Intertemporal Macroeconomic Models, Money and Rational Choices

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Theoretically, by not consuming today, consumption levels could increase significantly in the future, and vice versa. The economist Irving Fisher formulated the model with which economists analyze how rational, forward looking people make intertemporal choices, that is choices involving different periods of time. Intertemporal decisions made by companies include decisions on investment, staffing and long-term competitive strategy.

In Austrian economics , intertemporal equilibrium refers to the belief that at any one time the economy is in disequilibrium, and only when examining at it over the long term that it is in equilibrium. Austrian economists, who strive to solve complex issues — economic ones — by conducting thought experiments, postulate that the interest rate coordinates the intertemporal equilibrium by best allocating resources throughout the production structure. Thus intertemporal equilibrium can only be reached when individuals' consumption and investment choices are matched with the investment being carried out in the production structure which will allow goods to come to market in the future, in accordance with the time preference of the population.

This is a central tenet of the Austrian School , represented by economists such as Friedrich Hayek and Ludwig von Mises who believed that the genius of the free market is not that it perfectly matches supply and demand, but rather that it encourages innovation to best meet that supply and demand. Investopedia uses cookies to provide you with a great user experience. By using Investopedia, you accept our. Your Money. Personal Finance. Your Practice. Alternatively, Sergei might react by dramatically reducing his purchases of bats and instead buy more cameras.

The key is that it would be imprudent to assume that a change in the price of baseball bats will only or primarily affect the good whose price is changed, while the quantity consumed of other goods remains the same. Since Sergei purchases all his products out of the same budget, a change in the price of one good can also have a range of effects, either positive or negative, on the quantity consumed of other goods. In short, a higher price typically causes reduced consumption of the good in question, but it can affect the consumption of other goods as well.

Read this article about the potential of variable prices in vending machines. Changes in the price of a good lead the budget constraint to shift. A shift in the budget constraint means that when individuals are seeking their highest utility, the quantity that is demanded of that good will change.

In this way, the logical foundations of demand curves—which show a connection between prices and quantity demanded—are based on the underlying idea of individuals seeking utility. The preferred choice on the original budget constraint that provides the highest possible utility is labeled M 0. The other three budget constraints represent successively higher prices for housing of P 1 , P 2 , and P 3.

As the budget constraint rotates in, and in, and in again, the utility-maximizing choices are labeled M 1 , M 2 , and M 3 , and the quantity demanded of housing falls from Q 0 to Q 1 to Q 2 to Q 3. Figure 5. The utility-maximizing choice changes from M0 to M1 to M2 to M3. As a result, the quantity demanded of housing shifts from Q0 to Q1 to Q2 to Q3, ceteris paribus. Indeed, the quantities of housing are the same at the points on both a and b.

Thus, the original price of housing P0 and the original quantity of housing Q0 appear on the demand curve as point E0. The higher price of housing P1 and the corresponding lower quantity demanded of housing Q1 appear on the demand curve as point E1. So, as the price of housing rises, the budget constraint shifts to the left, and the quantity consumed of housing falls, ceteris paribus meaning, with all other things being the same.

This relationship—the price of housing rising from P 0 to P 1 to P 2 to P 3 , while the quantity of housing demanded falls from Q 0 to Q 1 to Q 2 to Q 3 —is graphed on the demand curve in Figure 5 b. The shape of a demand curve is ultimately determined by the underlying choices about maximizing utility subject to a budget constraint. The budget constraint framework for making utility-maximizing choices offers a reminder that people can react to a change in price or income in a range of different ways. For example, in the winter months of , costs for heating homes increased significantly in many parts of the country as prices for natural gas and electricity soared, due in large part to the disruption caused by Hurricanes Katrina and Rita.

Some people reacted by reducing the quantity demanded of energy; for example, by turning down the thermostats in their homes by a few degrees and wearing a heavier sweater inside. Even so, many home heating bills rose, so people adjusted their consumption in other ways, too. The short run demand for home heating is generally inelastic. Each household cut back on what it valued least on the margin; for some it might have been some dinners out, or a vacation, or postponing buying a new refrigerator or a new car.

