28th Annual Atlantic Schools of Business Conference 1

The Fisher Separation Theorem: Finance, Microeconomics and Macroeconomics

This paper is an extension of the Fisher separation theorem of finance and

microeconomic theory to macroeconomic theory. This extension highlights the close
relationship between the three disciplines and exposes a limitation of the two-period
separation theorem in that it ignores income changes suggested by the model itself.

Introduction

This paper is concerned with extending the Fisher separation theorem of basic finance and
microeconomic theory to include the Keynesian model of macroeconomics. To be sure it is a leap
(somewhat of the nature of the leap of faith attempted by Indiana Jones in the movies) and in more
than one step...a fundamental theorem of finance moved to microeconomics and then on to
macroeconomics. The journey is not without traps and there are those amongst us who would say that
we should not even try to follow this twisty path. We cannot deny the arguments, and we are aware of
the quicksand lining the road along the way. In fact, we will even point out some hidden bumps in the
asphalt that others may have missed. But the excursion is a worthwhile one, and one that leads the
reader to see how closely microeconomics, macroeconomics and finance theory are related.

We begin by describing the separation theorem, then we identify the elements that are similar in
standard microeconomics and in the macroeconomics of the Keynesian world. Finally, we explain
what is necessary to move from the microeconomic view to the macroeconomic view and how this
view leads one to question a conclusion of the separation theorem. This paper is a clarification and
elaboration of some issues presented in an earlier paper on the same topic (Hochstein, November,
1993)

The Fisher Separation Theorem

An important theorem presented early on to students of finance theory is known as the Fisher
separation theorem. It is described in the very early chapters of Copeland and Weston (1983) and
Brealy and Myers (1984), both popular finance textbooks in common reference today. The essence of
the theorem is that for any individual, the investment decision can be separated from the consumption
decision since they are both dependent upon different criteria. This separation of consumption from
investment means that while the consumption basket will likely differ from individual to individual,
the investment decision (if the endowment is the same) will be the same for all and as such is
independent of differing utility functions. In more simple language, people can trust agents to help
with the investment decision, and then use the funds available to consume whatever they want.

The theorem states: given perfect and complete capital markets, the production decision is governed
solely by an objective market criterion (represented by maximizing attained wealth) without regard to
individuals= subjective preferences which enter into their consumption decisions (Copeland and
Weston).
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A. The Investment Decision

The separation theorem can be explained by examining the investment decision first. Consider
someone with a given endowment of money, E. With the existence of capital markets, this money can
be saved and can grow by the interest rate, r, which is assumed here to be both the borrowing rate and
the lending rate.

Examine Figure 1 which measures current and future income on the axes. It illustrates an interest rate
line. It starts at the horizontal axis at E. The endowment of E, if saved until period 1 will permit a
total of F dollars, which is E times (1+r). The slope of this line is then - (1+r). Any point on this line
illustrates the income flows that can be used for current and future consumption expenditure, spending
which generates utility. For example, suppose, for the moment, that the initial selection of present and
future consumption is shown by point G. This indicates that OA of the endowment is to be used
immediately for current consumption, and AE is to be saved for the following period permitting OB to
be available for consumption then. The higher up along the interest rate line, the more the individual
can be described as a miser, (a saver), and the lower along the line, the more the individual can be
called a spendthrift since more of the current endowment is being spent immediately.

Figure 1. The Interest Rate Line

Dollars, period 1

Interest rate line shows cash flows

from borrowing or lending
F

G
B

A E Dollars, period 0

An increase in the endowment, with interest rates constant, is shown by a rightward shift of the interest
rate line, parallel to the original curve. Similarly, a decrease in the endowment is shown by a leftward
shift of this line.

In the separation theorem, individuals may be able to buy plant, machinery or other real assets
(investment). In this case, we can plot the returns possible to the investor via an investment-
opportunities line, shown in Figure 2. The diagram is derived by asking the individual to rank his or
her investment projects from high to low marginal returns. Assuming diminishing returns to the
investment projects, the individual beginning with an endowment shown by E will be able to choose
investments (assumed to be perfectly divisible) that will lead to returns which, when plotted, will
generate a curve convex to the origin.
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Figure 2. The Investment Opportunities Curve

Dollars, period 1

Investment Opportunities Curve

O E Dollars, period 0

What is our representative participant to do: invest, save or consume, and in which proportions? This
is economics, the answer depends upon maximization behaviour. First, consider the investment
decision with the help of two diagrams, Figures 3 and 4. Figure 3 simply combines Figures 1 and 2.
Figure 4 is this same diagram with decisions being made.

