Intermediate Macroeconomics

Econ 2102/2220B

Lecture 10

Fall, 2014

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 Goals

In Solow model we assume that saving rate is constant.

In other words, we have not understood the households
saving behavior.
In this lecture, we want to study why household save and
why they save that much.
Introduction to inter-temporal approach
Foundations for business cycle theories

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 Methodology and Applications

Methodology: micro-founded, dynamic, two-period models

Math: First Order Condition
Applications: 1) HKD 6000 cash handout; 2) Saving
puzzle in China; 3) Low saving rate in the U.S.;
Understand how modern macroeconomics analyzes the
real world issues and the first taste of cutting-edge macro
research.

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 Plan

Whats consumption?
How do economists think about consumption? The
inter-temporal approach
Permanent income theory
Precautionary savings
Applications:
- The effect of the 6000 HKD hand-outs
- Saving puzzle in China
- The decline of household saving rate in the U.S.

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 Understanding Consumption

Important part of the GDP: accounts for more than 2/3 of

GDP in the US; even higher part of GDP in developing
countries. (But in China, the consumption share is
relatively smaller, why?)
Components of aggregate consumption: Food, clothing,
transportation, health care, housing services, cars ...

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 Consumption
How do people consume and save?
What key economic forces shape their decisions? The
micro-foundations of consumption
We really need to think dynamically. why?
Saving means you give up current consumption for future
consumption
Inter-temporal approach
maximize a lifetime utility function that depends on current
and future consumption
forward looking: people recognize that income in the
future may differ from income today, and such differences
influence consumption today
choose an optimal consumption path (or consumption at
each period)

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 The Neo-classical consumption model

We think of time involving today and future

People may earn income today and in the future, they
consume today and in the future.
A key decision they have to make is how much to
consume today versus in the future.
In your micro class, you learn that people choose a bundle
of Apples and Bananas to maximize their utilities

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 Parts of the model: Utility function

Replace apples and bananas with today and future

Life time utility:
U = u(ctoday ) + u(cfuture )
u(): u 0 () > 0; u 00 () < 0
is discount factor, which captures the weight you place
on the future relative to today.
< 1: a given flow of utility is worth more when it occurs
today
= 1: you treat utility flows today and in the future equally

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 Parts of the model: inter-temporal
budget constraint
income vs. wealth (flow vs. stock)
constraint:
consumption + saving = income
making decision on ctoday or ffuture at the beginning of the
period, where ffuture is the end-of-period wealth.
today, the constraint:
ctoday = ytoday (ffuture ftoday )
future, the constraint:
cfuture = yfuture + (1 + r ) ffuture
Present value of consumption = financial wealth + human
wealth = total wealth
c y
ctoday + future = ftoday + (ytoday + future )
(1 + r ) 1+r
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 Key Assumptions

Consumption in any given year can be different from the

income
it is possible to borrow today : consume more than labor
income today
it is also possible to save today : consume less than labor
income today
what must be true is that the present value of consumption
equals the present value of lifetime resources

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 Choosing the consumption to maximize utility
maxctoday ,cfuture U = u(ctoday ) + u(cfuture )

subject to
cfuture
ctoday + =W
1+r
Lets transform the problem,

maxctoday U = u(ctoday ) + u((1 + r ) (W ctoday ))

First Order Condition:

u 0 (ctoday
) + u 0 (cfuture
) (1 + r )(1) = 0

or Euler equation,

u 0 (ctoday
) = (1 + r ) u 0 (cfuture
)

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The Euler Equation

u 0 (ctoday
) u 0 (cfuture
)
= 1
1 1+r

Or

u 0 (ctoday
) 1
=
u 0 (cfuture ) 1
1+r

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 The Euler equation

Any other consumption plans (ctoday , cfuture ) are not

optimal.
Given (ctoday , cfuture ), Euler equation does not hold.
You can always increase or decrease ctoday (or cfuture ) to
improve your welfare.
For example, (ctoday , cfuture )
u 0 (ctoday ) < (1 + r ) u 0 (cfuture )
You can decrease ctoday by one dollar, which increases
your welfare.
You should keep doing it, until the Euler equation holds
with equality.

