Intertemporal equilibrium explained

Intertemporal equilibrium is a concept which states economic agents make decisions taking into account the present and future time periods.

At a particular point in time an economy may not be in equilibrium because individuals do not just decide based on the current situation, but also take into account for what may happen in the future.

Explanation with examples

  • Suppose, workers receive a 10% rise in income – we might expect a 7% rise in consumption on goods and services. However, workers will not just decide how much to spend depending on their current income. If there is uncertainty in the economy, workers may decide to save the extra income and smooth this income bonus out over their life-cycle.
  • Similarly, if the government offered a tax cut, some workers will not spend this tax cut because they may believe that a current tax cut will require higher taxes in the future.
  • If there was a cut in interest rates, then it is cheaper for firms to borrow and finance investment. Conventional economic theory suggests lower interest rates will lead to higher levels of investment.  However, firms may take into account the long-term economic prospects of the economy. If they feel demand will be depressed for the next few years, then they will not borrow more – despite the lower interest rates.
  • Creative destruction. The economist Joseph Schumpeter coined the term ‘creative destruction’ – the idea that in market economies, inefficient firms go out of business. This can cause short-term job losses and falling output. However, this failure allows resource to be reallocated to more efficient long-term uses. If we analyse only the short-term, this failure may seem a welfare loss – but in the long-term, it enables an intertermporal equilibrium which is more efficient than subsidising a failing firm.
  • A mistake of command economies is that a focus is placed on meeting current targets, there is less incentive to think of how demand and needs will change over the long-term.
  • Therefore, the general equilibrium of an economy can only be viewed over the long-term, and in the short-term, they may be many instances of short-run disequilibrium.

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