Welcome to my

presentation
Student name: Nguyen Thi Huyen
Student code: 11141874
Major: Investment
 Summarize:
Intertemporal choice – Irving Fisher
& Life-Cycle hypothesis – Franco Modigliani
 Intertemporal choice – Irving Fisher
I. Intertemporal budget constraint
Example: A consumer who lives for 2 periods:
• Present: Income Y1 and Consums C1
• Future: Income Y2 and consums C2
Assume that:
• Consumer consumes all the incomes he will have in his whole life.
• Y2 is constant.
• Money saving => invests in financial market (the real interest rate = r).
• The consumers has the oppoturnity to borrow and save with the same
interest rate.
 Intertemporal choice – Irving Fisher
We have:
• - First period: Saving: S = Y1 – C1
• - Second period: Consumption: C2 = (1+r)S1 + Y2
= (1+r)(Y1 – C1) + Y2 (*)

=> (1+r)C1 + C2 = (1+r)Y1 + Y2

C1 + C2/(1+r) = Y1 + Y2/(1+r)
=> The consumers’s budget constraint: shows that total
consumption equals total income in the two periods.
 Intertemporal choice – Irving Fisher

Graphs:
• Point A: Y1 = C1, Y2 = C2 ( S1 = 0 )
• Point B: C1 = 0 => C2 max = (1+ r)Y1 + Y2
• PointC: C2 = 0 => C1 max = Y1 + Y2/(1+r)
 Intertemporal choice – Irving Fisher

II. Consumer Preferences

Higher indifference curves are
preferred to lower curves. The
consumer is equally happy at points
W, X and Y, but prefers point Z to X, Y
or W
 Intertemporal choice – Irving Fisher
III. Optimization

The consumer’s optimum: The

consumer achieves his highest
level of satisfaction by choosing
the point on the budget
constraint that is on highest
inddierence curve. At the
optimum, the indifference curves
is tangent to the budget
constraint.
 Intertemporal choice – Irving Fisher

IV.How changes in income affect

consumption

An increase in either first-period

income or second-period income shifts
the budget constraint outward. If
consumption in period one and
consumption in period two are both
normal goods, this increase in income
raises compsumtion in both periods.
 Intertemporal choice – Irving Fisher
How changes in the real interest rate
affect consumption
• The income effect:
Increase in the interest rate -> income
increase -> more consumption in both
periods.
• The substitution effect:
Increase in the interest rate ->
consumption in period two is less
expensive than itself in period one ->
more consumption in period 2 and less
consumption in the period one.
 Intertemporal choice – Irving Fisher

VI. Constrains on borrowing

• The inability to borrow prevents current consumption from exceeding
current income. A constraint on borrowing can therefore be expressed as
C1 ≤ Y 1

• For those consumers who would like to borrow but can not, consumption
depends only on current income
 Intertemporal choice – Irving Fisher

• A borrowing constraint: If the

consumer cannot borrow, he
faces the additional constraint
that first period consumption
cannot exceed first period
income.
 Intertemporal choice – Irving Fisher

In panel (a), the consumer

chooses first period consumption to
be less than first-period income ->
borrowing constraint is not binding
and does not affect consumption in
either period.
In panel (b), the borrowing
constraint is binding. The consumer
would like to borrow and choose
point D. But because borrowing is
not allowed, the best available
choice is point E.
 Franco Modigliani and the Life-cycle hypothesis
Consider a consumer with:
• W: initial wealth
• Y: expected income until retirement
• R: the number of years from now utill retirement
• T: the number of years she lives
Assume that:
• Interest rate = 0
-> Achieve the smoothest possible path of consumption over the lifetime for optimum

Consumer’s lifetime resources: W + RY.

C = (W + RY)/T
• Consumption function: C = (1/T)W + (R/T)Y
α=1/T: MPC out of wealth
β=R/T: MPC out of income
• The consumption depends on both income and wealth
 Franco Modigliani and the Life-cycle hypothesis

If the consumer smooths consumption

over her life, she will save and accumulate
wealth during her working years and then
dissave and run down her welth during
retirement
 Comparision
Intertemporal choice
- Analysis of consumption and
saving behavior of consumer
- Divide into 2 periods: present
and future
- No wealth
- Saving has real interest: r
- Consumption depends on the
cosumers’s life time resources
- Maximize the benefit over
lifetime
Life-Cycle Hypothesis
- Making a consumption plan of
consumer
- Not divide into any period
- Wealth: W
- Saving has no interest
- Consumption depends on both
income and wealth
- Smooth consumption over
lifetime
Thank for listening