Indeed, sharply higher energy prices can have effects beyond the energy market, leading to a widespread reduction in purchasing throughout the rest of the economy. A similar issue arises when the government imposes taxes on certain products, like it does on gasoline, cigarettes, and alcohol. Say that a tax on alcohol leads to a higher price at the liquor store, the higher price of alcohol causes the budget constraint to pivot left, and consumption of alcoholic beverages is likely to decrease.

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However, people may also react to the higher price of alcoholic beverages by cutting back on other purchases. For example, they might cut back on snacks at restaurants like chicken wings and nachos. It would be unwise to assume that the liquor industry is the only one affected by the tax on alcoholic beverages. This program provides a fixed amount of money per child to every family, regardless of family income.

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Traditionally, the child allowance had been distributed to families by withholding less in taxes from the paycheck of the family wage earner—typically the father in this time period. The new policy instead provided the child allowance as a cash payment to the mother. As a result of this change, households have the same level of income and face the same prices in the market, but the money is more likely to be in the purse of the mother than in the wallet of the father.

Should this change in policy alter household consumption patterns?

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Intertemporal Macroeconomic Models, Money and Regional Choice -

Basic models of consumption decisions, of the sort examined in this chapter, assume that it does not matter whether the mother or the father receives the money, because both parents seek to maximize the utility of the family as a whole. In effect, this model assumes that everyone in the family has the same preferences.

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  5. In reality, the share of income controlled by the father or the mother does affect what the household consumes. These findings suggest that when providing assistance to poor families, in high-income countries and low-income countries alike, the monetary amount of assistance is not all that matters: it also matters which member of the family actually receives the money. The budget constraint framework serves as a constant reminder to think about the full range of effects that can arise from changes in income or price, not just effects on the one product that might seem most immediately affected.

    People do not obtain utility just from products they purchase. They also obtain utility from leisure time. Leisure time is time not spent at work. The decision-making process of a utility-maximizing household applies to what quantity of hours to work in much the same way that it applies to purchases of goods and services. Choices made along the labor-leisure budget constraint , as wages shift, provide the logical underpinning for the labor supply curve.

    The discussion also offers some insights about the range of possible reactions when people receive higher wages, and specifically about the claim that if people are paid higher wages, they will work a greater quantity of hours—assuming that they have a say in the matter. According to the Bureau of Labor Statistics, U. This average includes part-time workers; for full-time workers only, the average was Wages and salaries are about three-quarters of total compensation received by workers; the rest is in the form of health insurance, vacation pay, and other benefits.

    The compensation workers receive differs for many reasons, including experience, education, skill, talent, membership in a labor union, and the presence of discrimination against certain groups in the labor market. How do workers make decisions about the number of hours to work?

    The economic logic is precisely the same as in the case of a consumption choice budget constraint , but the labels are different on a labor-leisure budget constraint. Hours of leisure are measured from left to right on the horizontal axis, while hours of labor are measured from right to left. She will choose the point that provides her with the highest total utility. Figure 6. A rise in her wage causes her opportunity set to swing upward. In response to the increase in wages, Vivian can make a range of different choices available to her: a choice like D, which involves less work; and a choice like B, which involves the same amount of work but more income; or a choice like A, which involves more work and considerably more income.

    For Vivian to discover the labor-leisure choice that will maximize her utility, she does not have to place numerical values on the total and marginal utility that she would receive from every level of income and leisure. All that really matters is that Vivian can compare, in her own mind, whether she would prefer more leisure or more income, given the tradeoffs she faces.

    A higher wage will mean a new budget constraint that tilts up more steeply; conversely, a lower wage would have led to a new budget constraint that was flatter. In effect, Vivian can choose whether to receive the benefits of her wage increase in the form of more income, or more leisure, or some mixture of these two. With this range of possibilities, it would be unwise to assume that Vivian or anyone else will necessarily react to a wage increase by working substantially more hours.

    Maybe they will; maybe they will not. The theoretical insight that higher wages will sometimes cause an increase in hours worked, sometimes cause hours worked not to change by much, and sometimes cause hours worked to decline, has led to labor supply curves that look like the one in Figure 7. The bottom-left portion of the labor supply curve slopes upward, which reflects the situation of a person who reacts to a higher wage by supplying a greater quantity of labor.

