A Simple Two-period Model

Luisa Lambertini
Macro-Finance, MFE

The economy is populated by a continuum of identical individuals distributed over the

interval [0, 1]. Hence, we can focus on the behavior of the representative agent of this economy.
This is a small open economy that consumes a single good and lasts two periods, labeled 1
and 2. Although this is a simple economy, it is a necessary and useful building block.

1 The Model

In period 1 the representative agent maximizes lifetime utility U1 , which depends only on
consumption levels, more precisely

U1 = u(c1 ) + βu(c2 ), (1)

where

• c1 is consumption of the single good in period 1;

• c2 is consumption of the single good in period 2;

• 0 < β < 1 is a fixed preference parameter, called the subjective discount factor or
time-preference factor, that means that the representative agent values consumption
today more than it values consumption tomorrow.

u(·) is the period utility function and we assume that it is strictly increasing in consumption
u0 (c) > 0 and strictly concave u00 (c) < 0. Typically we also assume that the Inada condition
is satisfied, namely
lim u0 (c) = +∞,
c→0

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which ensures that individuals always desire at least a little consumption in every period,
so that we do not need to add formal constraints of the type cs > 0 to the maximization
problem.

Let y1 denote the representative agent’s output in period 1 and y2 the output in period
2. For the moment we are going to assume that these output levels are exogenously given.
In other words, we are going to assume that yi is the endowment level of the representative
agent in period i without asking where such endowment comes from. r is the real interest
rate for borrowing or lending in the world capital market on date 1. Then consumption levels
must be chosen so as to satisfy the lifetime budget constraint of the individual:
c2 y2
c1 + = y1 + . (2)
1+r 1+r
This constraint restricts the present value of consumption spending to equal the present value
of endowment of output. Output is perishable and cannot be stored for consumption later
in life.

We assume for the moment that there is no uncertainty about future output and that the
consumer bases decisions on perfect foresight of the future.

There are several ways to solve the problem of maximizing (1) subject to (2). Here we
utilize the lagrangian method, but you could also solve c2 as a function of c1 and substitute
it into the lifetime utility function and maximize directly.

We want to solve
max u(c1 ) + βu(c2 ) (3)
c1 ,c2
c2 y2
subject to c1 + = y1 + .
1+r 1+r
The lagrangian associated to (3) is given by
c2 y2
 
max L = u(c1 ) + βu(c2 ) + λ −c1 − + y1 + . (4)
c1 ,c2 ,λ 1+r 1+r
Now we differentiate L with respect to c1 , c2 , λ. The first-order condition relative to c1 is

u0 (c1 ) − λ = 0. (5)

The first-order condition relative to c2 is

λ
βu0 (c2 ) − = 0. (6)
1+r

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The first-order condition relative to λ is
c2 y2
−c1 − + y1 + = 0, (7)
1+r 1+r
which is simply equal to the lifetime budget constraint.

We can write (5) as

u0 (c1 ) = λ,

which shows that the lagrangian multiplier λ has an economic interpretation: it is equal to
the marginal utility of consumption in period 1. (6) can be rewritten as

β(1 + r)u0 (c2 ) = λ,

which shows that the lagrangian multiplier λ must be equal to the present discounted value
of the marginal utility of consumption in period 2. Combining the two expressions above we
obtain
u0 (c1 ) = β(1 + r)u0 (c2 ) (8)

which is called an intertemporal Euler equation. This equation, which you will see many
many times in this course, has a simple interpretation: at a utility maximum, the consumer
cannot gain from shifting consumption between periods. A one-unit reduction of in first-
period consumption lowers U1 by u0 (c1 ). The consumption unit saved, i.e. not consumed,
can be converted (by lending it abroad) into 1 + r units of second-period consumption that
raise U1 by β(1 + r)u0 (c2 ). Hence, at an optimum, these two quantities must be equal.

An alternative interpretation of the intertemporal Euler equation can be seen by rewriting

(8) as
βu0 (c2 ) 1
0
= .
u (c1 ) 1+r
The left-hand side of the expression above is the representative agent’s marginal rate of
substitution of present (date 1) for future (date 2) consumption. The right-hand side is the
price of future consumption in terms of present consumption.

