Consumption and

Intertemporal Choice

Introduction
Objective :
– This 3rd chapter focuses on intertemporal decision.
– Objective : Understand the saving (S henceforth) behavior in
order to explore the causes of current account (CA henceforth)
deficit (CA = S − I)).
– A CA < 0 can be caused by changes in savings or investment or
both.
– If CA < 0 is the result of I behavior, then the open economy
version of the Solow model is well suited to rationalize CA < 0.
– If CA < 0 caused by changes in savings, then the Solow model
is helpless since the saving rate is fixed → s does not react to
changes in future income or interest rates which considerably
limits the predictive power of the model when it comes to
take the model to the data.
– If we want to explain increasing CA < 0 in the EA between
1993 and 2007, we need to understand the saving behavior.
– Savings decision is an intertemporal choice as this is
fundamentally a decision involving a trade-off between
 current and future consumption. If we can understand how
consumers arbitrage between future and present consumption,
then we can bring out the determinants of savings.
– It is important to understand well the basic
consumption/saving problem since it is at the core of modern
dynamic macroeconomics.

To understand the trade-off between current and

future C, we consider a simple endowment economy
(i.e., without capital) where agents live two periods.
– There are 3 basic and fundamental concepts related
to intertemporal choices : real interest rate (r), the
intertemporal marginal rate of substitution (I-MRS),
the rate of time preference (RTP) :
– The real interest rate (r) determines the return on
savings consisting of financial assets. It measures
the price of current consumption in terms of future
consumption you have to pay on the market. It can
be observed by agents.
– I-MRS (i.e., MRS of current consumption for future
consumption) = subjective price of current
consumption in terms of future consumption.
– I-MRS varies with consumption ; if we want to
compare preference for present consumption
between individuals or countries, we need to set the
same consumption time profile for all individuals ⇒
subjective rate of time preference (RTP), ⇒
MRS along a constant consumption path.
– RTP allows us to compare the subjective taste for
present consumption between individuals or
countries. RTP will determine whether the agent will
be a borrower or a lender (along a constant income
path) ⇒ tell us if savings is negative or positive.
Savings depends on the ratio of future to present
income :
– In an intertemporal model, consumption decisions
are based on future and current income.
– In face of high future income relative current
income, the agent will smooth consumption instead
of having a low consumption today and a high
consumption in the future.
– Consumption smoothing is the result of the taste
for diversity which means that the agent dislikes
large differences in consumption.
– The agent agent has a taste for diversity because
consuming only in the present or in the future is
very costly in utility terms : you prefer present and
future consumption to be close (not equal but close
enough to each other).
– Forward-looking agents along with convex
preferences (caused by decreasing marginal utility)
which reflect the fact that agents have a taste for
variety ⇒ Consumption smoothing.
– In the intertemporal model, savings helps to
neutralize the effects of large changes in income
across time on the time path of consumption.
Savings and the interest rate :
– A rise in r encourages agents to save less by making
a lender richer (income effect : IE) while it also
induces agents to save more by increasing the
relative price of present consumption (substitution
effect : SE). While with logarithmic utilities, IE and
 SE cancel out, savings is an increasing function of r
because there is a 3rd effect called the human
wealth effect (HE).
– Why ? In intertemporal models, we have present and
future values but all values must be expressed in the
same unit, say present unit.
– We use the discount factor to express future income
streams in present value terms (remind that the
agent is forward-looking and thus interest in the
sequence of income stream) ; a rise in the r lowers
the present value of future income ⇒ increases
saving.
– Concept of present discounted value. One £
1
gives 1 + r £ in one year or alternatively 1+r
£ gives
1
1 £ in one year. 1+r
is the present value of one £ in
one year : it is the market discount factor. If you
use the subjective discount factor, the present
1
value of one £ is : 1+δ
where δ is the subjective
time discount rate.
External imbalances in the euro area :
– Blanchard and Giavazzi [2002] document evidence
which reveals that Portugal and Greece ran large and
increasing current account deficits during the 1990s.
– There are two factors which cause the rise in foreign
debt (we put aside investment).
– The first factor is the convergence phenomenon ;
consumption decision is based on the present
discounted value of income stream ; during
convergence : current income much lower than
permanent income (income that generates a flat
consumption time profile : it can be viewed as the
average income across time) ⇒ if you are poor
today but rich tomorrow ⇒ borrow abroad to
smooth consumption.
– In other words, foreign borrowing helps agents to
neutralize the effects of low present income relative
to future income.
– The second factor is the sharp decline in interest
rates from 1993 (pre-entry in the euro area)
triggered by elimination of the exchange-rate
premium (since fixed parities between currencies)
 and the risk premium (financial markets expect no
default)
– If log utility : SE and IE effects cancel out. If r
declines, the present value of future income rises ⇒
present consumption rises ⇒ savings falls.
– In TC4 : we analyze the consequences of a sudden
stop modelled as a sharp increase in r.

