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.

2. CONSUMPTION
CHAPTER # 17

3. GROUP MEMBERS

KAMRAN KHALID
52

OMAIR UR REHMAN
53

UMER DRAZ
43

M. AMIR
50

HUSNAIN SHAH
47

4. HUSNAIN SHAH
ROLL # 47

5. 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.

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-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 saving in period 1
(S < 0 if the consumer borrows in period 1)
slide 6

7. Deriving the
intertemporal budget constraint

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 budget constraint
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 budget constraint
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

10. UMER DRAZ
ROLL # 43

11. Consumer preferences
C2
An indifference
curve shows 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 rate of
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

13. M. AMIR
ROLL # 50

14. Optimization
C2
The optimal (C1,C2)
is where the budget
line just touches the
highest indifference
curve.
At the
optimal point,
MRS = 1+r
O
C1
slide 14

15. How C responds to 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

16. KAMRAN KHALID
ROLL # 52

17. Keynes vs. Fisher

Keynes:
current consumption 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

18. OMAIR UR REHMAN
ROLL # 53

19. How C responds to 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 responds to 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

21. ANY QUESTION