1 U '(C0 )
-
U dC0  U '(C )
1
C
0
 Household budget constraint

C
1
p1C1  (W0 - p0C0 )(1  i0 )

p1dC1  - p0 dC0 (1  i0 )

dC1 1  i0
-
dC0 1  p1

C
0
 Household utility maximisation

C
1

1 U '(C0 ) 1  i0
- -
 U '(C ) 1  p1
1

C
0
 Households

General solution for stochastic -horizon case

 1  it 
U ' (C )  Et U ' (C ) 
t  t  1 1  p t 1 

Known as the dynamic IS curve

Known as the Euler equation for consumption
 Households - intuition

 1  it 
U ' (C )  Et U ' (C ) 
t  t  1 1  p t 1 

it↑ → U’(Ct)↑ → Ct↓ Higher interest rates

reduce consumption
Etπt+1↑ → U’(Ct)↓ → Ct ↑ Higher expected future
inflation increases
consumption