Professional Documents
Culture Documents
By
Dr. A. Makochekanwa
Department of Economics
University of Zimbabwe
Lecture 2
Oct 2014
INTER-TEMPORAL CHOICE
Oct 2014
Savings constraints
Traditional discussions of the choice of the correct social rate of
discount have focused on constraints on savings.
We need to ask three question:
1) What can the government do that individuals cannot do?
2) What can the gvt do that individuals cannot (or will not) undo?
3) If there are arguments that the social rate of time discount is not
equal to the market rate of interest, is there any reason to believe
that the appropriate remedy can, or ought to, involve an
alteration in the choice of techniques in public projects?
In the subsequent discussion, we shall consider these questions.
Oct 2014
V t V (C t ,V t 1 ,V t 2 ,...)
Oct 2014
The problem of this, and the unpredictable timing death, is that individuals
may leave more to their heirs than they would have left had there been
perfect markets.
In the limit, if there had been no bequest motive they would have left
nothing. Accordingly, if the gvt leaves more to ones heirs in the form of
public projects, it is likely that the gvts action will not be completely
undone.
Oct 2014
Oct 2014
The critical issue is whether capital accumulation and technical change can
offset the decreasing stock of natural resource and prevent environmental
problems from becoming more serious. This remains a moot (debatable,
controversial, disputable) question.
It is apparent, however, that, aside from the unintentional positive bequests
to heirs, there are probably unintended negative bequests in the form of
nuclear wastes, low air quality, and general environmental degradation.
Although this may redress the balance, it does so in an extremely inefficient
way (see the discussion below on alternative instruments for changing the
intergenerational distribution of income).
Oct 2014
U ( c )e
( n ) t
dt
n
s
Oct 2014
On the other hand, the long-run social rate of time preference is given by:
d ln U ' (c)e t U '' c c
'
dt
c
U
v
where
Hence
v U '' c /U '
r*
or
Oct 2014
as
n
v
n
s
Oct 2014
The preceding section argued that there is no convincing case for the existence of a
savings constraint (at least in a developed country). On the other hand, the market
obviously will provide an insufficient supply of pure pubic goods, including capital
goods.
The government must necessarily be involved in deciding how much of these goods to
produce. Because of the revenues for these public capital goods are raised at least
partially by distortionary taxation, the problem of the second best is unavoidable.
Moreover, since the benefits accrue over time to different generations, we inevitably
face a problem of intergenerational distribution. We explicitly assume that the
individuals are nonaltruistic, that is, they care only for their own consumption.
Thus, to decide on the level of public goods to be produced, we need to introduce a
social welfare function. We postulate that we are concerned with maximizing the
expression:
j
1
U
t
1
t
j
Oct 2014
(19)
Where is the utility of the jth individual in the ith generation, and is the
pure social rate of time preference; that is, if > 0, we weight future
generations utility less than that of the present generation.
If = 0, we simply add the individual, unweighted utilities. If the
horizon is infinite, this criterion may not be well defined, but there are
standard techniques for handling this difficulty. Expression (19) is just a
weighted sum. We will thus continue the analysis without restricting
to be zero.
The problem now is a standard indirect control problem. The gvt wishes
to choose, at each date, for the instruments under its control (taxes,
investment in public goods, levels of debt, etc.) a set of levels that are
feasible, satisfy the gvts budgetary constraints, and optimize social
welfare.
Oct 2014
(20)
Where: C1t = is the ith generations consumption in the first period of life
C2t = is the ith generations consumption in the second period of life
Lt = is the ith generations supply of labour
Oct 2014
From which we can immediately calculate the value of his savings S t, which is given by
(22c)
The level of utility attained by the individual will thus be a function of the wage, the
interest rate, and his exogenous income (lump-sum transfers). This is given by the
indirect utility function
Vt Vt ( wt , it , I t )
(23)
Yt F ( K t , Gt , Lt )
(24)
We assume F has constant or decreasing returns to scale in the private factors (K, L) but
may exhibit increasing returns in all three factors together.
The aggregate labour supply Lt is given by the solution to the utility maximization
problem stated in equation (22a). The determination of Kt, however, is somewhat more
complicated. The solution to the individuals utility maximization problem gives a
value to total savings.
To relate Kt to St, we have to make specific assumptions concerning depreciation and
the existence of alternative stores of value. The simplest depreciation assumption is
that all capital lives for only one period. Then, if there exists no alternative store of
value,
S t K t 1
(25)
Output is allocated to three uses: consumption, public investment, and private
investment. We simplify the analysis by assuming that
Yt C1t C 2t 1 K t 1 Gt 1
Oct 2014
(26)
We are now prepared to formalize our maximization problem. We wish to maximize the
present discount value of social welfare:
(27)
F ( K t , Gt , Lt ) C1t C 2t 1 Gt 1 K t 1
(28)
Where Kt+1 = St, and where St is given by equation (22c) and Lt is a function of the wage
rate and the consumer rate of interest given by equation (22a).
The instruments available to the gvt are the wage rate, the consumer interest rate, and the
expenditures on public investment goods. There are numerous other equivalent
formulations; this one is particularly simple to work with, as will be evident shortly.
Note that in this formulation we do not treat the level of taxation as a control variable,
but it is implicitly defined in each period. From equation (25) we will be able to find the
level of capital in each period and from equation (22a) we can find the labour supply.
Oct 2014
Oct 2014
t 1
(30)
t 1 F2 t
(31)
Equation (32) tells us that, in the steady state, the marginal return to public investment,
F2, should be equal to 1 + ; that is, the social rate of discount is equal to the pure rate
of social time preference. The relationship between F 2 and the market rates of interest,
however, is not so obvious.
Oct 2014
Where
That is:
If there were no tax on wages, the social rate of discount would be simply a weighted
average of producer and consumer interest rates. But close inspection shows that does
not have to lie between the two market rates, because of wage tax and because i is not
constrained to lie in the interval (0,1).
Oct 2014
END
Oct 2014