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FINANCE THEORY: Intertemporal Consumption-Saving
and Optimal Firm Investment
Decisions
Eric Zivot
Econ 422
Summer 2010
ECON 422:Fisher
? R.W.Parks/E. Zivot
1
Reading
PCBR, Chapter 1 (general overview of
PCBR
financial decision making)
z Varian, Intermediate Microeconomics: A
Modern Approach. Chapter 10,
Intertemporal Choice.
z Hirshleifer and Hirshleifer, Price Theory
and Applications, Chapter 14, The
Economics of Time.
z
ECON 422:Fisher
? R.W.Parks/E. Zivot
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1
Goals of this Section
z
z
z
z
Understand the economic principles behind
inter-temporal consumption-savings decisions
Introduce present value concepts
Understand the roll of financial markets for
the efficient allocation of savings and capital
investment
Understand what determines the level of
interest rates
ECON 422:Fisher
? R.W.Parks/E. Zivot
3
The Fisher Model
Model of intertemporal choice involving
consumption
ti and
d iinvestment
t
t decisions.
d i i
(Named after Yale economist Irving
Fisher)
z Key Assumptions:
z
? Two periods (generalizing to many future
periods is straightforward).
? Perfect capital markets
? the absence of uncertainty
ECON 422:Fisher
? R.W.Parks/E. Zivot
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2
I. Intertemporal Exchange
Model: Outline
A Objects of choice
A.
choice, endowments and
trade opportunities, preferences
B. Individual optima and comparative
statics
C. Market
C
a e e
exchange
c a ge equ
equilibrium
b u a
and
d the
e
determination of interest rates.
ECON 422:Fisher
? R.W.Parks/E. Zivot
5
Objects of choice
z
z
z
What is the consumer choosing?
One of the many possible ¡°Consumption
Streams¡±
A consumption stream is a sequence of time
dated consumption, for the present and for
the future; e.g. (C0,C1)
? C0 is the standard of living or consumption level
for period 0 (the present)
? C1 is the standard of living or consumption level
for period 1 (the future)
ECON 422:Fisher
? R.W.Parks/E. Zivot
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3
Representing a Consumption Stream
ECON 422:Fisher
? R.W.Parks/E. Zivot
7
Consumer Preferences:
Basic Assumptions
z
z
z
z
Consumers are able to choose between
alternative consumption streams.
Choices are consistent (transitive)
They prefer more consumption to less; i.e.,
they prefer higher standards of living to lower.
C
Consumers
choose
h
th
the mostt preferred
f
d
consumption stream among those attainable.
ECON 422:Fisher
? R.W.Parks/E. Zivot
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4
Ways to Represent
Consumer Preferences
Simple ranking of consumption choices
z Utility function, U(C0, C1)
z Indifference curves: level sets of utility
function
z
? Combinations of C0 and C1 such that utility
is constant (doesn¡¯t change)
? downward sloping, non intersecting, and
convex shape
ECON 422:Fisher
? R.W.Parks/E. Zivot
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Utility Function, U(C0,C1)
z
z
z
The utility function gives an index value for
each
h consumption
ti stream.
t
The utility function value ranks consumption
streams
The marginal rate of substitution, MRS, gives:
? slope of an indifference curve at a point.
? the rate at which a consumer is willing to exchange
future consumption for present consumption, (while
maintaining the same level of satisfaction.)
ECON 422:Fisher
? R.W.Parks/E. Zivot
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