INTERTEMPORAL

CHOICE & ASSET

MARKETS
Group 6
Intertemporal(Dyn
amic) choice is the Characteristics of the
choices of Budget Constaint
consumption over • Two time periods, 1& 2
time by a • Consumption for each period is
consumer. C1, C2
• Prices of C1, C2 is 1
• Endowment for each period is M1,
M2
Option A- I will save to myself, I
won't give out and I won't borrow

If the consumer spends his whole endowment in both periods, then C1=M1
; C2=M2. He is neither a borrower nor a lender. This is a 'Polonius point'

The consumer may also choose to consume less (save more) than his endowment in the first period, so that he may
consume more in period 2. (C1<M1). The consumer will consume M2+(M1-C1) in period 2.
Option 2- I can borrow or give out(save),
at a given interest rate

If the consumer saves when interest is accruable in the first period, he/she
can consume M2+(M1-C1)+r(M1-C1). Therefore, C2=M2+(1+r)(M1-C1).

If the consumer borrows (we assume from the next period), to consume more
in the first period, C2=M2-r(C1-M1)-(C1-M1).
C2=M2+(1+r)(M1-C1)

When (M1-C1) is positive, the consumer receives interest on savings and vice versa
New Budget Constraint
Future Value Present Value

(1+r)C1 + C2= (1+r)M1 = M2 C1 + C2/(1+r) = M1 + M2/(1+r)

Expresses budget constraint in form of
future value
Expresses budget constraint in terms of
present value
P2= 1/(1+r)
It is the most important way as it
measures future relative to the present

BOTH EQUATIONS ARE IN FORM OF P1X1+P2X2 =P1X1+P2X2

Present Value is the amount of C2 that will
generate the equal budget set as the
endowment.

Future value is the maximum amount of C2

when the consumer doesn't consume in C1
 Consumption Preferences are determined by the slope of
the IC curve
1) MRS=1; the consumer is indifferent about substituting
consumption between 1&2

2) For perfect complements; the consumer will choose to share

Consumption preference consumption equally between two periods and will not
substitute.
3) Intermediate case of well-behaved preferences; The consumer
is willing to substitute consumption today for tomorrow.
 Convexity of preferences
Rests on the notion that
averages are better than
extremes. The consumer
would rather have an
average amount in each
period that to have more
today and less tomorrow
Changes in Interest Rate (a pivotal movement around the
endowment point)
1) Lenders : Consumption bundle is orginially to the left
of endowment point, by consumer's choice. An increase
in interest rate should also increase shift consumption to
the left of endowment, as the consumer remains a lender
(Principle of Revealed Preference) but on a higher IC
that rests on a 'endowed' new Budget line. If Int. rate
goes so low, he MIGHT become a borrower
2) Borrowers: Consumption is originally to the right of
endowment. When int. rate drops, consumption also shifts to
the right of endowment on a new IC. This is because they
have less interest to pay from C2. The consumer remains a
borrower and is made worse off.

If int. rate increases, the consumer may decide to become a

lender
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 The Slutsky Equation

The slutsky equation can be used to analyse the change in

consumption preferences, as changing interest rate is similar to
changing prices.

CT1/!P1 = CS1/!P1 + (M1-C1)CM1/!M

The sign of the slutsy equation depends on the sign of (M1-

C1)

Inc. eff. (+) Sub. eff. (-)

In any economy, without inflation, price remains constant at
1. This means that sacrificing consumption in period 1 (C1
units) would increase consumption in period 2 to (1+r)C2
units.
To incorporate inflation into the model, let P1 = 1 and P2
remain the same.
The total money spent on consumption in period 2 is P2C2 =
P2M2+(1+r)(M1 - C1) ………………(1)
Consumption in 2nd Period is C2=M2++(M1 – C1)
…………………….(2)
M2 is the endowment in period 2
(M1 – C1) is the amount of consumption in period 1 that is
given up for period 2
Let π be inflation and (1+π) = P2 adjusted for inflation
Substitute P2with (1+π) in equation 2

C2=M2++(M1 – C1) …………(3)

Let ρ = represent real interest rate while (1+ρ) = is extra consumption gotten in period 2 after giving up consumption in

period 1.

Therefore M2+(1+ρ)+(M1 – C1)

Present Value
Present Value is the way
of discounting future From the Pv equation, the present Value
payments into current of M2 is M2/(1+r). If M2=1; PV= 1/1+r
currency.

PVt= 1/(1+r)t-1 (for 2 or more periods)

Present Value is majorly used in comparing between two or more
investments in order to ascertain the one that will be more profitable
to the investor
A Higher and positive net present value
is the criteria for selection.
If asset K pays #100 now and will pay #200 next
year and asset E pays no amount now and #310 next
period. Which is a better investment? Given a 20%
int. rate.