A Two-Period Model of
an Open Economy
– two-period model = the agent lives two periods ;
– in this economy, there are only households ;
– endowment economy (thus no firms and no capital) ;
– let us denote the first period (indexed by 1) as the
present period and the second period as the future
period (indexed by 2) ;
– open economy : agent can borrow from abroad or
lend to abroad.
Households
Preferences :
– workers receive in each period an exogenous income
stream equal to Y1 at period 1 and Y2 at period 2 ;
– Agents are forward-looking (base their decisions on
present and future income) and value present C1 and
future C2 consumption.
– The agent chooses consumption at period 1, C1 ,
and at period 2, C2 , in order to get the maximum
lifetime utility.
– This lifetime utility is the sum of U (C1 ) = ln C1 , plus
the instantaneous utility in period 2 U (C2 ) = ln C2.
– The lifetime utility Λ is equal to the sum of utility
stream :

Λ = ln C1 + ln C2 . (1)

Budget Constraints :
– Since agents can borrow or lend to the ROW, they
are able to transfer C across time by lending to
abroad (B1 > 0) or by borrowing from abroad
(B1 < 0).
– In the 1st period, the current revenue, Y1 , can be
consumed, C1 , or saved by holding foreign assets,
B1 :

Y1 = C1 + B1 , (2a)
C2 = Y2 + (1 + r) .B1 , (2b)

– and in the 2nd period the agent can consume

financial wealth inclusive of interest payments,
(1 + r) .B1 , plus an exogenous stream of income, Y2 .
Transversality Condition :
– In the second period, we set the assumption that
the agent cannot borrow or lend to the ROW :

B2 = 0. (3)

– Because life ends at the end of period 2, you do not

want to lend to anyone and no one wants to lend
you as well since in period 3 nobody will be around
to collect the debt because life ends in period 2.
Intertemporal Budget Constraint (IBC) :
– Eliminate B1 from (2a) by using (2b)
C2 − Y2
C1 + B1 = C1 + = Y1 .
1+r
– Collecting consumption on the LHS and income on
the RHS leads to the IBC :
C2 Y2
C1 + = Y1 + ≡ Ω, (4)
1+r 1+r
– where the RHS of eq. (4) represents total wealth, Ω
defined as the present discounted value of income
stream.
– Thus the RHS (like the LHS) of the intertemporal
budget constraint (4) is expressed in period 1 units.
– Eq. (4) says that the present value of consumption
expenditure during life must equal total wealth.

