Macroeconomics BBE Unit 1 Lesson 3 Fisher s Inter Temporal Budget Constraint Consumption

Hi everyone, welcome back. So, in the previous two lessons we have discussed about the Keynesian consumption theory. We have started with unit one and there are four consumption theories in your syllabus. First was about Keynesian that we have completed and in Keynesian theory we discussed about the various conjectures, then we discussed about the derivation of the consumption function and then we discussed about certain empirical studies which support the Keynesian consumption function, but there are certain others anomalies which are associated with APC, because of which we discussed the consumption puzzle, i.e. short-run consumption function and long-run consumption function. Now, these two theories, Modigliani's theory and Freedman's theory, these two theories, these are an improvement over the Keynesian consumption function. But in order to understand these two theories, the second theory is important to understand that is Fisher's inter-temporal choice. So, today we will discuss Fisher's inter-temporal choice. This is an important concept from the aspect of your exams. So, let us start discussing Fisher's inter-temporal choice. So, see inter-temporal means that we are talking about time period and when we say inter-temporal means we are talking about related to two time periods. So, here when we say that this theory is related to consumption, then we base it on the fact that any consumer has a choice, that either he will consume now, i.e. in the present time period, or he will consume in the future, i.e. in the next time period. So, he has this choice, that is why we call it inter-temporal choice. And this theory was given by the economist Irving Fisher, that is why it is named after him. So, here we will take into account two things. Whenever we are discussing about consumer choices, so we will take into account the indifference curve, also the budget constraint. But now, we will take it from the aspect of consumption in time period 1 and consumption in time period 2. This theory is based on some assumptions. We have assumed that any consumer has only two time periods to spend. In the first time period, he can consume or save. And in the second time period, he can only consume. There is no period 3, so he will not save in the second time period. So, this is the basic assumption on which this theory is based. First, we will understand about what type of constraints to consumers face. Then, we will understand about the indifference curves. And finally, we will discuss about the optimization. So, this is the entire inter-temporal choice theory. In this lesson, we will discuss the basic assumptions of this theory. And we will discuss about the constraints that the consumers face. Let's start. So, as we have already discussed, temporal is related to the time period or time related. Inter-temporal is decision in one time period, they have affecting the options availability in the future. So, they have effect on the future consumption also. So, theoretically, in case of consumption, by not consuming today, we are actually preferring consumption levels could increase significantly in future and vice versa. So, that is why that decisions taken in one time period have an effect on other time period also. Now, Keynesian consumption theory relates current consumption with current level of income. So, Fisher's inter-temporal choice, it says that a rational, a forward-looking consumer, they make inter-temporal choice. Next week, it is my friend's birthday. That is the decisions to consume and save considers both present as well as the future. Now, so there is a trade-off between two words. And here, these two words are consumption in present and consumption in future. Here, the trade-off is consumption in first time period that is in present and consumption in second time period that is consumption in future. So, there is a trade-off between these two things. And hence, in making this trade-off, the consumers should and must look ahead to the income they expect to receive in the future. And thus, the consumption of goods and services, they hope that they can afford in future. Now, this Fisher's model, as I already discussed in the beginning of this lesson, it is based on two things. First, constraints faced by the consumer. And these constraints are in terms of the income and the preferences of the consumer. And these two together determine their choices about their consumption and saving decisions. Now, there are three assumptions in this theory. The first assumption is that entire life is divided between period one, period two. So, there is no period three. The consumer does not save in period two as there is no period three. Saver means that if the consumer consumes less now, then he will consume more in the next time period. And if he consumes more now, suppose his income is 100 rupees but consumption is 200 rupees, then he is a borrower and he will have to pay off in the next time period along with the paying the interest rate. So, these are certain assumptions of this theory. Let us now discuss the inter-temporal budget constraint. So, inter-temporal budget constraints represents various combinations which a consumer has of consumption in present and consumption in future. So, various combinations of consumption and saving or consumption in present and consumption in future available to the consumer given his entire resources, i.e. given his total