Macroeconomics 2 (PMAK) : Discussion Session 5

Macroeconomics 2 (PMAK)
Discussion Session 5
Bopjun Gwak
Goethe University Frankfurt
June 18, 2018
Bopjun Gwak (Goethe University Frankfurt) PMAK - Discussion Session 1 June 18, 2018 1 / 17
Today’s Agenda
1 Aggregate Demand
2 Consumption
3 Government Spending /Ricardian Equivalence
Aggregate Demand
Yt = Ct + It + Gt + (EXt − IMt )
US - aggregate demand Germany - aggregate demand

0%
8%
20%
Priate Consump5on Priate Consump7on
20%
Private Investment Private Investment
Public consump5on + Public consump7on +

16% 54%
investment investment
Net Exports 64% Net Exports

19%
Private Consumption
Model from lecture:

2 periods: today and tomorrow
No uncertainty
No constraints on saving/borrowing
Income: Y1 , Y2
Consumption: C1 , C2
Real interest rate: r
Lump-sum taxes T1 , T2
Consumption-Saving Decision
Lifetime utility of households:
U(C1 , C2 ) = u(C1 ) + βu(C2 ) (1)
where 0 < β < 1 is the discount factor.
Intertemporal budget constraint:
C2 = (Y1 − T1 − C1 )(1 + r ) + (Y2 − T2 ) (2)

or:
C2 Y2 − T2
C1 + = Y1 − T1 + (3)
1+r 1+r
| {z } | {z }
PV of lifetime consumption PV of lifetime net income
A simple model of the consumption-saving decision
Optimal consumption-saving decision
C2
Y2
C2*
Y1 C1* C1
Mirko Wiederholt (Goethe University Frankfurt) Macroeconomics 2 Lecture 7 11 / 25

In the optimum, the slope of the indifference curve is equal to the slope of
the budget constraint.
1. Graphical Solution
1 Slope of the budget constraint: −(1 + r ).

2 Along the indifference curves dU = 0:
∂U
∂U ∂U dC2 ∂C
dU = dC1 + dC2 = 0 ⇔ = − ∂U1 = MRS
∂C1 ∂C2 dC1 ∂C 2
The slope of the indifference curve is equal to the marginal rate of

substitution.
u 0 (C1 )
U = u(C1 ) + βu(C2 ) : MRS = −
βu 0 (C2 )
⇒ Optimality condition (combining 1 & 2):
u 0 (C1 )
=1+r
βu 0 (C2 )
2. Analytical Solution
Maximization problem:
max U(C1 , C2 ) = max u(C1 ) + βu(C2 )

C1 ,C2 C1 ,C2
C2 Y2 − T2
s.t. C1 + = Y1 − T1 +
1+r 1+r
Solve by substituting the budget constraint into U(.):
C2 = (1 + r )(Y1 − T1 ) + (Y2 − T2 ) − C1 (1 + r )
⇒ max u(C1 ) + βu[ (1 + r )(Y1 − T1 ) + (Y2 − T2 ) − C1 (1 + r ) ]
C1 | {z }
C2
FOC: u 0 (C1 ) + βu 0 (C2 )(−(1 + r )) = 0

u 0 (C1 )
⇔ =1+r
βu 0 (C2 )
Alternative approach: Lagrange.
Optimality condition:
u 0 (C1 ) = β(1 + r )u 0 (C2 )
1 + r is the relative price of present consumption. It measures the

amount of future consumption which must be given up to enable the
consumer to increase present consumption by one unit.
C1
What happens to C2 if β increases?
Remember (from lecture): u 0 (.) > 0, u 00 (.) < 0. Then:

if (1 + r )β = 1 : u 0 (C1 ) = u 0 (C2 ) ⇒ C1 = C2
0 0
if (1 + r )β < 1 : u (C1 ) < u (C2 ) ⇒ C1 > C2
0 0
if (1 + r )β > 1 : u (C1 ) > u (C2 ) ⇒ C1 < C2
Exercise: Log-utility
Exercise
Consider log-utility:
U(C1 , C2 ) = ln(C1 ) + β ln(C2 )
Suppose that β(1 + r ) = 1.
(a) Calculate analytically the optimality condition.
(b) Calculate C1 and C2 as a function of total life-time income (in present
value terms).
Different Tax policies
Exercise
Consider the following two different tax policies:
1 Raise taxes today and tomorrow by one unit.
2 Leave taxes today unchanged, and raise taxes tomorrow by 2 + r units.
How is consumption in period 1 (period 2) affected?
Government Spending
Intertemporal government budget constraint:
G2 T2
D1 + G 1 + = T1 + (4)
1+r 1+r
Dt : real stock of public debt at the beginning of period t
Tt : real net tax revenue in period t
Gt : real government spending in period t
2 periods: at the end of period 2 the government pays back all debt.
(No-Ponzi condition as for households)
Government Spending
Exercise
Suppose that the government cuts taxes in period 1, i.e. dT1 < 0. Current and
future government spending G1 and G2 is unchanged. Calculate the change
in current consumption dC1 .
Ricardian Equivalence
Exercise
Suppose that the government wants to increase its government expenditure
by one unit each period, i.e. dG1 = dG2 = 1. Consider the following two
different tax policies:
1 dT2 = 0
2 dT1 = 0
How is dC1 affected under both policies?
Ricardian Equivalence
Ricardian Equivalence Theorem

A cut in current taxes which is not accompanied by a cut in present or
planned future public spending will have no effect on private consumption.
Financing current public spending by debts rather than by taxes leaves
private consumption unaffected.
Taxes and debts are equivalent methods of public finance (Ricardian
equivalence).
Why Ricardian equivalence may fail?
Ricardian Equivalence: Discussion
Reasons why Ricardian equivalence may fail:

Finite horizons and intergenerational distribution effects
Different interest rates for private and public debt
Intragenerational redistribution
Distortionary taxes
Credit constraints

Macroeconomics 2 (PMAK) : Discussion Session 5

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Macroeconomics 2 (PMAK)

Goethe University Frankfurt

June 18, 2018

3 Government Spending /Ricardian Equivalence

US - aggregate demand Germany - aggregate demand

Public consump5on + Public consump7on +

Net Exports 64% Net Exports

Model from lecture:

Lifetime utility of households:

U(C1 , C2 ) = u(C1 ) + βu(C2 ) (1)

where 0 < β < 1 is the discount factor.

Intertemporal budget constraint:

C2 = (Y1 − T1 − C1 )(1 + r ) + (Y2 − T2 ) (2)

Mirko Wiederholt (Goethe University Frankfurt) Macroeconomics 2 Lecture 7 11 / 25

1 Slope of the budget constraint: −(1 + r ).

The slope of the indifference curve is equal to the marginal rate of

⇒ Optimality condition (combining 1 & 2):

max U(C1 , C2 ) = max u(C1 ) + βu(C2 )

Solve by substituting the budget constraint into U(.):

FOC: u 0 (C1 ) + βu 0 (C2 )(−(1 + r )) = 0

u 0 (C1 ) = β(1 + r )u 0 (C2 )

1 + r is the relative price of present consumption. It measures the

Remember (from lecture): u 0 (.) > 0, u 00 (.) < 0. Then:

Intertemporal government budget constraint:

Ricardian Equivalence Theorem

Why Ricardian equivalence may fail?

Reasons why Ricardian equivalence may fail:

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