    The middle, close-to-vertical portion of the labor supply curve reflects the situation of a person who reacts to a higher wage by supplying about the same quantity of labor. The very top portion of the labor supply curve is called a backward-bending supply curve for labor, which is the situation of high-wage people who can earn so much that they respond to a still-higher wage by working fewer hours. Figure 7. A Backward-Bending Supply Curve of Labor The bottom upward-sloping portion of the labor supply curve shows that as wages increase over this range, the quantity of hours worked also increases.

    The middle, nearly vertical portion of the labor supply curve shows that as wages increase over this range, the quantity of hours worked changes very little. The backward-bending portion of the labor supply curve at the top shows that as wages increase over this range, the quantity of hours worked actually decreases.

    All three of these possibilities can be derived from how a change in wages causes movement in the labor-leisure budget constraint, and thus different choices by individuals. Americans work a lot. To get a perspective on these numbers, someone who works 40 hours per week for 50 weeks per year, with two weeks off, would work 2, hours per year.

    The gap in hours worked is a little astonishing; the to hour gap between how much Americans work and how much Germans or the French work amounts to roughly six to seven weeks less of work per year. Economists who study these international patterns debate the extent to which average Americans and Japanese have a preference for working more than, say, Germans, or whether German workers and employers face particular kinds of taxes and regulations that lead to fewer hours worked.

    It is also interesting to take the amount of time spent working in context; it is estimated that in the late nineteenth century in the United States, the average work week was over 60 hours per week—leaving little to no time for leisure. The different responses to a rise in wages—more hours worked, the same hours worked, or fewer hours worked—are patterns exhibited by different groups of workers in the U.

    These workers do not much change their hours worked as wages rise or fall, so their supply curve of labor is inelastic. However, part-time workers and younger workers tend to be more flexible in their hours, and more ready to increase hours worked when wages are high or cut back when wages fall.

    The backward-bending supply curve for labor, when workers react to higher wages by working fewer hours and having more income, is not observed often in the short run. However, some well-paid professionals, like dentists or accountants, may react to higher wages by choosing to limit the number of hours, perhaps by taking especially long vacations, or taking every other Friday off.

    Over a long-term perspective, the backward-bending supply curve for labor is common.


    Over the last century, Americans have reacted to gradually rising wages by working fewer hours; for example, the length of the average work-week has fallen from about 60 hours per week in to the present average of less than 40 hours per week. Recognizing that workers have a range of possible reactions to a change in wages casts some fresh insight on a perennial political debate: the claim that a reduction in income taxes—which would, in effect, allow people to earn more per hour—will encourage people to work more.

    The leisure-income budget set points out that this connection will not hold true for all workers. Some people, especially part-timers, may react to higher wages by working more. Many will work the same number of hours. Some people, especially those whose incomes are already high, may react to the tax cut by working fewer hours. Of course, cutting taxes may be a good or a bad idea for a variety of reasons, not just because of its impact on work incentives, but the specific claim that tax cuts will lead people to work more hours is only likely to hold for specific groups of workers and will depend on how and for whom taxes are cut.

    A decision about how much to save can be represented using an intertemporal budget constraint. Household decisions about the quantity of financial savings show the same underlying pattern of logic as the consumption choice decision and the labor-leisure decision. Since then, the rate of personal savings has fallen substantially, although it seems to have bounced back a bit since The discussion of financial saving here will not focus on the specific financial investment choices, like bank accounts, stocks, bonds, mutual funds, or owning a house or gold coins.

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    Here, the focus is saving in total—that is, on how a household determines how much to consume in the present and how much to save, given the expected rate of return or interest rate , and how the quantity of saving alters when the rate of return changes. Savings behavior varies considerably across households. One factor is that households with higher incomes tend to save a larger percentage of their income.

    Another factor that causes personal saving to vary is personal preferences. Some people may prefer to consume more now, and let the future look after itself. Others may wish to enjoy a lavish retirement, complete with expensive vacations, or to pile up money that they can pass along to their grandchildren. There are savers and spendthrifts among the young, middle-aged, and old, and among those with high, middle, and low income levels. Parallel open-economy welfare analyses are now beginning to emerge.

