The Euler Equation in a very simple case

Assume we have only 2 periods, 1 and 2. y1 and y 2 are the income received in each period; is the discount
rate (rate of time preference); r is the rate of interest. The problem for the consumer is to choose the
consumption in each period ( c1 , c2 ) in order to maximize utility, subject to his budget constraint:

u ( c2 )
Max u (c1 )
1
y2 c2
s.t . y1 c1
1 r 1 r

or

L u (c1 )
u ( c2 )
y1
y2
c
c2
Max
1 1 r 1 r
1

The first-order conditions (neglecting the budget constraint) are:

u '(c1 ) 0
1 1
u '(c2 ) 0
1 1 r

From which we get

u '(c1 ) 1 r

u '(c2 ) 1

(Euler equation). An increase in r (all else constant) means that consumption in period 2 will increase
relative to consumption in period 1 (the marginal utility increases with a reduction in consumption).
If rises (the future is discounted more heavily, the present is preferred), consumption in period 1 will
increase relative to consumption in period 2).
1
If the utility function is logarithmic u (c ) log(c ) then u '(c ) , so that the Euler equation becomes
c
1
c1 1 r

1 1
c2

or

c2 1 r

c1 1