The intertemporal approach is the dominant theoretical approach in modern macroeconomics. It thus runs throughout this text as its main theme.
By way of introduction, it is worth laying out the main elements of this approach, in the context of the simplest possible intertemporal macroeconomic models. This is the main function of the present chapter.
The intertemporal approach is fully grounded on neoclassical microeconomics, as it is based on the assumption that households maximize their intertemporal utility and firms maximize the present value of their profits, subject to the appropriate resource, technological, market and information constraints.
The approach is also based on the concept of general intertemporal equilibrium, either through the operation of fully competitive markets, or through markets subjected to various distortions relative to the competitive model. Relative prices, such as real interest rates and real wages, and nominal magnitudes such as the price level, inflation and nominal interest rates, are assumed to be determined by appropriate general equilibrium concepts, which depend on market structure and assumptions about price and wage flexibility.
Intertemporal, or dynamic, general equilibrium models are thus based on the resource, technological, market and informational possibilities of households, firms and the government to choose the optimal path of consumption, production, employment and investment. These possibilities are described by the appropriate intertemporal budget constraints. The analysis of the role of money and the interrelated intertemporal budget constraints of the private and the public sector illuminate the role of monetary and fiscal policy and the possibilities of the government and government agencies, such as central banks, to improve upon macroeconomic outcomes.
The properties of intertemporal models depend on the equilibrium concept used, on the nature of the assumed market and informational distortions and on the assumptions adopted about the degree of price and wage flexibility.
In this chapter we focus on competitive economies lasting for only two periods, period 1, the present, and period 2, the future. The two period competitive model is the simplest possible intertemporal general equilibrium model, and can be analyzed with the help of very simple mathematical tools. We use it to investigate some of the salient characteristics of the intertemporal approach, without the complexity and the distractions that sometime emerge from multiperiod dynamic general equilibrium models.
As will become apparent in the remainder of this book, many of the properties of the two period model carry over to multiperiod intertemporal models, such as infinite horizon models. In addition, many of the models that are based on market distortions such as transactions costs, externalities, increasing returns to scale and imperfect or asymmetric information, can be best understood in juxtaposition to simple competitive intertemporal models.
We start by investigating general equilibrium in a one period competitive macroeconomic model, with exogenous capital and labor endowments. Then we investigate intertemporal general equilibrium in a two period competitive macroeconomic model, which allows for savings and investment. We also investigate extensions of the two period model to examine intertemporal substitution in labor supply, the role of money and monetary policy, and the role of fiscal policy.
Many of the themes examined through the two period models of this chapter will be revisited in the context of the infinite horizon models used to analyze economic growth, aggregate fluctuations and the role of monetary and fiscal policy in the remainder of this book.