Chapter overview

This chapter surveys the most prominent work

on consumption:
▪ John Maynard Keynes: consumption and
current income
▪ Irving Fisher and Intertemporal Choice
▪ Franco Modigliani: the Life-Cycle Hypothesis
▪ Milton Friedman: the Permanent Income
Hypothesis
▪ Robert Hall: the Random-Walk Hypothesis
▪ David Laibson: the pull of instant gratification
Irving Fisher and Intertemporal
Choice

▪ The basis for much subsequent work on

consumption.
▪ Assumes consumer is forward-looking and
chooses consumption for the present and future
to maximize lifetime satisfaction.
▪ Consumer’s choices are subject to an
Intertemporal budget constraint,
a measure of the total resources available for
present and future consumption
The basic two-period
model
▪ Period 1: the present
▪ Period 2: the future
▪ Notation
Y1 is income in period 1
Y2 is income in period 2
C1 is consumption in period 1
C2 is consumption in period 2
S = Y1 - C1 is ______________
(S < 0 if the consumer borrows in period 1)
Deriving the
intertemporal budget constraint
▪ Period 2 budget constraint:
C 2 = Y 2 + (1 + r ) S
= Y2 + (1 + r) (Y1 – C1)

▪ Rearrange to put C terms on one side

and Y terms on the other:
(1 + r ) C 1 + C 2 = Y 2 + (1 + r )Y1

▪ Finally, divide through by (1+r ):

The intertemporal budget
constraint
(1 + r ) C 1 + C 2 = Y 2 + (1 + r )Y1
C2 Y2
C1 + = Y1 +
1+r 1+r

present value of present value of

Consumption (of both Income (of both
periods) periods)
The intertemporal budget
constraint C Y2
C2 C1 + 2
= Y1 +
1+r 1+r
The budget
constraint
shows all __________ Consump =
combination _____ income in both
s periods
of C1 and C2
that just Y2
exhaust the _______
consumer’s
resources.
C1
Y1
_____________
The intertemporal budget
constraint C Y2
C2 C1 + 2
= Y1 +
The slope of 1+r 1+r
the budget
line equals
_________ ) 1
(1+r )

Y2

C1
Y1
Consumer preferences

An indifference C2 Higher
curve shows all indifference
combinations curves
of C1 and C2 represent
that make the higher levels
consumer of happiness.
equally happy Y

Z
X IC2
W
IC1
C1
 Consumer preferences
C2 The slope of
an indifference
Marginal rate of curve at any
substitution (MRS ): point equals
the amount of C2 the MRS
1 at that point.
consumer would be
MRS
________________
_________________.
IC1
C1
Optimization
C2
The optimal (C1,C2) At the
is where the budget optimal point,
line just touches the
__________
highest indifference
curve.
O

C1
 How C responds to changes in
Y An increase in Y1 or Y2
C2
Results: shifts the budget line
Provided they are outward.
both normal goods,
C1 and C2 both
increase,

C1
Keynes vs. Fisher
▪ Keynes:
current consumption depends only on current income
▪ C=f(Y)
▪ =a + bY
▪ Fisher:
current consumption depends on
lifetime resources, interest rate on savings;
the timing of income is irrelevant
because the consumer can borrow or lend between
periods.