The intertemporal approach is the dominant theoretical approach in modern macroeconomics.

Hence, it is the main theme of this text. 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.

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 through 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, who choose the optimal path of consumption, production, employment, and investment. These possibilities are described by appropriate intertemporal budget constraints. The analysis of the role of money and the interrelated intertemporal budget constraints of the private and public sectors illuminate the role of monetary and fiscal policy and the possibilities of the government and government agencies (such as central banks) to affect and improve on macroeconomic outcomes. The properties of intertemporal models depend on the equilibrium concept used, the nature of the assumed market and informational distortions, and 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).

As will become apparent in the remainder of this book, many properties of the two-period model carry over to multiperiod intertemporal models, such as infinite-horizon models. In addition, many 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 when juxtaposed with simple competitive intertemporal models.

We start by investigating general competitive equilibrium in a one-period 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 themes examined through the two-period models of this chapter will be revisited and expanded on 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. Therefore, the investment required to understand the two-period intertemporal model has high payoffs.

2.1