Lec6 Cons Inv 2

MACROECONOMICS
C o n s u m pti o n and Investment
Souvik Dutt a
CONSUMPTION
• Tinti n became a reporter today.
He is 20 years old.
• He plans to work until age 60 and
expects to die at age 80.
• He expects to earn 150 francs
every year he works (Y ).
• Spreading resources earned
during his service life ( S ) over the
remaining years of life (T ),
Tintin will spend
S ×Y
C = .
T
or 100 francs every
year.
Applicati on 1: m p c and nature of income
Suppose annual income rises by ∆ Y .
• If this increase is permanent,

• the increase in annual consumption will be
S ×∆Y
∆C = .
T
• Therefore, mpc = ∆∆ YC =ST
.
• If this increase is transitory,
• the increase in annual consumption will be
∆Y
∆C = .
T
• Therefore, mpc = ∆C
∆Y =T1
.
Applicati on 2: m p c and age distributi on
Consider two individuals, 1 and 2, both of whom will retire at

age R and expect to die at age D . Suppose
• 1’s current age is A 1 .

R− A1
• A’s mpc out of permanent income will be .
D−A1
• 2’s current age is A 2 .
R− A2
• B’s mpc out of permanent income will be .
D−A2
If A 1 < A 2 , it can be shown that 1’s mpc is greater than 2’s

mpc.
Deviations from L C H :
1. Borrowing constraints
2. Myopia
3. Precautionary savings
4. Bequest
• The theory assumes that when current desired consumption
is more than current income, an individual can borrow.
• But borrowing may not be an option for every individual
due to financial market frictions.
2. Myopia
4. Bequest
• The theory assumes that when current desired consumption
is more than current income, an individual can borrow.
• But borrowing may not be an option for every individual
due to financial market frictions.
2. Myopia
4. Bequest
• The theory assumes that individuals are able to correctly
value future consumption.
• But individuals could attach too much importance to the
present relative to the future.
2. Myopia
4. Bequest
• The theory assumes that individuals save/dis-save only to
smooth consumption over the lifetime.
• But individuals could also save for future contingencies such
as unexpected healthcare expense.
2. Myopia
4. Bequest
• The theory assumes that individuals only save for personal
consumption.
• But individuals could also save for consumption of future
generations.
Inter-temporal model
• Unti l now, we had simply assumed that individuals would
want to smooth consumption.
• Next, we consider a model where an individual optimally
chooses current and future levels of consumption.
• The key feature of this model is that consumer choice must
satisfy an inter-temporal budget constraint.
T h e basic two-period model
• (Y 1 , Y 2 ): income in periods 1 and 2.

• (C 1 , C 2 ): consumption in periods 1 and 2.
• r: interest rate.
• S = Y 1 − C 1 : saving in period 1
• Period 2 budget constraint is:
C 2 = Y 2 + (1 + r ) S
= Y 2 + (1 + r )(Y 1 − C 1 ).
• Re-arranging terms
(1 + r ) C 1 + C 2 = (1 + r)Y 1 + Y 2 .
• Dividing both sides by 1 + r, we have ......

..... the inter-temporal budget constraint:
C2
1 1 .
Y1 2+ r 1+ r
` C ˛+ ¸ x = ` Y ˛+ ¸ x
Present- value o f cons umption Prese nt-val u e of in come
C2
(1  r )Y1 Y 2
Consump =
Saving
income in
both periods
Y2
Borrowin
g
F i g u r e 6: Inter-temporal
Y1 budget constraint
C1
Y1 Y 2 (1  r )
C2
The slope of
the budget
line equals 1
(1+r ) (1+r
)
Y2
C1
Y1
F i g u r e 7: Inter-temporal budget constraint

Higher
C2
An indifference indifference
curve shows curves
all combinations represent
of C1 and C2 that higher levels
make the of happiness.
consumer
equally happy. IC2
IC1
C1
F i g u r e 8: Consumer preference
C2 The slope of an
Marginal rate of indifference
substitution curve at any
(MRS ): the amount point equals the
of C2 MRS
the consumer 1 at that point.
would be willing to MRS
substitute for
one unit of C1.
IC1
C1
F i g u r e 9: Consumer preference
C2
The optimal (C1,C2)
At the optimal point,
is where the budget
MRS = 1+r
line
just touches
the highest
indifference curve. O
C1
F i g u r e 10: Consumption equilibrium

Lec6 Cons Inv 2

Uploaded by

Copyright:

Available Formats

Lec6 Cons Inv 2

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lec6 Cons Inv 2

Uploaded by

Copyright:

Available Formats

MACROECONOMICS

C o n s u m pti o n and Investment

Suppose annual income rises by ∆ Y .

• If this increase is permanent,

Consider two individuals, 1 and 2, both of whom will retire at

• 1’s current age is A 1 .

If A 1 < A 2 , it can be shown that 1’s mpc is greater than 2’s

• (Y 1 , Y 2 ): income in periods 1 and 2.

• Dividing both sides by 1 + r, we have ......

F i g u r e 7: Inter-temporal budget constraint

F i g u r e 10: Consumption equilibrium

You might also like