2 An Alternative Interpretation

Let bp2 denote the amount of lending (if positive), borrowing (if negative) that the repre-
sentative consumer does in period 1. This is the endowment that the consumer does not

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consume and save by lending it to the rest of the world. bp2 is lent in period 1 and repaid
back, principal plus interest, at the beginning of period 2. Hence, in period 2 the representa-
tive consumer receives bp2 (1 + r). We assume that the consumer begins life with no existing
lending/borrowing, i.e. bp1 = 0. We also assume that the economy ends period 2 holding no
uncollected claims on foreigners, i.e. bp3 = 0.

Thus the lifetime budget constraint can be broken down in period 1 and period 2 budget
constraints, respectively
c1 + bp2 = y1 , (9)

c2 = bp2 (1 + r) + y2 , (10)

where bp2 can be positive or negative.

We can solve (9) for c1 and (10) for c2 and plug the expressions into U1 to obtain

max
p
u(y1 − bp2 ) + βu(y2 + (1 + r)bp2 ). (11)
b2

The first-order condition relative to bp2 is

−u0 (c1 ) + βu0 (c2 )(1 + r) = 0, (12)

which is exactly the intertemporal Euler equation (8).

First-order conditions are not enough to ensure that we have a maximum. Second-order
conditions need to be checked too. In order to have a maximum, the first derivative should
be equal to zero and the second derivative should be negative. Let’s differentiate (12) with
respect to bp2 and we find
u00 (c1 ) + βu00 (c2 )(1 + r)2 < 0

because of our assumption that the period utility is strictly concave, namely u00 (c) < 0.
Hence, we indeed have a maximum.

3 Equilibrium

An important special case for a small open economy is the one in which β = 1/(1 + r), so
that the subjective discount rate equals the market discount factor. In this case

u0 (c1 ) = u0 (c2 ),

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which implies that the consumer desires a flat lifetime consumption path, c1 = c2 . Now we
can solve for the consumption levels

(1 + r)y1 + y2
c1 = c2 =
2+r

and lending is
c2 − y 2 y1 − y2
bp2 = y1 − c1 = = .
1+r 2+r
Notice that, in this case, we have been able to solve for c1 , c2 without specifying the period
utility function.

Let’s go back to lecture 1 and the definition of current account. In our simplified model
there is no government spending (G = 0) and no investment (I = 0), where capital letters
refer to macroeconomic variables, namely to aggregates of individual variables. In our model
the national income identity is
Y = C + CA

where CA is the current account. In our model aggregate and individual variables are iden-
tical. Hence
CA1 = y1 − c1 = bp2 .

Hence, lending in period 1 is equal to the current account in period 1. Remember that the
current account is the change in the value of the country’s net claims on the rest of the world,
i.e. the change in its net foreign assets. bp2 = CA1 > 0 means that the country lends to the
rest of the world and therefore increases by CA1 its net foreign wealth.

Under the assumption that β = 1/(1 + r)

y1 − y2
CA1 = .
2+r

Since the consumer desires a flat consumption profile, it lends any excess of first-period over
second-period endowment. See figure 1.

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4 Autarky Interest Rates and the Intertemporal Trade
Pattern

Suppose the economy is closed and cannot borrow from/lend to another country. In this case
c1 = y1 and c2 = y2 . The marginal rate of substitution in autarky is the left-hand side of the
expression below
βu0 (y2 ) 1
0
= ,
u (y1 ) 1 + rA
which defines the autarky interest rate rA . With interest rate rA , the country would be happy
to consume exactly its endowment. See figure 1.

Notice that international capital markets allows a country to have different output and
consumption profiles. In other words, point C and point A need not coincide for an open econ-
omy. What are the gains from intertemporal trade? The distance between the indifference
curve through A and that through C.

5 Comparative Statics

• y1 ↑: CA1 ↑

• y2 ↑: CA1 ↓

• r ↑: budget line gets steeper but still goes through point A. The effect on c1 , c2 , CA1
depends on the sign and size of CA1 . It is easy to see, if CA1 < 0 in the original
equilibrium, an increase in the interest rate will improve the CA and reduce c1 . On
the other hand, if CA1 > 0 in the original equilibrium, an increase in the interest rate
will worsen the CA and raise c1 . In general, an increase in interest rate makes creditors
better off and debtors worse off. See Figure 1.

