File PDF

Sofar: one-period (static) model
This week: focus on a some dynamics

Intertemporal decisions: economic trade-offs across
A Two-Period Model: time
Dynamic consumption-saving decision
The Consumption-Saving Decision Consumption smoothing
and Ricardian Equivalence Ricardian equivalence
Two period model
Copyright © 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 1 Copyright © 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 2
Two-period Model Basic Idea
Trade off between consuming now or future (Discounted) Life time total consumption can not
exceed (discounted) life time total income
Saving/borrowing
However in period by period terms, income does not
Simple model, but captures important aspects necessarily has to match consumption
of dynamic decision making Real interest rate determines the relative price future
Several issues to be addressed among others C in terms of current C
consumption smoothing i.e.
c y −t
c1 + 2 = y1 − t1 + 2 2
1+ r 1+ r
Consumers Consumers
m consumers (m being large) If s1>0, consumer is lender at period 1

If s1<0, consumer is borrower
Live only two periods (current and future) trade one type of financial asset, bond (that can be
no work-leisure decision, but receive issued by government or consumer)
exogenous income (apple trees) Assumptions regarding bond holding:
No risk associated with holding bonds, no default risk
Focus on consumption/saving decision Direct trading of bonds in the financial market, no
intermediaries
Consumer budget constraint at period 1 Bond pays of 1+r units of consumption good next
c1 + s1 = y1 - t1 period
r, real interest rate is the same for lenders and
borrowers
1
Consumers Life-time Budget constraint
Consumer budget constraint at period 2 Then substitute s1 into period 1 BC and rearrange to
obtain life-time BC
c2 = y2 – t2 + (1+r) s1 Present value of lifetime consumption is equal to PV
of lifetime disposable income!!
Solve for s1 in period 2 BC c y −t
c1 + 2 = y1 −t1 + 2 2

1+r 1+r

c2 − y2 + t2
s1 =
1+ r
Lifetime wealth Next step:
Bring intertemporal budget constraint together

y − t2 with the preferences of the consumers!!
W = y 1 − t1 + 2
1+ r The same logic as earlier lectures will apply
or
c2
W = c1 +
1+ r
Recall from Week 4 assumptions for consumers! Figure 6 Consumer’s Lifetime Budget Constraint
A1. More is always preferred than less!

A2. Diversity is important
A3b. Current and future consumption are normal goods!
Write the Wealth equation in slope-intercept form!
c2
W = c1 +
1+ r
= = > c 2 = − (1 + r ) c1 + W (1 + r )
2
Figure 2 A Consumer’s Indifference Curves Table 1
Consumer Optimization Figure 3 A Consumer Who Is a Lender
Optimal consumption bundle is at the tangency of

indifference curve to budget constraint
At Figure 3, endowment point is at E, but consumer

chooses point A..
At Point A
MRSc1,c2=1+r
Consumer lends distance DB that is s1=y1-t1-c1*>0
A Consumer Who Is a Borrower Figure 4 A Consumer Who Is a Borrower
s1=y1-t1-c1*<0
3
The Effects of an Increase in Current Income for a Lender The Effects of an Increase in Current Income for a Lender
Lifetime wealth increases from

In a static setting we showed earlier that an y − t
= − +
increase in income (dividend income or a
2 2
W 1 y 1 t 1
1 + r
reduction in taxes) will increase consumption t o
y −t 2
and will reduce labour supply (pure income W 2 = y '
1 − t 1 +
1
2
+ r
effect) t h e c h a n g e i n w e a l t h
∆ W = W − W = y '
− y
Here, how does an increase in income affect t h e c h a n g e i n
2 1
s a v i n g s
1 1
intertemporal consumption/saving decisions?? ∆ s = ∆ y 1 − ∆ t − ∆ c > 0
i.e. an increase in y1 leads to an increase in

consumption in both periods and an increase in
Copyright © 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 19 savings
Copyright © 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 20
Figure 5 The Effects of an Increase in Current Figure 6 Percentage Deviations from Trend in
Income for a Lender GDP and Consumption, 1982-1999
Theory meets Data Some explanations
Theory predicts consumption smoothing 1 Imperfect credit markets

Aggregate consumption data very strongly 2. Market prices move along the business
favours smoothing cycle
If you take out durable goods (say cars, fridges
that yield utility for very long periods of time)
results are even stronger
Still data exhibits a bit more consumption
variability than the theory would predict.
Why?
4
Figure 7 An Increase in Future Income Figure 8 Temporary Versus Permanent
Increases in Income
Figure 11 An Increase in the Real Interest Rate Figure 12 An Increase in the Real Interest Rate
for a Lender
Figure 13 An Increase in the Real Interest Rate Table 2

for a Borrower
5
Table 3 Figure 14 Example with Perfect Complements
Preferences
Consumer’s Demand for Current Consumption Figure 15 A Consumer’s Demand for Current Consumption
Goods, cd, as a Function of Current Income
Current consumption is increasing in the

increase in income (current and future)
Consumer’s Demand for Current Consumption Figure 16 A Shift in a Consumer’s Demand for
Current Consumption
Current consumption demand will shift in