Figure 3. The Interest Rate Line and Investment Opportunities Curve

Dollars, period 1

O E Dollars, period 0

From Figure 4, the choice for the first use of the funds, say EH, is to invest rather than save because
the amount returned from saving, OI, is less than the amount returned through investment, OJ. Again,
since, OJ exceeds OI, invest.
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Figure 4. The Choice

Dollars, period 1

B
J

O H E
Dollars, period 0
Once this investment decision is made, the interest rate line shifts to the right (since the new income
value is larger than the endowment), parallel to the initial one, but now it goes through point B (not
shown). This process is said to continue again and again until the optimum investment value is found.
Investment continues until the return on the marginal project equals the interest rate since all previous
investments would be profitable (McConnell et.al. 1996). This can be illustrated when the interest rate
line is tangent to the investment opportunities curve, at point D on Figure 5. Our participant will
invest EK and be able to choose any point on the new interest rate line for present and future
consumption.

Figure 5. Investment
Dollars, period 1

D
L

O K E

Dollars, period 0

B. The Consumption Decision

The amount of present versus current consumption is the last piece of the puzzle. But again the
theoretical solution is quite simple. The traditional procedure found in basic consumer theory is to
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permit the household to maximize satisfaction by choosing a point on the constraint which reaches the
highest possible indifference curve from the map of curves assumed to exist for all consumers. The
tangency solution prevails (Hochstein, 1993). An example is shown in Figure 6. One of the family of
indifference curves, the highest one possible, is drawn on the diagram. At point P the marginal rate of
substitution between present and future consumption will equal the marginal rate of time preference,
or the interest rate. In this particular case, money used for current consumption is OQ, and for future
consumption is OR.

Figure 6. Consumption
Dollars, period 1

Indifference Curve

P
R

O Q E

Dollars, period 0

While other individuals can be assumed to have different tastes, (Point P can be anywhere along the
interest rate line drawn) and thus choose different bundles of consumption, the procedure is the same,
of course. While not drawn here, it can be easily shown that some will choose to save heavily for the
future, period 1, and some will choose to live to the hilt in the present. Chacun son gout.

Summary

We can summarize the result of the Fisher separation theorem with the help of Figure 7. The
individual under investigation begins with an endowment in the present shown by E dollars. The
investment opportunities curve open to this person is ES. Investment is profitable up to EK dollars.
This investment in real assets will generate OL dollars in the next period. Now a new income stream
of OK + OL dollars exists. The point at which the interest rate line is tangent to the investment
opportunities curve (D) indicates the current saving, optimum investment and the current and future
income stream for consumption. One can note, as an aside, that the present value of this income stream
is OR dollars and since OR exceeds the initial endowment of OE, this indicates the beneficial aspects
of investment.

Consumption of goods in the present and the future depends upon time preference or tastes as
measured by indifference curves. The indifference curve that is relevant in the case under review here
is shown with a tangency at point P, indicating that utility is maximized at point P with OQ income for
current consumption, and OR income for future consumption. Notice that the indifference curve going
through point P is higher than any one which is constrained by the investment opportunities curve.
While point D, the investment decision will be the same for anyone with the same investment
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opportunities, P can be anywhere along the drawn interest rate line RT. The investment decision can
be separated from the consumption decision.

Figure 7. Summary

Dollars, period 1

D
L
P
R

O K Q E R
Dollars, period 0
The model shown here can also illustrate the importance of capital markets (Copeland and Weston, P.
12). With these efficient markets in existence, funds can be transferred between borrowers and
lenders so that individuals with investment opportunities can borrow the funds and use them to
purchase real assets whose return exceeds the market interest rate. They might not be able to obtain
the funds as easily without these markets. Money can be transferred from those with wealth but few
investment opportunities to those with less wealth and more opportunities. Everyone will be made
better off without anyone being worse off. Clearly capital markets generate an increase in welfare for
the system.

Because of space limitations we have not shown position P in other places along the interest rate line.
The procedure is identical, but the conclusion can have saving more than investment, or even saving
equal to investment.

An Extension

The separation model is interesting as far as it goes, but it does not go far enough. It is presented as a
straightforward consumer theory microeconomic problem, one which requires all the marginal
conditions be met...the marginal rate of substitution in consumption must equal the marginal rate of
transformation in investment for an optimum solution. And they will both equal the market interest
rate. (It is recognized that I have not differentiated between the borrowing and lending rates, but the
essence of the argument presented here remains even with these additional caveats). This is very
similar to standard micro theory of the consumer maximizing satisfaction from consuming two goods
given a budget constraint.

What would Keynes have said about the model? Certainly I suspect that he would have agreed with
the standard micro theory approach, but there are critical macroeconomic terms in this model...saving,
investment, consumption. And these are not fully explored. In fact, he might have not agreed with an
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important result of the model. Let me explain.

