Chartered Financial Analyst (CFA) Practice Exam Level 2

What does Intertemporal Rate of Substitution measure?

1. The trade-off between present and future consumption

2. The relationship between savings rates and investment yields

3. The impact of external economic shocks on consumption choices

4. The difference in utility between various assets

The correct answer is: The trade-off between present and future consumption

The Intertemporal Rate of Substitution measures the trade-off between present and future consumption. It reflects how much individuals are willing to give up in terms of current consumption to increase consumption at a future date. This concept is pivotal in understanding consumer behavior over different time periods and underpins many economic models concerning preferences and choices. When individuals face the decision of whether to consume now or save for future consumption, the Intertemporal Rate of Substitution quantifies this decision-making process. A higher rate indicates that individuals value future consumption significantly more compared to present consumption, leading them to save more of their current income for future use. Conversely, a lower rate suggests a preference for immediate consumption. It’s important to distinguish this concept from the other options. While the relationships among savings rates and investment yields, the impacts of economic shocks, or the differences in utility between various assets are all meaningful topics in economics, they do not specifically address the essence of intertemporal choice, which is fundamentally about balancing immediate versus future consumption.