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 The Euler equation

A thought experiment (Approximation): The optimal

consumption is (ctoday
, cfuture ) and you consider deferring
consumption today by a (very) small amount of c.
the cost of deferring is c u 0 (ctoday
)
the benefit of deferring is,
c (1 + r ) u 0 (cfuture
)
Given the optimal consumption choice, you must be
indifferent between deferring and not deferring
u 0 (ctoday
) = (1 + r ) u 0 (cfuture
)

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 Example: Log Utility

1
u(c) = log(c) and u 0 (c) =
c
the Euler equation reads,
1 1
= (1 + r )
ctoday cfuture
rearrange it

cfuture
= (1 + r )
ctoday
consumption profile

(1 + r ) > 1, cfuture
> ctoday

(1 + r ) = 1, cfuture
= ctoday

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 Example: = 1
the Euler equation,

cfuture
= ctoday
1+r
inter-temporal budget constraint,
c

ctoday + future = W
1+r
so, the present value of future consumption equals
consumption today
1
ctoday = W
2
and
1
cfuture = (1 + r ) W
2
Or

cfuture 1
= W
1+r 2
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 Effects of a rise in r on consumption

Does ctoday change if r increases?
y
W = ftoday + (ytoday + future )
1+r
ctoday decreases in r . It is called wealth effect.
it works through the total wealth.
Think about substitution effect and income effect. They
cancel out under log utility.
Substitution, income and wealth effects. (see the
supplementary note online.)

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 Permanent income hypothesis
Observation: the consumption today is independent of
the current income
it is proportional to a consumers overall wealth, W
... which depends on the present discounted value of
income.
consumption does not track the current income but is
determined by permanent income.
In other words: consumption profile is independent of the
income profile
Keep W the same, change ytoday and yfuture , consumption
profile does not change
If ytoday is too high (low), relative to yfuture , you save
(borrow).

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 Marginal propensity to consume

How does ctoday respond to a temporary increase in

income, say 100 HKD?
Continue the example with log utility and = 1
you should consume only 50 HKD, instead of 100 HKD
you smooth out the windfall over both of the periods
we call the ratio, 1/2, marginal propensity to consume
if we increase the number of periods in his life, for example
to 80 periods, where each periods represents a year of life,
then the marginal propensity to consume is approximately
equal to one divided by the number of periods (show it is
true, given = 1 and r = 0 in problem set 2)

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Income shocks and permanent income theory
if one expects to live for another 50 years and he gets an
temporary increase in current income, then he only
consumes roughly 2% of the windfall and save almost 98%
of it.
if one expects to live for another 50 years and he gets an
permanent increase in his income, then he consumes all
the increase.
suppose one expects to live many periods from now,
unexpected temporary shocks:
Announce an increase in y2 at the beginning of Period 2
Announce an increase in y3 at the beginning of Period 2
unexpected permanent shocks:
Announce an increase in income from Period 2 on at the
beginning of Period 2
Announce an increase in income from Period 3 on at the
beginning of Period 2

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 Borrowing constraint

A key assumption: borrow and save freely at the market

interest rate r
For some people, it is not true! examples...
in this case, we say you are borrowing constrained!
constrained by the lack of borrowing opportunities
Suppose you want to borrow today, but you are somehow
borrowing constrained. how much do you consume today?
Whats your marginal consumption propensity, if you are
borrowing constrained?
What does your consumption profile look like, if your
income increases over time but you are borrowing
constrained?

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 Hand-outs of HK $6,000

The budget was announced February 23rd as an effort to

pre-empt inflation; as such it was left devoid of explicit cash
rebates. (Hong Kong too-y , Economist, Mar 7th 2011)
But within hours, a sharp reaction prompted an abrupt
change in course: suddenly the budget was to include a
hand-out of HK $6,000 ($771) to every permanent
resident, along with other one-off benefits.
Whats the effect of this policy (HK $6,000 hand-outs)?

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Effects of the hand-outs!

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 Heterogeneity

Seriously, whats your prediction on its effect on aggregate

consumption?
Euler equation are roughly good approximations for the
inter-temporal consumption behaviour, especially for those
relatively rich households. (Marginal propensity to
consume out of temporary income shocks is low.)
For poorer households with low income and wealth, who
are borrowing constrained, consumption track income quite
well. (Marginal propensity to consume out of temporary
boost in income is high.)

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