PVK= 100 + 200/(1+0.2)=266.7

PVE = 0 + 310/(1+0.2)=258.33

A I S THE PR EFERRED INVESTMENT

 Asset Markets
Assets are goods that provide a flow of services
over time.
Assets can provide a flow of consumption
services, like housing services, or can provide a
flow of money that can be used to purchase
consumption.
Assets that provide a monetary flow are called
financial assets.
Bonds are examples of financial assets and the
flow of services they provide is the flow of
interest payments.
We will examine the functioning of asset
markets under conditions of complete
certainty about the future flow of services
provided by the asset.
That is, our assumption is that there is
complete certainty about the future flow of
services provided by the asset. This implies a
constant rate of return.
Rate of Return is the annual income got from an investment as a proportion of
the original investment, usually expressed as a percentage.

Consider an Asset K that has a current price P1 and is expected to have the same price tomorrow
without dividends and cah payments between the periods.

Suppose that another asset E can also hold for two periods and will pay a given rate of interest
If total investment is #1
Asset K: we first ask how many units of the asset we must purchase to
make a #1 investment. P0x=1 and x=1/p0
The future value of Asset K: P1x= P1/P0 (no r for K)
Asset E: If we invest #1, we will have (1+r) dollars next period. Since both
assets are both held in equilibrium and give the same rate of return, then
dollar invested in either of them must be worth the same amount second
period. Thus we have an equilibrium condition:
Asset K = P1/P0 = (1+r) = Asset B

What happens when equality isn't satisfied?

 Unequal Rate of Return

Scenario 1: P1/P0<(1+r). People who own assets K can sell 1 unit in the first period for P0 and
invest the money in asset E. Next period, their investment in E will be worth P0(1+r). which is
greater than P1 by the above equation. This will guarantee that in period 2, they will have
enough money to repurchase asset A, but with extra money now. This is known as riskless
arbitrage or simply arbitrage.

In equilibrium, a well-functioning market should eliminate any opportunity for arbitrage.

 How will the market eliminate arbitrage?
Scenario 2: P1/P0<(1+r). In this scenario, anybody who owns asset K
would want to sell it in the first period for P0, since they were
guaranteed enough money to repurchase it in the second period.
Who will they sell it to? who would buy?
There would be plenty of people willing to supply asset K at P0, but
there wouldn't be anyone foolish enough to demand it at that price. This
means that supply will exceed demand and price will fall.
How far will price fall?
Just enough to satisfy the arbitrage condition until, P1/P0=(1+r)
 Abitrage and Present Value

Arbitrage condition : (1+r) = P1/P0;

Rearranged: P0 = P1/(1+r)
This states that an asset's current price must be its present value.
Essentially we have converted the future-value comparison in the arbitrage condition to a present-value comparison.
So, if the no-arbitrage condition is met, we can be certain that assets will be sold for their present value.

The no-arbitrage equilibrium rule assumes that the asset services provided by the two assets are identical. If the services
provided by the assets have different characteristics, then we would want to adjust for them before we state that the two
assets must have the same equilibrium rate of return.
Assets with Consumption
Returns
Generally, assets have monetary returns attached to their ownership.
However there exists certain class of assets which pay the holder in
terms of utility/satisfaction as well.
A valid example is the utility that comes from housing. If
an individual owns a house which he/she lives in, part of
the returns accruing to your ownership is the fact that
you satisfyyour wantof shelter without paying rent. Or he
gets to pay the rent to yourself, hence enjoying the
monetary returns and the satisfaction as well.
If the house initially cost P, then the total rate of return on your initial investment in housing is h = (T +
A)/P
The total return to owning your house is the sum of the rental return, T, and the investment return, A. If your house initially
cost P, the total rate of return on your initial investment in housing will be h = (T + A)/P
Note: This total rate of return (h) is composed of the consumption rate of return (T /P), and the investment rate of return(A/P).
Let us assume, for financial assets, the rate of return is r. Therefore, the equilibrium condition is given as r = (T + A)/P
 Taxation of Asset Returns

The fact that different assets are taxed differently means that the arbitrage rule must adjust for the tax
differences in comparing rates of return.
Suppose that one asset pays a before-tax interest rate, rb, and another asset pays a return that is tax exempt, re. Then if
both assets are held by individuals who pay taxes on income at rate t, we must have
(1 − t)rb = re.
That is, the after-tax return on each asset must be the same.
Market bubbles
In a bubble, the price of an asset increases, for one reason or another, and this leads
people to expect the price to go up even more in the future. But if they expect the asset
price to rise significantly in the future, they will try to buy more today, pushing prices
up even more rapidly.
These effects tend to occurs:
·The first effect—high prices reducing demand—tends to stabilize prices.
·The second effect—high prices leading to an expectation of even higher prices in the
future—tends to destabilize prices.
All bubbles eventually burst.
Why?
Prices fall and some people are left holding assets that are worth much less than they
paid for them.