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Definition: Elasticity of intertemporal substitution
The elasticity of intertemporal substitution is a key concept of finance and macroeconomics that measures the change in the consumption growth rate with the change in the real interest rates i.e. nominal interest rates adjusted for inflation.
The measure of the sensitivity will depend on the reaction of individuals to the change in interest rates.If the investors treat high real interest rates as an opportunity to save and get higher returns, the consumption will increase. On the contrary, if the investors treat it as an opportunity to earn a higher return on alternate investments, the consumption will decrease.
The net change in consumption will decide the responsiveness of the consumption growth to the change in interest rate and hence decide whether the elasticity of intertemporal substitution will be positive or negative.
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