    While much work still lies ahead, we can now hope to evaluate international monetary arrangements at the same level of rigor that is applied already to understanding the long-run effects of tax policies. While the new open-economy macroeconomics provides a firmer foundation for intertemporal policy analysis than the earlier Mundell-Fleming approach, it does not overturn except in special and implausible models a central insight that was at the core of Mundell's analysis of the optimum currency area.

    When prices are sticky and labor is internationally immobile, country-specific shocks can be weathered most easily if the exchange rate is flexible. Indeed, if region-specific shocks are sufficiently variable and large within a candidate currency area, then the flexibility benefits from retaining region-specific currencies may outweigh the allocation costs of having several currencies, rather than one, trading at uncertain mutual exchange rates. One important factor omitted from the Mundellian calculus has come to the fore in recent international monetary experience: the credibility of domestic monetary institutions and of the exchange rate regime.

    Depending on the circumstances, credibility can be a two-edged sword, cutting in favor of either floating or fixed exchange rates. Even when a country announces and maintains a par value for its currency's exchange rate, circumstances normally will arise in which the country wishes it could change the exchange rate. The country will do so, devaluing or revaluing its currency, if the short-run benefits outweigh whatever costs the government perceives from reneging on its previous promise to maintain the currency at par. Indeed, in the face of severe adverse country-specific shocks and under capital mobility, speculative expectations of devaluation can raise domestic interest rates sharply, thereby making devaluation more probable and possibly hastening its occurrence.

    6.4 Intertemporal Choices in Financial Capital Markets

    This credibility problem of pegged exchange rates makes the exchange rate less predictable and may imply welfare benefits far below those that a credibly fixed exchange rate might confer. Furthermore, without some high-cost commitment mechanism to bind policymakers to the fixed exchange rate, the arrangement could be unstable, absent strict and effective controls on capital flows.

    This latter prediction seemed exotic when I first suggested it in the mids, 15 but the experience of the s -- including the European currency crises of , the Latin American "Tequila" crisis of , and the worldwide financial crises of -- have driven many observers to the same conclusion. In fact, relatively few countries have succeeded in maintaining a fixed exchange rate even for a period of five years. Some of my recent work, inspired by the European and Tequila crises, has modeled mechanisms through which investor expectations can interact with the political and economic objectives of policymakers, yielding multiple equilibriums in which speculation against a currency can result in a realignment that would not have occurred otherwise.

    Many of the resulting papers modeled crises as shifts from benign to malign equilibriums. Governments of the major currency areas developed fairly strong monetary policy institutions such as independent central banks after the inflationary excesses of the s. They seem to have concluded that, despite inexplicable exchange rate volatility, the quicker and less painful adjustment that exchange rate flexibility allows far outweighs the putative gains from fixed exchange rates -- gains that, in any case, would be sharply reduced by the inherently low credibility of exchange rate commitments. Still, there are more than a few cases in which the difficulty of building credible domestic policy institutions is such that high inflation can be controlled only through some extreme commitment mechanism centered on a fixed exchange rate.

    Argentina, in the wake of hyperinflation in , wrote into its constitution a currency board system under which all base money is backed by foreign reserves and domestic pesos are convertible into dollars at a rate. In cases like Argentina's, the credibility of the exchange rate commitment is greatly enhanced by political consensus based on a widespread fear of lapsing into the monetary instability of the past. Paradoxically, countries with strong domestic monetary institutions might lack the ability to credibly fix their exchange rates, in part because the alternative to fixed rates is not unthinkable.

    But even the currency boards have been tested by speculators and, in some cases, have come close to shattering. Perhaps the ultimate sacrifice of policy autonomy in the interest of credibility is to adopt a foreign currency altogether, as in Ecuador's recent decision to "dollarize" its economy. By adopting a shared currency, the eleven founding members of the European Economic and Monetary Union EMU , soon to be joined by Greece, have eliminated the credibility problem of mutually pegged exchange rates.

    After the currency instability of , prospective euro zone members were able to make a relatively smooth transition to the common currency in large part because of their countries' overarching political objective of maintaining stable exchange rates so as to qualify for the first wave of EMU in January While the political costs of exiting the EMU probably are prohibitive, it remains to be seen whether the non-EMU members of the European Union -- Denmark, Sweden, and the United Kingdom -- will find the political advantages of joining decisive.

