Problem Set: Intertemporal Choice

Ravit Thukral Classes

1. Problem 1: An individual lives for two periods, 1 and 2, and has lifetime utility function

U (C1 ) + βU (C2 ),

where C1 and C2 are the consumptions of this individual in period 1 and period 2 respectively, and
0 < β < 1 is the subjective discount factor. The following conditions are satisfied:

U ′ (C) > 0, U ′′ (C) < 0, lim U ′ (C) = ∞, lim U ′ (C) = 0.

The individual earns an exogenously given income w > 0 in period 1 of his life and earns nothing in
the second period of his life. But he can lend or borrow freely at an exogenously given rate of interest
r > 0.
It follows that C1 = w − S and C2 = (1 + r)S, where S is the savings made by the individual in period
1. Note that C1 (or S) and C2 are endogenously determined and the exogenously given parameters of
the model are w, r, and β.

(a) Suppose β(1 + r) = 1. Solve for C1 and C2 in terms of the exogenously given parameters.
(b) Now remove the restriction that β(1 + r) = 1. How would savings S be affected if β goes up,
ceteris paribus?

2. Problem 2: Consider an agent living for two periods, 1 and 2. The agent maximizes lifetime utility,
given by:
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U (C1 ) + U (C2 ),
1+ρ
where ρ > 0 captures the time preference, while C1 and C2 are the agent’s consumption in period 1 and
period 2, respectively. The agent supplies one unit of labor inelastically in period 1, earning a wage
w. A portion of this wage is consumed in period 1 and the rest is saved (denoted s). In period 2 the
agent does not work, but receives interest income on the savings. Principal plus the interest income
on savings goes to finance period 2 consumption. Thus, C1 + s = w and C2 = (1 + r)s, where r is the
rate of interest.
Assume that the per period utility function can be represented by (and only by) any positive linear
transformation of the form
C 1−θ − 1
U (C) = ,
1−θ
where 0 < θ < 1.

(a) Demonstrate, deriving your claim, how optimal savings, s, would respond to changes in r.
(b) Now suppose, initially, r = ρ. What happens to optimal savings, s, if r and ρ increase by the
same amount (so that the condition r = ρ continues to hold)?

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3. Problem 3: Consider an economy where a representative agent lives for three periods. In the first
period, she is young – this is the time when she gets education. In the second period, she is middle-aged
and with the level of education acquired in the first period, she generates income. More specifically,
if she has h units of education in the first period, she can earn w̄h in the second period, where w̄ is
the exogenously given wage rate. The agent borrows funds for her education when she is young and
repays with interest when she is middle-aged.
If in the first period, the agent borrows e, then the human capital h at the beginning of the second
period becomes h(e), where
dh d2 h
> 0 and < 0.
de de2
In the third period of her life, she consumes out of her savings made in the second period, that is,
when she was middle aged. Assume that the exogenous rate of interest (gross) on saving or borrowing
is R̄. For simplicity, assume that an agent does not consume when she is young and, thus, the lifetime
utility is
u(cM ) + βu(cO ),
where cM and cO are the level of consumption when they are middle-aged and old respectively and
β ∈ (0, 1) is the discount factor.

(a) Write down the utility maximization problem of the agent and the first order conditions.
(b) How does the optimal level of education vary with the wage rate and the rate of interest?

4. Problem 4: Consider an inter-temporal choice problem in which a consumer maximises utility,

u(c2 )
U (c1 , c2 ) = u(c1 ) +
1+δ
where ci is the consumption in period i, i = 1, 2, and δ is the discount factor (measure of the consumer’s
impatience), subject to
c2 Y2
c1 + = Y1 + ≡W
1+r 1+r
where Yi is the consumer’s income in period i = 1, 2, and r is the rate of interest. Assume ci > 1 ∀i.

(a) Let u(ci ) = log(ci ). Find a condition such that there is consumption smoothing.
(b) Plot the two cases where
i. the consumer biases its consumption towards the future, and
ii. the consumer biases its consumption towards the present.
Put c2 on the vertical axis and c1 on the horizontal axis.
(c) Suppose there is consumption smoothing. Solve for c∗1 = c1 (r, Y1 , Y2 ). Interpret this equation.
(d) Define YP , the permanent income, as that constant stream of income (YP , YP ) which gives the
same lifetime income as does the fluctuating income stream (Y1 , Y2 ). What does this imply about
the optimal choice of c1 , c2 , and YP ? Interpret your result graphically.