Derivation of Intertemporal
Choices
Intertemporal MRS Analytically :
– Our objective is to determine the optimal trade-off
between C1 and C2.
– Consumption decisions are always based on the
maximum price you are willing to pay ; willingness to
pays is measured by the marginal utility.
– In a two-good economy with C1 and C2, your
willingness to pay for C1 (in terms of C2 ) is
Mu1
measured by the ratio of marginal utilities, Mu2
: it
reflects the amount of C2 your are willing to give up
in exchange for one additional unit of C1 .
– Assuming logarithmic utility, i.e., U (Ci ) = ln Ci ,
∂U (Ci ) 1
marginal utility is Mui = ∂Ci
= Ci
. The ratio of
marginal utilities thus reduces to :
1
M u1 C1
= 1
,
M u2 C2
C2
.
= (5)
C1
– The term on the LHS represents the intertemporal
marginal rate of substitution (I-MRS) which
measures the number of future consumption units
the agent is willing to give up to consume one
additional unit in present : it gives the maximum
price the agent is willing to pay for present
consumption.
– This ratio is decreasing because when C1 increases
and C2 declines, Mu1 falls whilst Mu2 increases.
Intertemporal MRS Graphically :
– To determine the optimal trade-off between C1 and
C2, we use a graphical representation of the lifetime
utility : Λ = ln C1 + ln C2 .
– The indifference curve maps lifetime utility into a
graphical representation shown in Figure below.
– The indifference curve is downward sloping because
you want to consume more of C1 , you need to give
up C2 units.
– Graphically, the intertemporal MRS is measured by
the slope of the indifference curve in the
(C1 , C2 )-space.
– The MRS of C1 for C2 is minus the slope of an
indifference curve. For example, MRS at point A in
Figure is minus the slope of a tangent to the
indifference curve at point A.
– Recall that a preference for diversity, or diminishing
marginal rate of substitution (MRS), is captured by
the convexity in an indifference curve, which here
also represents a consumer’s desire to smooth
consumption over time.
– Formally, the slope of the indifference curve in the
(C1 , C2 )-space is obtained by totally differentiating
Λ :
∂Λ ∂Λ
dΛ = .dC1 + .dC2,
∂C1 ∂C2
= Mu1 .dC1 + Mu2 .dC2 .

– Setting the above equation to zero since we are

along the same utility function, we get a measure of
the intertemporal MRS :
dC2 M u1
=− = intertemporal MRS. (6)
dC1 M u2
– As can be seen in Figure , as we increase C1, the
MRS falls as a result of our taste for diversity
(indifference curve is convex since utility is concave ;
utility is concave because of decreasing marginal
utility).

–
Relative price of present consumption in the
intertemporal market :
– The IBC (4) which writes as
C2
C1 + = Ω,
1+r
Y2
where Ω = Y1 + 1+r
.
– IBC can be rewritten as follows :

C2 = (1 + r) . (Ω − C1 ) . (7)

– Eq. (7) states that that when the agent increases C1

by one unit, the agent must give up 1 + r units of
C2 .
– Thus the price of C1 in terms of C2 is equal to one
plus the real interest rate, 1 + r, since it gives the
number of future consumption units we have to give
up to consume one additional C1 unit on the
intertemporal market.
Optimal consumption bundle in the (C1 , C2)-space
– When the MRS equates the intertemporal relative
price, 1 + r, then the consumer chooses the optimal
basket (C1 , C2 ) which allows him/her to get the
 maximum utility while satisfying the intertemporal
budget constraint at the same time.
– Graphically, the consumer’s optimal consumption
bundle is determined by where an indifference curve
is tangent to the budget constraint. At point EC , it
M u1
is then the case that M u2
is equal to 1 + r :

Mu1 C2
I-MRS = = = 1 + r, (8)
Mu2 C1
that is, the MRS of C1 for C2 (minus the slope of
the indifference curve) is equal to 1 + r, which is
minus the slope of the consumer’s lifetime budget
constraint.
– In Figure below, the consumer chooses the
consumption bundle at point EC ⇒ this choice is
made along IBC independently from the level in Y1
or Y2 : what matters is total wealth and the shape of
preferences.
– The endowment point is at EY . We assume that
Y1 = Y2 = Y . Since B1 = Y1 − C1 , the agent will be a
lender if C1 < Y1 (B1 > 0) and a borrower (B1 < 0) if
C1 > Y1 .
– In the top panel of Figure , the agent is a borrower.
In the bottom panel of Figure , we show the optimal
consumption choice for a consumer who is a lender.
– We can notice that the agent with a flat indifference
curve is a lender and the agent with a steep
indifference curve is a borrower. Because both
agents have the same income, the savings decision is
the result of the taste for present consumption. To
compare the willingness to pay present consumption
across individuals, we need to calculate the rate of
time preference.
–

