Elasticity of intertemporal substitution
Elasticity of intertemporal substitution (or intertemporal elasticity of substitution) is a measure of responsiveness of the growth rate of consumption to the real interest rate. If the real rate rises, future consumption may increase due to increased return on savings; but future consumption may also decline as the saver decides to consume more immediately given that he can get a higher return on what he does save (i.e. not consumes). The net effect on future consumption is the elasticity of intertemporal substitution.
The definition depends on whether one is working in discrete or continuous time. We will see that for CRRA utility, the two approaches yield the same answer. The below functional forms assume that utility from consumption is time additively separable.
Total lifetime utility is given by
In this setting, the real interest rate will be given by the following condition:
A quantity of money invested today costs units of utility, and so must yield exactly that number of units of utility in the future when saved at the prevailing gross interest rate . (If it yielded more, then the agent could make himself better off by saving more.)
Solving for the real interest rate, we see that
In logs, we have
Logs are very close to percentage changes, so we can interpret as a net interest rate like 5%, whereas is the corresponding gross interest rate like 1.05.
The elasticity of intertemporal substitution is defined as the percent change in consumption growth per percent increase in the net interest rate:
By substituting in our log equation above, we can see that this definition is equivalent to the elasticity of consumption growth with respect to marginal utility growth:
Either definition is correct, however, assuming that the agent is optimizing and has time separable utility.
Let utility of consumption in period be given by
Since this utility function belongs to the family of CRRA utility functions we have Thus,
This can be rewritten as
Hence, applying the above derived formula
Let total lifetime utility be given by
where is shorthand for , is the utility of consumption in (instant) time t, and is the time discount rate. First define the measure of relative risk aversion (this is useful even if the model has no uncertainty or risk) as,
then the elasticity of intertemporal substitution is defined as
If the utility function is of the CRRA type:
(with special case of being )
then the intertemporal elasticity of substitution is given by . In general, a low value of theta (high intertemporal elasticity) means that consumption growth is very sensitive to changes in the real interest rate. For theta equal to 1, the growth rate of consumption responds one for one to changes in the real interest rate. A high theta implies an insensitive consumption growth.
Ramsey Growth model
In the Ramsey growth model, the elasticity of intertemporal substitution determines the speed of adjustment to the steady state and the behavior of the saving rate during the transition. If the elasticity is high then large changes in consumption are not very costly to consumers and as a result if the real interest rate is high they will save a large portion of their income. If the elasticity is low the consumption smoothing motive is very strong and because of this consumers will save a little and consume a lot if the real interest rate is high.
Empirical estimates of the elasticity vary. Part of the difficulty stems from the fact that microeconomic studies come to different conclusions than macroeconomic studies which use aggregate data. A meta-analysis of 169 published studies reports a mean elasticity of 0.5, but also substantial differences across countries.