6 Adding Government Consumption

So far we have assumed that the government did not consume. Now we add the government to
our model. For the moment, we are going to assume that government spending is completely

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wasteful, namely that the government spends g1 in period 1 and g2 in period 2, but this
government consumption does not affect directly the utility function of agents. While this is
a strong assumption, it is easier to start from here. One could assume, on the other hand, that
the period utility of the representative agent is of the form u(c) + v(g), where v 0 > 0, v 00 < 0
as for u(·). For example, government spending on clean air improves the utility of agents.
For the moment, however, we are going to simply assume that g does not enter into U1 .

The lifetime budget constraint of the government is

g2 τ2
g1 + = τ1 + (13)
1+r 1+r

where τ1 , τ2 are lump-sum taxes in period 1 and 2, respectively.

τ1 = g1 + bg2 , (14)

τ2 + bg2 (1 + r) = g2 , (15)

where bg2 > 0 is government lending to the rest of the world, bg2 < 0 is government borrowing
from the rest of the world. As for consumers, we are assuming that bg1 = bg3 = 0.

The lifetime budget constraint for individuals is now

c2 y2 − τ2
c1 + = y1 − τ1 + . (16)
1+r 1+r

Optimal consumption under β = 1/(1 + r) is now given by

(1 + r)(y1 − τ1 ) + y2 − τ2 (1 + r)(y1 − g1 ) + y2 − g2
c1 = c2 = = ,
2+r 2+r

where the last equality has used (13). Optimal consumption in period 1 and 2 does not depend
on the temporal profile of taxation but rather on the overall spending of the government.
This property of optimal consumption is called Ricardian equivalence.

Private saving depends on the temporal profile of taxes. In fact,

y1 − τ1 − (y2 − τ2 )
bp2 = y1 − τ1 − c1 = .
2+r

National saving is equal to

b2 = y 1 − c 1 − g 1 ,

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which in our model without investment, at least for the moment, is equal to the current
account
CA1 = y1 − c1 − g1 .

If we substitute optimal consumption we obtain

(1 + r)(y1 − g1 ) + y2 − g2 (y1 − g1 ) − (y2 − g2 )

CA1 = y1 − − g1 = .
2+r 2+r

Consider the case where the government balances its budget every period so that τ1 =
g1 , τ2 = g2 . Then bg2 = 0 and bp2 = CA1 and the current account and consumer’s lending are
the same. Consider instead the case where g2 = τ1 = 0 and

g1 > 0, τ2 = (1 + r)g1 , bg2 = −g1 < 0.

In words, the governments consumes in period 1 and finances this consumption by borrowing
from abroad; it levies taxes in period 2 to pay back the loan. In this case

(1 + r)(y1 − g1 ) + y2
c1 = c2 = ,
2+r
y1 − y2 + g1 (1 + r))
bp2 = y1 − τ1 − c1 = ,
2+r
y1 − g1 − y2
CA1 = b2 = ,
2+r
where bp2 > CA1 . Because taxation takes place in period 2, private lending increases. On the
other hand, government consumption takes place in period 1, so that the current account
worsens. See Figure 2.

7 Comparative Statics

• g1 ↑: CA1 ↓

• g2 ↑: CA1 ↑

• τ1 ↑: b2 ↓

• τ2 ↑: b2 ↑

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 A
y2

Ass: β (1+r) = 1

C
c2
-(1+ra)

CA1

b2p < 0
-(1+r)

c1’ c1 y1+ y2/(1+r)

y1

Figure 1: Intertemporal Allocation

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 g1>0, t2=(1+r) g1; g2=t1=0

A b2p becomes less negative

y2
CA1 becomes more negative

A’
y2-t2 Ass: β (1+r) = 1

C
c2
C’
c2’

CA1

CA1’

b2p’ < 0
g1
b2p < 0

c1’ c1 y1-g1+y2/(1+r) y1+ y2/(1+r)

y1-g1 y1

Figure 2: Intertemporal Allocation with Government Spending and Taxes

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