Rate of Time Preference

(RTP)
Why do we Need to Compute the RTP ?
– To explain why two agents with the same
endowment Y1 and Y2 can choose different C1 and
 C2 according to their preferences, and thus can
become a borrower or a lender, we have recourse to
the RTP.
– But we want this measure to be comparable
between individuals or countries.
– Since the intertemporal MRS varies with
consumption (it decreases when C1 increases), we
have to choose a reference which is the same for all
people.
– As long as the consumption bundle is identical across
individuals, the choice of this basket is unimportant.
How we measure the RTP ?
– Graphically, in the (C1, C2 )-space, we are along the
line which splits the space into two equal parts.
Along this (bissecting) line, C1 is equal to C2 . The
rate of time preference is defined as the
intertemporal MRS along C1 = C2 .
– Graphically, the slope of the consumer’s indifference
curve along a constant consumption path C1 = C2 is
equal to 1 + ρ where ρ is the RTP. The slope is at
least equal to one since you are willing to give up at
 least one unit of C2 in exchange for one unit of C1 ;
if ρ > 0, it means that you are willing to give up
more than one unit of C2 and thus you have a
preference for consuming in present.
– The RTP plus one thus measures the intertemporal
MRS along a constant consumption line.
– RTP : It measures the willingness to pay one
additional unit of present consumption. The slope is
at least equal to one since you are willing to give up
at least one unit of C2 in exchange for one
additional unit of C1 .
– Formally, we calculate the RTP as follows :
Mu1 ¯¯
(1 + ρ) = ¯ ,
Mu2 C1 =C2
C2 ¯¯
= ¯ ,
C1 C1=C2
= 1. (9)

– Since ρ = 0, this agent is patient.

– According to (9), we have ρ = 0 : the RTP is equal
to zero which means than along the line C1 = C2 ,
the agent is willing to give up one unit of C2 in
exchange for one unit of C1 .
– When indifference curves are steep (as considered in
Figure below), the I-MRS is high and thus the RTP
is large : you are willing to give up a large number of
C2 units. When indifference curves are flat, the
I-MRS is low (but at least equal to one along
C1 = C2 ) and thus the RTP is small : you are not
willing to give up a large amount of C2 units.
– Let us assume that Y1 = Y2 = Y . When preferences
are steep, then ρ is high and it is most likely that this
agent will be a borrower (i.e., ρ > r along C1 = C2 ).
When preferences are flat, it is most likely that the
agent will be a lender (i.e., ρ < r along C1 = C2 ).

–
Determinants of Savings
of an Open Economy
– To bring out the determinants of savings, we
proceed in four steps. We first show the role of the
income path.
– Then we highlight the implications of the RTP.
Both the income path and the RTP determines
whether the economy is a borrower or a lender.
– Third, we analyze the implications of a change in
the interest rate on savings by breaking down the
effects into a substitution effect (SE), an income
effect (IE), and a human wealth effect (HE).

Economic Convergence,

Savings and Foreign Borrowing

Intertemporal Problem
– We assume that the utility function is logarithmic,
i.e., U (Ci ) = ln(Ci ) in each period i = 1, 2.
– Lifetime utility is the sum of utility in period 1 and
period 2 (see eq. (1) :

Λ = ln C1 + ln C2 .

– Budget constraints in period 1 and 2, as described

by eq. (2a) and eq. (2b), respectively :

C1 + B1 = Y1 ,
C2 = (1 + r) .B1 + Y2 ,

where B1 is savings.
Our objective is to derive an analytical expression for
savings. To solve the model, we proceed in four steps :
– First, we derive the IBC by eliminating B1 from
budget constraints which leads to (4) and allows us
to express C2 in term of C1 :
C2
C1 + = Ω,
1+r
C2 = (1 + r) . (Ω − C1 ) .

The above equation states that the consumer must

give up 1 + r units of C2 in exchange for one
 additional unit of C1 : 1 + r is the price of present
consumption.
– Second, the agent chooses the optimal consumption
path, i.e., the demand for C1 in terms of C2 , by
equating the maximum price the consumer is willing
to pay present consumption, measured by the I-MRS
Mu1
= Mu2
, to the relative price of present consumption
in the market, 1 + r :
Mu1 C2
= = 1 + r.
Mu2 C1
– Third, noting that the above equation implies that
C2
1+r
= C1 and inserting this expression into the IBC
allows us to solve for C1 :
C2
C1 + = Ω,
1+r
C1 + C1 = Ω,
Ω
C1 = . (10)
2
– Fourth, inserting the optimal level for C1 described
by (10) into the period 1-budget constraint, i.e.,
B1 = Y1 − C1 , leads to the expression of optimal
 savings :

