[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

typically save. This is not always the case, though: in 1999 U.S. households actually
dissaved, spending more than they earned in income. We will focus on firms as the
major borrowers in the economy.
SPENDING IN PERIOD 2
(JOAN’S RETIREMENT YEARS)
B
w (1 + r)
D
Figure 9.1
High consumption in
retirement years
Current
consumption
Trade-off: At every point on this
budget constraint, Joan can trade
$1 of consumption in period 1 for
$(1 + r ) in period 2.
Joan’s two-period
budget constraint
E
“Smooth consumption”
choice
F
Current
saving
High consumption
in working years
C
Wages (w)
SPENDING IN PERIOD 1 (JOAN’S WORKING YEARS)
THE TWO-PERIOD BUDGET CONSTRAINT
The two-period budget constraint BC describes the possible
combinations of current and future consumption available.
Wages not spent in period 1 become savings, which earn
interest. As a result, forgoing a dollar of consumption today
increases future consumption by more than a dollar.
THE HOUSEHOLD DECISION TO SAVE
The assumption that individuals spend their money in a rational manner, thinking
through the alternatives clearly, holds for decisions about saving as well as about
spending and working. In making their saving decisions, individuals are making a
choice about when to spend or consume. If they consume less today—that is, if they
save more today—they can consume more tomorrow.
We use the budget constraint to analyze this decision. Instead of showing a choice
between goods, the budget constraint now shows, as in Figure 9.1, a choice between
spending in two time periods: here, “working years” and “retirement years.” Consider
the case of Joan. She faces the lifetime budget constraint depicted in the figure. The
first period is represented on the horizontal axis, the second on the vertical axis.
Her wages during her working life (the first period) are w. Thus, at one extreme,
she could consume all of w in the first period (point C) and have nothing for her
retirement. At the other extreme, she could consume nothing in
the first period, save all of her income, and consume her savings,
together with any accumulated interest she has earned on her savings,
in the second period (point B). If we use r to denote the rate
of interest, her consumption in the second period at point B is
w(1 + r). In between these extremes lies a straight line that defines
the rest of her choices. She can choose any combination of firstand
second-period consumption on this line. This is Joan’s
two-period budget constraint.
By postponing consumption—that is, by saving—Joan can
increase the total amount of goods that she can obtain, because
she is paid interest on her savings. The cost, however, is that she
must wait to enjoy the goods. But what is the relative price, the
trade-off between future and current consumption? To put it
another way, how much extra future consumption can she get if
she gives up one unit of current consumption?
If Joan decides not to consume one more dollar today, she can
take that dollar, put it in the bank, and get back at the end of the year
that dollar plus interest. If the interest rate is 5 percent, then for
every dollar of consumption that Joan gives up today, she can get
$1.05 of consumption next year. The relative price (of consumption
today relative to consumption tomorrow) is thus 1 plus the interest
rate. Because Joan must give up more than $1.00 of consumption
in the second period to get an additional $1.00 worth of consumption
today, current consumption is more expensive than future consumption.
The opportunity cost of current consumption is the
future consumption that is forgone, and this cost depends on the rate
of interest.
192 ∂ CHAPTER 9 CAPITAL MARKETS