Chapter 9 A Two-Period Model: The Consumption-Savings Decision and Credit Markets Copyright © 2014 Pearson Education, Inc.

Chapter 9 Topics Consumer’s consumption/savings decision – responses of consumer to changes in income and interest rates. Government budget deficits and the Ricardian Equivalence Theorem. © 2014 Pearson Education, Inc.

Budget Constraints The consumer’s current-period budget constraint: © 2014 Pearson Education, Inc.

Budget Constraints The consumer’s future-period budget constraint: © 2014 Pearson Education, Inc.

Solve the future-period budget constraint for s: Simplify Solve the future-period budget constraint for s: © 2014 Pearson Education, Inc.

Next, Substitute in the current-period budget constraint obtaining lifetime budget constraint: © 2014 Pearson Education, Inc.

Consumer’s Lifetime Budget Constraint Substitute in the current-period budget constraint obtaining lifetime budget constraint: © 2014 Pearson Education, Inc.

Consumer’s Lifetime Wealth © 2014 Pearson Education, Inc.

Simplified Lifetime Budget Constraint © 2014 Pearson Education, Inc.

Simplified Lifetime Budget Constraint: Slope-Intercept © 2014 Pearson Education, Inc.

Figure 9.1 Consumer’s Lifetime Budget Constraint © 2014 Pearson Education, Inc.

Figure 9.2 A Consumer’s Indifference Curves © 2014 Pearson Education, Inc.

Marginal condition that holds when the consumer is optimizing: Optimization Marginal condition that holds when the consumer is optimizing: © 2014 Pearson Education, Inc.

Figure 9.3 A Consumer Who Is a Lender © 2014 Pearson Education, Inc.

Figure 9.4 A Consumer Who Is a Borrower © 2014 Pearson Education, Inc.

An Increase in Current Income for the Consumer Current and future consumption increase. Saving increases. The consumer acts to smooth consumption over time. © 2014 Pearson Education, Inc.

Figure 9.5 The Effects of an Increase in Current Income for a Lender © 2014 Pearson Education, Inc.

Observed Consumption-Smoothing Behavior Aggregate consumption of non-durables and services is smooth relative to aggregate income, but the consumption of durables is more volatile than income. This is because durables consumption is economically more like investment than consumption. © 2014 Pearson Education, Inc.

Figure 9.6 Percentage Deviations from Trend in Consumption of Durables and Real GDP © 2014 Pearson Education, Inc.

Figure 9.7 Percentage Deviations from Trend in Consumption of Nondurables and Services and Real GDP © 2014 Pearson Education, Inc.

An Increase in Future Income for the Consumer Aggregate consumption of non-durables and services is smooth relative to aggregate income, but the consumption of durables is more volatile than income. This is because durables consumption is economically more like investment than consumption. © 2014 Pearson Education, Inc.

Figure 9.8 An Increase in Future Income © 2014 Pearson Education, Inc.

Temporary and Permanent Increases in Income As a permanent increase in income will have a larger effect on lifetime wealth than a temporary increase, there will be a larger effect on current consumption. A consumer will tend to save most of a purely temporary income increase. © 2014 Pearson Education, Inc.

Figure 9.9 Temporary Versus Permanent Increases in Income © 2014 Pearson Education, Inc.

Figure 9.10 Stock Price Index and the Consumption of Nondurables and Services © 2014 Pearson Education, Inc.

Figure 9. 11 Scatter Plot: Consumption of Nondurables and Services vs Figure 9.11 Scatter Plot: Consumption of Nondurables and Services vs. Stock Price Index © 2014 Pearson Education, Inc.

Figure 9.12 An Increase in the Real Interest Rate © 2014 Pearson Education, Inc.

An Increase in the Market Real Interest Rate An increase in the market real interest rate decreases the relative price of future consumption goods in terms of current consumption goods – this has income and substitution effects for the consumer. © 2014 Pearson Education, Inc.

Figure 9.13 An Increase in the Real Interest Rate for a Lender © 2014 Pearson Education, Inc.

Figure 9.14 An Increase in the Real Interest Rate for a Borrower © 2014 Pearson Education, Inc.

Effects of an Increase in the Real Interest Rate for a Lender © 2014 Pearson Education, Inc.

Effects of an Increase in the Real Interest Rate for a Borrower © 2014 Pearson Education, Inc.

Perfect Complements Example With perfect complements, the ratio of future consumption to current consumption is constant. The consumer’s budget constraint must hold. © 2014 Pearson Education, Inc.

Perfect Complements Example With perfect complements we can solve explicitly for current and future consumption: © 2014 Pearson Education, Inc.

Perfect Complements Example Substituting for lifetime wealth gives: © 2014 Pearson Education, Inc.

Figure 9.15 Example with Perfect Complements Preferences © 2014 Pearson Education, Inc.

Government Budget Constraints The government’s current-period budget constraint: © 2014 Pearson Education, Inc.

Government Budget Constraints The government’s future-period budget constraint: © 2014 Pearson Education, Inc.

Government Budget Constraints The government’s present-value budget constraint: © 2014 Pearson Education, Inc.

Credit Market Equilibrium Condition Total private savings is equal to the quantity of government bonds issued in the current period. © 2014 Pearson Education, Inc.

Income-Expenditure Identity Credit market equilibrium implies that the income-expenditure identity holds. © 2014 Pearson Education, Inc.

Ricardian Equivalence The Ricardian Equivalence Theorem is illustrated algebraically, numerically, and in two graphs. © 2014 Pearson Education, Inc.

Ricardian Equivalence Key equation: The consumer’s lifetime tax burden is equal to the consumer’s share of the present value of government spending – the timing of taxation does not matter for the consumer. © 2014 Pearson Education, Inc.

Ricardian Equivalence Then, substitute in the consumer’s budget constraint – taxes do not matter in equilibrium for the consumer’s lifetime wealth, just the present value of government spending. © 2014 Pearson Education, Inc.

Figure 9.16 Ricardian Equivalence with a Cut in Current Taxes for a Borrower © 2014 Pearson Education, Inc.

Figure 9.17 Ricardian Equivalence and Credit Market Equilibrium © 2014 Pearson Education, Inc.

Figure 9.18 Perfect Substitutes, MRSl,C <1 + r. © 2014 Pearson Education, Inc.

Figure 9.19 Perfect Substitutes, MRSl,C <1 + r. © 2014 Pearson Education, Inc.

Figure 9.20 Competitive Equilibrium in the Example © 2014 Pearson Education, Inc.

Figure 9.21 Total Government Surplus for the United States © 2014 Pearson Education, Inc.

Figure 9.22 Total government Debt (federal, state, and local) © 2014 Pearson Education, Inc.