B1 = Y1 − C1 ,
Ω
= Y1 − ,
µ2 ¶
1 Y2
B1 = . Y1 − . (11)
2 1+r
Savings depends on lifetime income :
– As shown in eq. (15), savings depends on the time
sequence of income. Since in the data, savings is
expressed in percentage of income, we divide both
sides of (15) by Y1 :
· ¸
B1 1 1 Y2
= . 1− . . (12)
Y1 2 1 + r Y1
– According to (12), when households are expected to
be richer in the future, as captured by a rise in the
Y2
ratio of future to current income, Y1
, they increase
B1
C1 and thus lower the savings rate initially, i.e., Y1
Y2
falls as Y1
increases. Henceforth, a country which
experiences an economic convergence will have a
low savings rate and is likely to be a net debtor
B1
initially, i.e., Y1
< 0.
– How it works ? Let us assume that Y1 is low and that
Y2 is expected to be high. In an intertemporal model,
the distribution of income across time is decoupled
from consumption decisions. First, the agent is
forward-looking and bases his/her consumption
choices on the present value of lifetime income, Ω.
Second, the agent dislikes large differences in
consumption and thus will choose to consume in the
present half of total wealth, see eq. (10). As Y2
becomes much larger than Y1 , the agent keeps C1
unchanged and neutralizes the effect of income on
consumption by borrowing abroad. Formally, since Y1
is low and C1 is high, then B1 = Y1 − C1 < 0.
– Figure shows optimal choices for present
consumption (on the horizontal axis) and future
consumption (vertical axis).
– While the agent is patient since ρ = 0, period
1-income is much lower that period 2-income. Since
the agent wishes to have a flat consumption time
profile, he/she borrows in the first period, i.e.,
B1 < 0, and pays back his/her debt in period 2.
–

Implications of the RTP for the

Savings Behavior
Savings depends on RTP only along a constant
income path :
– So far, we have considered preferences which imply
that ρ = 0.
– While agents are forward-looking, they value more
present than future consumption ⇒ discount future
utility
– To discount future utility, we use the subjective
1
discount factor which is equal to 1+ρ
.
– Thus lifetime utility is equal to the presented
discounted value of utility stream :
1
Λ = ln C1 + . ln C2 , (13)
1+ρ
where parameter ρ ≥ 0 is the RTP which measures
that extent to which the agent discounts the future.
Mu1 1 1
– Calculating Mu2
where Mu1 = C1
and Mu2 = 1+ρ
. C12
and equating the I-MRS to 1 + r gives the optimal
time path for consumption :
Mu1 C2 . (1 + ρ)
= = 1 + r. (14)
Mu2 C1
– Performing the same steps as previously, we have
1+ρ
C1 = 2+ρ
.Ω so that

B1 = Y 1 − C 1 ,
1+ρ
= Y1 − .Ω,
2+ρ
· ¸
1+ρ Y2
B1 = Y 1 − . Y1 + ,
2+ρ 1+r
· ¸
1 1+ρ
B1 = . Y1 − .Y2 . (15)
2+ρ 1+r
– If we assume Y1 = Y2 = Y eq. (15) becomes :
· ¸
B1 1 1+ρ Y
= . 1− . ,
Y 2+ρ 1+r Y
1 r−ρ
= . . (16)
2+ρ 1+r
According to (16), when Y1 = Y2 = Y , savings
behavior is exclusively explained by the differential
between the r and ρ
– Figure shows the situation of a consumer with a
high RTP since the slope of the indifference curve
along a constant consumption path, 1 + ρ, is higher
than 1 + r.
– When ρ > r, the agent will be a borrower in period
1, i.e., B1 < 0 ; graphically, the slope of the
indifference curve along a constant consumption
path is higher than the slope of the budget
constraint, i.e., 1 + ρ > 1 + r.
–

