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Consumption
The document summarizes Irving Fisher's work on intertemporal choice theory and consumption. It discusses (1) Fisher's assumption that consumers maximize lifetime satisfaction subject to an intertemporal budget constraint, (2) a basic two-period model where consumption in period 1 (C1) and period 2 (C2) exhaust lifetime income, (3) how the intertemporal budget constraint relates C1 and C2 to present values of lifetime income and consumption, (4) indifference curves representing consumer preferences between C1 and C2, and (5) how consumption responds to changes in income and interest rates according to the model.
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Consumption
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- 3. GROUP MEMBERS KAMRAN KHALID 52 OMAIRUR REHMAN 53 UMER DRAZ 43 M. AMIR 50 HUSNAIN SHAH 47
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- 5. Irving fisher andintertemporal 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. More they consume today less they enjoy tomorrow. Consumer’s choices are subject to an intertemporal budget constraint, a measure of the total resources available for present and future consumption
- 6. The basic two-periodmodel 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 saving in period 1 (S < 0 if the consumer borrows in period 1) slide 6
- 7. Deriving the intertemporal budgetconstraint Period 2 budget constraint: C2 Y2 (1 r )S Y2 (1 r ) (Y 1 C 1) Rearrange to put C terms on one side and Y terms on the other: (1 r )C 1 C2 Y2 (1 r )Y 1 Finally, divide through by (1+r ): C1 C2 1 r present value of lifetime consumption Y1 Y2 1 r present value of slid e lifetime income 7
- 8. The intertemporal budgetconstraint C2 The budget constraint shows all combinations of C1 and C2 that just exhaust the consumer’s resources. (1 r )Y 1 C2 C1 Y2 Saving Y2 1 r Y1 Y2 1 Consump = income in both periods Borrowing C1 Y1 Y1 Y 2 (1 r) slide 8 r
- 9. The intertemporal budgetconstraint The slope of the budget line equals (1+r ) C2 C1 C2 1 r Y1 Y2 1 1 (1+r ) Y2 C1 Y1 slide 9 r
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- 11. Consumer preferences C2 An indifference curveshows all combinations of C1 and C2 that make the consumer equally happy. Higher indifference curves represent higher levels of happiness. IC2 IC1 C1 slide 11
- 12. Consumer preferences C2 Marginal rateof substitution (MRS ): the amount of C2 consumer would be willing to substitute for one unit of C1. 1 MRS The slope of an indifference curve at any point equals the MRS at that point. IC1 C1 slide 12
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- 14. Optimization C2 The optimal (C1,C2) iswhere the budget line just touches the highest indifference curve. At the optimal point, MRS = 1+r O C1 slide 14
- 15. How C respondsto changes in Y Results: Provided they are both normal goods, C1 and C2 both increase, C2 An increase in Y1 or Y2 shifts the budget line outward. …regardless of whether the income increase occurs in period 1 or period 2. C1 slide 15
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- 17. Keynes vs. Fisher Keynes: currentconsumption depends only on current income Fisher: current consumption depends only on the present value of lifetime income; the timing of income is irrelevant because the consumer can borrow or lend between periods. slide 17
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- 19. How C respondsto changes in r An increase in r pivots the budget line around the point (Y1,Y2 ). C2 B As depicted here, C1 falls and C2 rises. However, it could turn out differently… A Y2 C1 Y1 slide 19
- 20. How C respondsto changes in r Income effect If consumer is a saver, the rise in r makes him better off, which tends to increase consumption in both periods. Substitution effect The rise in r increases the opportunity cost of current consumption, which tends to reduce C1 and increase C2. Both effects C2. Whether C1 rises or falls depends on the relative size of the income & substitution effects. slide 20
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