Background
Elasticity of intertemporal substitution (EIS) is a concept in economics that captures how willing a consumer is to reallocate their consumption between different time periods in response to changes in the rate of return on savings or investments. Essentially, it measures the degree to which people are willing to postpone current consumption for future consumption when faced with changes in interest rates.
Historical Context
The concept of EIS emerged from the broader field of intertemporal choice, which has been investigated by various economists over time. Irving Fisher laid the groundwork for thinking about intertemporal choices in terms of an individual’s rate of time preference. Later developments by Robert Lucas and others integrated these ideas into macroeconomic modeling, significantly influencing how economists think about savings, investment, and consumption behavior over time.
Definitions and Concepts
Elasticity of intertemporal substitution, denoted commonly by the symbol ε_s, is formally defined as the percentage change in the growth rate of consumption resulting from a one-percent change in the intertemporal rate of substitution, which is often related to the real interest rate. Mathematically, it can be represented as:
\[ \epsilon_s = \frac{\Delta(C_{t+1}/C_t)}{\Delta(1 + r)} \]
where \( C_t \) and \( C_{t+1} \) are consumption at times t and t+1, and \( r \) is the real interest rate.
Major Analytical Frameworks
Classical Economics
Classical economics mainly focused on static analysis and did not specifically address intertemporal consumption choices.
Neoclassical Economics
In neoclassical economics, the EIS is deeply integrated into models of optimal consumption. The Ramsey-Cass-Koopmans model, for instance, utilizes EIS to explain how consumers adjust their consumption and savings paths over their lifecycle.
Keynesian Economics
Keynesian models typically emphasize current period consumption and are more concerned with immediate adjustments in response to short-term fluctuations. The robustness of Keynesian frameworks for addressing intertemporal choices often comes into critique given the assumption of sticky consumption.
Marxian Economics
Marxian economics does not explicitly deal with EIS, focusing more on class struggles, production relations, and capital accumulation.
Institutional Economics
Institutional economics might examine how various institutions (such as financial markets, cultural norms regarding savings, or policies) impact EIS and the broader implications for economic performance.
Behavioral Economics
Behavioral economists study the psychological aspects influencing intertemporal choices, noting that consumers often display hyperbolic discounting and may not act in ways consistent with high EIS values predicted by rational choice models.
Post-Keynesian Economics
Post-Keynesian models extend traditional Keynesian thought to consider the dynamic relationship between consumption, savings, and investment, albeit without always explicitly modeling EIS.
Austrian Economics
Austrian economics, particularly through the study of time-preference theory, is fundamentally concerned with intertemporal choices but often addresses EIS from a qualitative not quantitative standpoint.
Development Economics
EIS is pertinent in development economics for understanding how individuals in developing countries allocate resources for immediate versus future consumption, impacting their long-term financial planning and economic growth potential.
Monetarism
Monetarists incorporate EIS in discussing the effects of monetary stabilization policies on consumption and investment patterns over time.
Comparative Analysis
Different economic schools offer unique perspectives on the importance and modeling of EIS. Neoclassical and Monetarist frameworks tend to quantitively integrate EIS into their models, while behavioral economists challenge these models by highlighting real-world deviations in consumer behavior.
Case Studies
- The impact of changes in interest rates on savings and consumption in Japan during the Lost Decade.
- Analysis of household saving behavior in response to economic policies in post-recession US.
Suggested Books for Further Studies
- “Intertemporal Choice and Policy Analysis" by Paul Samuelson
- “Macroeconomic Analysis and Policy” by D. Wynne, William D. Nordhaus
- “Behavioral Intertemporal Economics” by Richard H. Thaler and Cass R. Sunstein
Related Terms with Definitions
- Intertemporal Choice: The process by which individuals make decisions about what and how much to consume over different time periods.
- Real Interest Rate: The rate of interest an investor expects to receive after allowing for inflation.
- Time Preference: The relative valuation placed on receiving a good or service at an earlier date compared to a later one.
- Lifecycle Hypothesis: A theory that describes the spending and saving habits of people over the course of their life.