    In purely economic terms, it is hard to argue that they have suffered much if at all from their retention of national currencies. In my work on monetary regimes, I argue that strong domestic monetary institutions -- institutions that largely overcome dynamic consistency problems -- make fixed exchange rates much less attractive. One might still ask whether some form of international monetary coordination mechanism is helpful at the stage where countries put into place their domestic institutions. After all, if a policy institution is designed simply to address domestic problems, might its creation not involve spillover effects abroad that could be internalized through coordinated institution-building by several countries?

    Perhaps surprisingly, there seems to be little scope for such coordination, as Rogoff and I show. Our preliminary numerical experiments suggest that the welfare differences between coordinated and uncoordinated Nash equilibrium rules are tiny indeed. Even if the world's economies, including its richest ones, are far from full economic integration, the clear trend is toward increasingly closer integration of goods and asset markets.

    Is that trend likely to continue? My own research in this area focuses on the asset-market side of globalization. A major reason countries have pursued capital account liberalization is the prospect of economic efficiency gains analogous to those that free trade in goods and services delivers. Conversely, controls on international capital movement are difficult and costly to enforce for any period of time and have become progressively harder to maintain as international product trade has expanded.

    While capital-account liberalization in principle has distributive effects similar to those of trade liberalization, the political opposition to freer trade in capital has not at least in recent decades been nearly as visible as opposition to freer trade in goods. Here, too, attempts to reach international agreement have suffered setbacks. Potential gains to global trade in assets come from a number of sources, including a better allocation of the world's savings and more effective risksharing among countries. Harold Cole and I made an early attempt to quantify the potential benefits from the international sharing of consumption risks.

    We found them to be quite small, generally well below 1 percent of GDP per year. Free international capital mobility can compromise national sovereignty over economic policies, however. One symptom of this is what Alan M.

    6.4 Intertemporal Choices in Financial Capital Markets

    Taylor and I have labeled the "trilemma" of the exchange rate a proposition recently associated with Mundell's work, but actually familiar much earlier to writers such as John Maynard Keynes. Countries can choose at most two items from the following list of three: free mobility of capital, a fixed exchange rate, and a monetary policy oriented toward domestic goals.

    Taylor and I argue that the widespread use of floating exchange rates has, in fact, promoted capital account liberalization by permitting countries to pursue domestically oriented monetary policies even in the presence of free cross-border asset transactions. Of course, where countries have adopted fixed rates, either to banish a legacy of economic policy abuse Argentina or in the interest of political goals EMU , we see capital mobility, but a renunciation of active monetary policy.

    Either way, most countries are moving to options that involve open capital markets.

    Inter temporal Choice (ECO)

    Another realm in which capital mobility may threaten national sovereignty is that of tax policy. If capital can flee high-tax jurisdictions, then tax competition will force capital taxes downward, and countries will be driven to rely increasingly on taxes on labor. In the extreme, governments could find themselves unable to provide the services and infrastructure that their electorates desire without imposing a crushing fiscal burden on workers. This is not to say that there are no problems intrinsic to a globalized capital market in a world of sovereign nations -- far from it.

    Globalization is like a powerful new medicine, one that offers immense possible benefits but must be used with caution because of the possible side effects. Domestic financial stability is endangered when countries open up their capital markets without adequate institutional safeguards against excessive risk taking. That lesson was underscored by the Asian crisis of By extension, connections between national markets and inconsistencies among the many different national supervisory regimes can create conditions in which a global crisis may occur as we also saw in Attempts are under way to address these structural flaws, and the future of the global capital market ultimately will depend on their success.

    Intertemporal Macroeconomic Models, Money and Rational Choices Intertemporal Macroeconomic Models, Money and Rational Choices
    Intertemporal Macroeconomic Models, Money and Rational Choices Intertemporal Macroeconomic Models, Money and Rational Choices
    Intertemporal Macroeconomic Models, Money and Rational Choices Intertemporal Macroeconomic Models, Money and Rational Choices
    Intertemporal Macroeconomic Models, Money and Rational Choices Intertemporal Macroeconomic Models, Money and Rational Choices
    Intertemporal Macroeconomic Models, Money and Rational Choices Intertemporal Macroeconomic Models, Money and Rational Choices

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