First we need to make some additional assumptions. We want to translate the separation theorem into
a macroeconomic model. We need the following information: income (Y), consumption (C), saving
(S) and investment (I). These concepts are all there. Using Figure 7, income is the initial endowment,
OE. Consumption (in the current period, period 0) is OQ. Saving, (Y - C) is OE - OQ or QE.
Investment is EK. For ease of exposition, suppose we put numbers on these letters, numbers that
roughly match the sketch:

Initial endowment, Income, Y1........................... OE..................$100,000

Consumption, C................................................ OQ................. 80,000
Saving, S.......................................................... QE.................. 20,000
Investment, I..................................................... EK.................. 35,000

We can incorporate this information into a circular flow, as macroeconomics does (Hochstein, 1998).
The basic model is one with no government or foreign trade, and where depreciation is assumed to be
zero. The circular flow diagram, using the data shown above, is shown below in Figure 8. Income
begins at $100,000. Saving is 20,000 and consumption is 80,000. Investment is 35,000. Since
investment exceeds saving, income will rise. In other words, the second period=s income, Y2, will be
higher than the initial period=s income Y1, because injections exceed leakages. The second income,
made up of C + I, is $115,000. This change in income, so important in macroeconomic theory, is not
accounted for in the straightforward separation theorem.

Figure 8. Circular Flow Model

C = 80,000 I = 35,000

S = 20,000 Households Firms

Y1 = 100,000
Y2 = 115,000
There
S, is the more traditional way to show this initial income position from a macro perspective and
thatI is with the expenditure diagram (the C+I and 45 degree line sketch) as well as with the leakages-
injections diagram (S,I). These two are shown in figure 9, without further explanation.
Figure 9. Traditional Keynesian Diagrams
S
C
C+I
In conclusion, the Fisher separation model leaves itself open to an extension into standard
macroeconomic theory since it uses the terms that C+I
are the bread and butter of macroeconomics. To the
extent this is possible the extension brings to light an important issue that is hidden by the separation
35,000 C I
model,
115,000that of income growth. If investment is larger than saving (in the simplest macro model), then
20,000
income will rise and the higher income which will occur in the following period is not accounted for in
80,000 Y
Y1 = 100,000

Y
Y1 = 100,000
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the separation model. It says there is an endowment that can be spread over two periods, and then it
ignores a change in this endowment due from the economic system. But income will change.

Can this move be made

Is our move from microeconomics to macroeconomics a legitimate one? On one level it certainly is.
The macro system is developed by summing the activity of participants in the micro world.
Consumption is nothing more than the addition of all the purchases of individuals who make their
decisions at a micro level. Investment of GDP comes about because of individual purchases of
machinery or plant. And there are numerous examples of this move from microeconomics to
macroeconomics being made in the literature. For example, the field of welfare economics is famous
for its use of microeconomic concepts such as firm marginal cost curves to handle macroeconomic
problems such pollution issues (Solberg, 1992); the theory of international trade uses
Αmacroeconomic≅ indifference curves to decide on the optimum amount of imports and exports. The
theory of health economics has been known to examine Αhealth≅ as a normal good (a micro term)
because individuals buy more of it when overall income (a macro term) increases (Feldstein, 1993).

But just because others have done it, doesn=t make it legitimate. We all are aware that what may be
true in microeconomics is not always true in macroeconomics. Any one individual can increase saving
and his or her income can be kept constant, but if all economic agents increased saving, ceteris
paribus, income would fall. Thus, we must be careful in the move from one view to the other.

In this particular case, the implications of the Fisher separation theorem on the macroeconomic
landscape, the jump from finance and microeconomics to macroeconomics brings out some interesting
results. Standard micro consumer theory has a consumer with a given income choosing between two
goods in the present. Finance has slipped a caveat into the theory and has a consumer choosing to
save and invest in the present which has implications for consumption in the present and future
periods. Is it proper to permit investment to occur and then ignore the macroeconomic implications of
this activity on income? We don=t think so.

The critical assumption of the theorem, that a particular endowment can only be increased by using
individual investment decisions, has to be reexamined. If the participant studied in this paper is
similar to many other participants in the economy, and if indeed overall investment exceeds savings,
then the second period=s income will not be limited to the result of investment as calculated. There is
a macro multiplier effect, and income will rise by more than the amount of investment. The investor
from Finance will have to be prepared to have the macro economy force a reappraisal of endowments
period by period.
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References

Brealy, Richard and Stewart Myers (1984), Principles of Corporate Finance McGraw Hill, USA.

Copeland, Thomas E. and J. Fred Weston (1983), Financial Theory and Corporate Policy, second
edition Addison-Wesley Publishing Company, Inc. Canada.

Feldstein, Paul J. (1993), Health Care Economics Delmar Publishers, USA

Hochstein, Alan (November 1993) "The Fisher Separation Theorem and the Circular Flow
Diagram: A Combination" in Conference Proceedings of the 23rd Annual Atlantic
Schools of Business Conference Organizational and Regional Restructuring.

Hochstein, Alan (1993), Microeconomics: An Advanced Introduction Thompson Educational

Publishing Inc. Toronto

Hochstein, Alan (1998), Macroeconomics: An Advanced Introduction for MBA Students Mimeo.
Mconnell, Campbell R., Stanley L. Brue and Thomas P. Barbiero (1996) Macroeconomics seventh
Canadian edition. McGraw-Hill Ryerson Limited. Canada

Solberg, Eric J. (1992) Microeconomics for Business Decisions D.C. Heath and Company. Canada.