Inter-Temporal Choice Consumer Model - Essay Example

Inter-temporal Choice Consumer Model Contents Introduction 3 The Model of Inter-temporal Choice 3 Intertemporal Choice on the rise in rate of interest 4 Conclusion 8 References 9 Introduction The inter-temporal choice model, framed by Irving Fisher is a representation of the behaviour and the choice of consumption of the rational consumers over two time horizons which would ensure that the satisfaction of the consumers are optimised over the entire lifetime. Thus the choice of an individual consumer over a period of time can be referred to as the inter-temporal choices that the individuals would make throughout the life time. The rate of interest prevailing in the economy would affect the choice of the consumers in a number of ways. This essay would look into the effect of the increase in the rates of interest on the choices of the individual consumers. The Model of Inter-temporal Choice A number of assumptions have to be considered before providing an analysis of the inter-temporal choices of the consumers. 2 periods of time have been taken into consideration in the entire lifetime of an individual. The income that the person earns in the first period is Y1 while that is earned in the period 2 is Y2. On the other hand the consumption level of the consumers in period 1 and 2 are C1 and C2 respectively. The rate of interest or the cost of capital at the present period is r. This is the present rate at which the consumer can either lend or borrow a sum of money. In such a scenario the inter-temporal budget constraint of the individual would be as follows: This equation would be valid in relation to the present value. On the other hand the budget constraint in terms of the future value would be (1+r) C1 + C2 = (1+ r) Y1+ Y2 The individuals have a choice in this context. They can either save some of the income in the present period for use in the future period consumption. Alternatively he can borrow and consume in the present period and repay the borrowed amount in the future period. Thus in each period of time he would have some income to spend. In the first case it has been assumed that the consumer decides to borrow. In this case the consumption of period 1 would be more than the consumption in period 2. This would be true is C1>Y1. Thus in the second period he has to pay an interest of amount r (C1-Y1) along with the principle amount of (C1-Y1) which he had borrowed in period 1. In such case the budget constraint of the consumer would be C2 = Y2 – r (C1 - Y1) - (C1 - Y1) = Y2 – (1+r) (Y1 - C1) Thus the positivity or negativity of the term (Y1 - C1) determined whether the individual is a saver or a borrower in period 1. Alternatively the consumer can save more and consume less in period 1. He would earn an interest on his savings and therefore his consumption in period 2 would be more (Varian, 2010, pp. 183-202). The interest is thus the opportunity cost that the lender earns or the borrower pays for either giving up the use of the money at the future period or the possibility of the use of the funds at the present period. It is the value that provides various alternatives for the use of money at a certain time period. Intertemporal Choice on the rise in rate of interest A ) The budget constraint of the consumer has been represented with the help of the diagram below. In the initial phase before the rise of the rate of interest rate the budget line of the consumer was the black downward sloping curve. The vertical and the horizontal intercepts of the curves show the maximum consumption that the individual can make in the period 1 and period 2 respectively. On the other hand the preferences of the individual have been represented with the help of the indifference curves. These curves are the locus of the points in which the consumer would be indifferent between different bundles at a constant budget constraint. The optimal consumption would take place at a point where the indifference curve is tangent to the budget line of the consumer. Figure 1: Borrower in Period 1 In the above figure the, the point of tangency of the indifference curve and the budget line of the consumer would be optimum point of consumption would be the point A. This is because the individual would be consuming more in the period 1 by borrowing more money. On the other hand in the second period he would have to repay the principal and the interest and hence the level of consumption would be less (Mankiw, 2002, pp. 4219-274). If the rate of interest in such a scenario rises then the borrowing pattern of the consumer would get changed. This means that the opportunity cost would increase for the borrower. Hence the new budget line would be formed which is given by the red line. As the interest rate rises the individual would tend to become a lender as the opportunity cost of saving money would rise or else he becomes worse off with the rise in the rate of interest by remaining a borrower (Frank, 2010, pp. 323-394). Thus he would tend to consume less in period 1. In such a case the consumer would move to a lower indifference curve which represents his worse off condition. b) The opposite would be true for an individual who would be a lender or a saver in period 1. Figure 2: Saver in period 1 In case of the saver the initial optimal point was A and the initial budget line is the line represented in black because the individual would prefer to consume more in period 2 compared to period 1. With the rise in the rate of interest the saver would remain the same because as the rate of interest rise the opportunity cost of consuming in the present period would go further up. The final point of consumption for the individual would be the point C. In other words, the lender would be better off with the rise in the rate of interest (Baumol and Blinder, 2009, pp. 149-183). Conclusion Thus the essay provides an idea about the choices that the individuals make and the changes in the rate of interest has different impacts on the people depending on their consumption patterns. References Varian, H.R., 2010. Intermediate Microeconomics: a modern approach. New York: W.W. Norton and Company. Baumol W.J. and Blinder A.S., 2009. Microeconomics: Principles and Policy. Mason: South Western Cengage Learning. Frank, R. H., 2010. Microeconomics and Behavior. New York: McGraw-Hill Irwin. Mankiw, N. G., 2002. Macroeconomics. New York: Worth Publication. Read More