Real interest rates
Future income
6
Incorporating Government: Assumptions Government Present Value Budget Constraint
Given current and future G, T, assume we are Solve for B1 in G2+(1+r)B1=T2

initially at the competitive eq’m with r
B1=(T2-G2)/(1+r)
∆T is put upon initial T
Current Period Government BC Substitute into current period Gov. BC to obtain
G1=T1+B1 intertemporal Gov BC
Future Period Government BC
G2 T
G2+(1+r)B1=T2 G1 + = T1 + 2
1+ r 1+ r
Competitive Equilibrium In Equilibrium
Three conditions Recall from National Accounts

Sp+Sg=I+CA
RepCon: Optimal consumption/saving decision
given real interest rates Here I=0, CA=0 Î Sg=-B
Government BC holds
Credit markets clear! (Sp=B) In equilibrium
Y=C+G
Government Ricardian Equivalence
Remember form one-period model that Def: If current and future government
government expenditures crowds out private spending are held constant, then a change in
consumption current taxes with an equal and opposite
Need to make a distinction btw decrease in change in the present value of future taxes
taxes and an increase in government spending leaves the equilibrium real interest rate and
Now it is possible as we allow governments to the consumptions of individuals unchanged
borrow
7
Step 1 Step 2
Indicate competitive eq’m with *

Life time BC of the rep. consumer and government A lump sum increase in taxes ∆t so that t1**=t1*+∆t in
aggregate T1**=T1*+m∆t
c2 y2 − t 2 *
c1 + = y 1 − t *1 +
1 + r * 1 + r * Then Government intertemporal BC is
G 2 T 2*
G 1 + = T 1 +
*
w h ere T *
= m t *
1 + r * 1 + r *
c o m p e titiv e e q ' m c r e d it m a r k e t c le a r s G2 T **
in
G1 + = T **1 + 2 *
Y = C + G *
1+ r *
1+ r
a g g r e g a te p r iv a te s a v in g
S p* = Y − C * − T
g o v 't b o r r o w in g is
B * = G − T *
Step 3: showing that r* is still eq’m real interest Step 3 cont’d

rate
Present value of taxes paid by each consumer is After substituting

**
t 2 1 G 1
t1** + = (G1 + 2 * ) c1 +
c2
= y1 +
y2
− (G1 +
G2
)
1 + r* m 1+ r 1 + r* 1 + r* m 1 + r*
Present value of taxes for each consumer is the per Substituting present value of G (and remember
capita present value of G. mt*=T* and mt2*=T2*
c2 y − t ** t*
c1 + = y1 − t **1 + 2 * 2 c1 +
c2 y
= y1 + 2 * − t *1 + 2 *
1+ r *
1+ r 1+ r *
1+ r 1+ r
Step 3 cont’d Figure 6-17 Ricardian Equivalence with a Cut in

Current Taxes for a Lender
Since consumer’s consumption is unchanged in each

period before and after the ∆T, it must be
Y=C*+G
Î Changes in taxes leave the r* unchanged
Change in private savings thus
∆Sp=T*-T**=-m∆t
8
Ricardian Equivalence and the Burden of Government Social Security Programs
Debt: Critically Recalling Assumptions
Tax changes are identical across households: (in

reality life is more distortionary) Two types
All government debt is cleared within the lifetime (in pay as you go
reality Gov’t can reallocate the tax burden across Fully funded
generations)
Lump-sum taxation affects everybody in an identical
way (reality is more distortionary taxation)
Credit markets are perfect (in reality there are credit
market imperfections, limited participation)
There is no inflation (no money)
Figure 8.18 Pay-As-You-Go Social Security for Figure 8.19 Pay-As-You-Go Social Security for
Consumers Who Are Old in Period T Consumers Born in Period T and Later
Fully Funded Social Security
As long as population growth is larger than the Government invests the proceeds from social
real interest rate pay as you go will deliver a security taxes in the private credit market.
better outcome for everybody Or people simply save now and invest in the
The smaller the burden on younger generation financial markets to fund their retirement
(due to population increase) the higher the rate For simplicity we deal with only one interest
of return of the system. rate r
Aging population problem in Europe!
9
Figure 8.20 Fully Funded Social Security When Credit Market Imperfections and Consumption
Mandated Retirement Saving Is Binding
Assume r2>r1, where r2 is borrowing rate, and r1is lending