income. Now, suppose we say that in period one, his income is Y1 and his consumption is C1. And we are assuming that suppose this consumer about whom we are discussing, he is a saver. So, if he is a saver, then his income will be more than his consumption. So, this means that saving is equal to Y1 minus C1. And he will also earn some interest rate on this saving which he will consume in the next time period with that interest rate. So, now suppose in the next time period, income is Y2 and consumption is C2. So, the total consumption in C2 will be equal to Y2 because it is the income of the second time period. In addition to that, he will also consume the savings which he had saved in the first time period. And he will also consume the interest rate on that saving. For example, if we say that our income in time period one was 100. And our saving in time period one is suppose 20 rupees. On which we are getting interest rate on this saving of suppose 2 rupees. Now our income in Y2 is suppose 110. So, what will be our consumption? We will consume this 110 because we do not have any period three. We will not save. In addition to that, we will also consume this saving. So, we have written the same thing here also. That consumption is equal to 1 plus R saving Y2. When you expand this, 1 plus R savings into plus Y2. This will be savings plus whatever interest rate we have got on savings plus Y2. This will be the entire consumption of this consumer in time period two. Now, this R is the real interest rate. And here when will be the saving? When our C1 means consumption in time period one is less than Y1. Means income in time period one. Or it can be borrowing also. Borrowing will be in the case when consumption in time period one that is C1 is greater than income in time period one that is Y1. So, the consumer does not have, does not save in the period two. Since there is no period three as it is assumed there are only two periods. And for simplicity, we say that the rate of saving is equal to rate of borrowing. It is not generally necessary that rate of saving will always be equal to rate of borrowing. So, now here we say whatever variables we have taken here. Means income, consumption, interest rate whatever we have taken. These are all real variables. There are two types of variables. Real and nominal. Nominal is when we take our exact amount in monetary terms. Real is that is adjusted for inflation. Now, since the consumer has the opportunity to save or borrow. So, consumption in any period can be greater or less than income in that period. So, here we say that our equation C2 is equal to. We had taken this equation on this page. C2 is equal to 1 plus r into s plus y2. So, we get C2 is equal to 1 plus r. Y1 minus C1 plus y2. When we expand this, we get C2 is equal to 1 plus r of y1 minus 1 plus r. And when we divide this both sides by 1 plus r, we get C1 plus C2 divided by 1 plus r is equal to y plus y2 divided by 1 plus r. And this is termed as consumer's intertemporal budget constraint. Along with the diagram, it can also come for 5 or 10 marks. Now, if we say that suppose this r is equal to 0. C1 plus C2 is equal to y1 plus y2. It means that total consumption in the two time periods is equal to total income in the two time periods. I hope now what do we mean by intertemporal budget constraint. Let us move on to the diagrammatic derivation of this constraint. As we said while explaining that when we talk about intertemporal budget constraint or intertemporal choice, consumers have to trade off consumption in present and consumption in the future. That is consumption in time period 1. And this black line shows the budget constraint. Now, so here if we say at point A, so here consumer consumes exactly his income in both the time periods. Suppose as he moves from this A point, as he moves from this A point towards B point, he becomes a saver. And as he moves from this A point to C point, he becomes a borrower. Now, at point B, here the consumer. At point B, if you see, the consumer is at zero point. Consumption zero. Whereas, at point C, consumer consumes everything in the first time period. Practically, it is not possible that you consume only now and not in the next time period. But diagrammatically, this is feasible. So, at point B, consumer consumes nothing in first time period because C1 is equal to zero. As we can see, I'll just open this full page. Yes, now I think full page should be visible to you. At point B, C1 is zero as we have discussed and S is equal to Y1. So, all the income is saved. Similarly, at point C, C1, we are consuming everything. We are not saving anything and C2 is equal to zero. This is written over here. At point C, consumer consumes nothing in the second time period and he borrows everything. And between these two periods, that is between A and B, he is a saver and between A and C, he is a borrower. Therefore, we can say that the consumer can afford all the combinations that is available here in this budget constraint. I hope Irving Fisher's Intertemporal Budget Constraint is clear. In the next lesson, we will discuss about the consumer preferences. And indifference curve. We will involve indifference curve also and we will discuss optimization, that is tangency of the Intertemporal Budget Constraint and the indifference curves. All the best for your preparation, everyone. Do prepare well. I'm here to help you. If you have any problem, any doubt, you can post it in the comments. I'll try to resolve. All the best.