February 05, 2004
Intertemporal Substitutiion
Why do people save money?
We begin this discussion with a review of intertemporal substitution. This extension of the two goods - two prices diagram shows how a utility maximizing agent chooses his or her optimal consumption in two time periods given the ability to save and borrow money at interest rate R.
When we incorporated inflation into the analysis, we found that using the real interest rate instead of the nominal interest rate allowed us to analyze the problem with minimal changes to the setup.