– When r = ρ, savings is nil, i.e., B1 = 0, and thus the

agent consumes his/her whole revenue ; graphically,
the slope of the indifference curve along C1 = C2 is
exactly equal to the slope of the IBC, i.e.,
1 + ρ = 1 + r.
Determinants of Foreign Borrowing :
– If we assume ρ = 0 the agent is patient and should
be a net lender. However, if we assume that
 present income is much lower than future
income, i.e., Y1 << Y2, then the agent will be a
borrower in the present period because the agent
dislikes large differences in consumption across time
and borrows abroad to smooth consumption.
– If we consider ρ > 0, and assume Y1 = Y2 = Y , the
small open economy will borrow abroad as long
as ρ > r.
– To sum-up, the savings rate depends negatively on
Y2
RTP and the ratio Y1
and thus the small open
economy is more likely to be a net debtor (B1 < 0)
when ρ is high and/or the ratio Y2 /Y1 takes large
values.

Savings and the Interest Rate

Formal Derivation of Savings :
– Lifetime utility is the sum of utility in period 1 and
period 2 as in eq. (1) :

Λ = ln C1 + ln C2 .
– The agent chooses an optimal trade-off between C1
and C2 by equating the intertemporal MRS to the
relative price of present consumption :
Mu1 C2
= = 1 + r, (17)
Mu2 C1
which implies that ρ = 0.
– Budget constraints in period 1 and 2, as described
by eq. (2a) and eq. (2b), respectively :

C1 + B1 = Y1 ,
C2 = (1 + r) .B1 + Y2 .

– By using the fact that C1 = Y1 − B1 and

C2 = (1 + r) .B1 + Y2 , eq. (17) can be rewritten as
follows :
(1 + r) .B1 + Y2
= 1 + r. (18)
Y 1 − B1
– If Y2 = 0, then the above equation (18) reduces to :
(1 + r) .B1
= 1 + r. (19)
Y 1 − B1
The LHS term is the intertemporal MRS but the
interpretation is now modified : it measures the
number of C2 units the agent requires in exchange
for one unit of C1 .
– Figure plots the MRS, i.e., the LHS of eq. (19) in
the (B1 , I-MRS)-space. This term measures the
number of C2 units you require in exchange for
giving up one unit of C1 . This term is increasing
with B1 : as the household saves more, he/she must
give up more present consumption units. Because
the disutility becomes larger, the household will
require in exchange a higher amount of future
consumption goods.

–
Effect of dr > 0 on Savings when Y2 = 0 :
– An increase in r produces two well-known opposite
effects :
– A substitution effect (SE) which provides
incentives to substitute C2 for C1 as the relative
 price of C1 increases : B1 rises. The term on the
RHS of eq. (19) increases. This term reflects the
number of future consumption units you can get by
giving up one unit of C1 .
– SE graphically : the horizontal line moves upwards
which increases savings form B1 to B10 . The move
from E to F is caused by the SE.
– An income effect (IE) which exerts a positive
impact on C1 and thus a negative impact on B1
because 1 + r increases interest receipts in period 2
and thus makes the agent richer. The term on the
LHS of eq. (19) increases : this term reflects the
number of future consumption units you require in
exchange of giving up one unit of present
consumption.
– IE graphically : the I-MRS shifts upwards which
lowers savings from B10 to B1. The move from F to
H is the result of the IE.
– In Figure , the SE and IE cancel out and savings
remains unchanged at B1 .
–
– Remark : It is worth mentioning that the rise in r
makes the agent richer as long as the agent is a
lender (i.e., B1 > 0), otherwise it would make the
agent poorer (i.e., if B1 < 0).
Savings is increasing with r if Y2 > 0 :
– When Y2 > 0, the equality between the Intertemporal
MRS and the relative price of present consumption
is :
(1 + r) .B1 + Y2
= 1 + r.
Y 1 − B1
– Dividing both terms by 1 + r leads to :
Y2
B1 + 1+r
= 1. (20)
Y1 − B 1
 Y2
– A rise in 1 + r lowers 1+r
; because the agent feels
poorer, he/she reduces C1 which increases B1 for
the equality to hold.
– when Y2 > 0, a rise in r produces a third effect called
the human wealth effect (HE). As long as Y2 > 0,
B1 becomes increasing in r even if SE = IE.
– Graphically, the HE leads the I − M RS-schedule to
shift to the right and savings decision moves from H
to G.
– Because for logarithmic utility, the IE and SE cancel
out, the HE leads to a rise in savings from B1 to B100 .