rate
Complication in the life time BC
c2 = y2 – t2 + s(1+r1) if s≥0 (consumer is lender)
c2 = y2 – t2 + s(1+r2) if s≤0 (consumer is borrower)
Life time BC then
c2 y 2 − t2
W 1 = c1 + = y 1 − t1 + if s ≥ 0
1 + r1 1 + r1
c2 y 2 − t2
W 2 = c1 + = y 1 − t1 + if s ≤ 0
1 + r2 1 + r2
Figure 6-18 A Consumer Facing Different Figure 6-19 Effects of a Tax Cut for a Consumer
Lending and Borrowing Rates with Different Borrowing and Lending Rates
Effects of a Tax Cut In Sum
Ricardian equivalence is violated! Two period macroeconomic model

Tax cut is effecteively low interest loans from Intertemporal consumption/saving decisions
Lifetime BC
the government to the consumers
Consumption smoothing
If there are credit market imperfections Y1 increasesÎ both C, C increase and S incraeeses
government deficits maybe useful to give Y2 increases Î both C, C increase and S decreases
‘access’ to credit markets Permamnet income increase has larger consumption
implications than temporary income increase
Monitoring issues
r changes, triggers both substititon and income effect
r changes affect borrowers and lenders differently
10
In sum
Consumption smoothing
Initial conditions (borrower or lender) matter if
there is a change in the real interest rate
Fiscal policy: Ricardian equivalence
Copyright © 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 61
11

File PDF

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

File PDF

Uploaded by

Copyright:

Available Formats

 Sofar: one-period (static) model

 This week: focus on a some dynamics

Two-period Model Basic Idea

 m consumers (m being large)  If s1>0, consumer is lender at period 1

Lifetime wealth Next step:

 Bring intertemporal budget constraint together

A1. More is always preferred than less!

Write the Wealth equation in slope-intercept form!

Consumer Optimization Figure 3 A Consumer Who Is a Lender

 Optimal consumption bundle is at the tangency of

 At Figure 3, endowment point is at E, but consumer

 Consumer lends distance DB that is s1=y1-t1-c1*>0

A Consumer Who Is a Borrower Figure 4 A Consumer Who Is a Borrower

 Lifetime wealth increases from

intertemporal consumption/saving decisions?? ∆ s = ∆ y 1 − ∆ t − ∆ c > 0

 i.e. an increase in y1 leads to an increase in

Theory meets Data Some explanations

 Theory predicts consumption smoothing  1 Imperfect credit markets

Figure 13 An Increase in the Real Interest Rate Table 2

 Current consumption is increasing in the

 Current consumption demand will shift in

 Given current and future G, T, assume we are  Solve for B1 in G2+(1+r)B1=T2

Competitive Equilibrium In Equilibrium

 Three conditions  Recall from National Accounts

Government Ricardian Equivalence

 Indicate competitive eq’m with *

Step 3: showing that r* is still eq’m real interest Step 3 cont’d

 Present value of taxes paid by each consumer is  After substituting

Step 3 cont’d Figure 6-17 Ricardian Equivalence with a Cut in

 Since consumer’s consumption is unchanged in each

 Î Changes in taxes leave the r* unchanged

 Change in private savings thus

 Tax changes are identical across households: (in

Fully Funded Social Security

 Assume r2>r1, where r2 is borrowing rate, and r1is lending

Effects of a Tax Cut In Sum

 Ricardian equivalence is violated!  Two period macroeconomic model

Copyright © 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 61

You might also like

Sofar: one-period (static) model

This week: focus on a some dynamics

m consumers (m being large) If s1>0, consumer is lender at period 1

Bring intertemporal budget constraint together

Optimal consumption bundle is at the tangency of

At Figure 3, endowment point is at E, but consumer

Consumer lends distance DB that is s1=y1-t1-c1*>0

Lifetime wealth increases from

i.e. an increase in y1 leads to an increase in

Theory predicts consumption smoothing 1 Imperfect credit markets

Current consumption is increasing in the

Current consumption demand will shift in

Given current and future G, T, assume we are Solve for B1 in G2+(1+r)B1=T2

Three conditions Recall from National Accounts

Indicate competitive eq’m with *

Present value of taxes paid by each consumer is After substituting

Since consumer’s consumption is unchanged in each

Î Changes in taxes leave the r* unchanged

Change in private savings thus

Tax changes are identical across households: (in

Assume r2>r1, where r2 is borrowing rate, and r1is lending

Ricardian equivalence is violated! Two period macroeconomic model