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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

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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

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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

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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

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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.

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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

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Representing a Consumption Stream

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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.

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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

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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.)

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