14 Consumption

Question 1

What proportion of GDP does consumption account for?

Answer 1

More than 2/3.

Question 2

What is the neoclassical consumption model?

Answer 2

Individuals choose their consumption at each moment in time to maximise a lifetime utility function that depends on current and future consumption.

Question 3

First insight of the neoclassical model

Answer 3

Two periods only: today and the future.

Income is received today and in the future, consumption happens today and in the future.

Question 4

What are the two main elements of the neoclassical consumption model?

Answer 4

• The inter-temporal budget constraint
• A utility function

Question 5

Derive the intertemporal budget constraint

Answer 5

Question 6

Utility in the neoclassical consumption model. What does it exhibit?

+ diagram

Answer 6

Utility given as a function of consumption.

It exhibits diminishing marginal utility.

Question 7

How can we express utility as a function of the two time periods?

Answer 7

Question 8

What does β represent and what does it value indicate?

Answer 8

It is some number that captures the weight an individual places on the future, relative to today.

If below 1: utility is worth more today.

If equal to 1: utils today = utils in the future.

If above 1: utils in the future worth more.

Question 9

How do we choose consumption to maximise utility?

Answer 9

Question 10

What is Euler’s equation? What does it say?

Answer 10

The individual must be indifferent between consuming today or saving it to consume later.

Question 11

If u(c) = log(c) then what does the Euler equation look like?

Answer 11

Question 12

What does the Euler equation with logs indicate?

Answer 12

LHS: the growth rate of consumption. Therefore, consumption is chosen so that the growth rate is the product of the discount parameter and the interest rate earned on savings.

If impatient, β is lower, so the growth rate is smaller. The reverse is also true.

Question 13

Steps in solving for c_today and c_future

Answer 13

Question 14

What effect does a rise in R have on consumption?

Answer 14

Remember that total wealth also depends on R.

Higher interest rate reduces the present value, therefore reducing consumption in the case of log utility.

Question 15

How do the income and substitution effects play into a rise in R?

(log utility)

Answer 15

In the case of log utility, the two effects offset each other - this is why the interest rate does not appear explicitly in the solutions for consumptions.

Question 16

How do the income and substitution effects play into a rise in R?

(non-log utility)

Answer 16

Substitution effect of higher IR - current consumption is more expensive (saving will lead to more consumption in the future).

Income effect - consumers are richer, current saving leads to more income in the future, which makes them want to consumer today.

Effects work in opposite directions.

Question 17

Permanent-income hypothesis and the neoclassical model

Answer 17

We see that consumption is proportional to overall wealth.

Although, total wealth depends on interest rates too.

Question 18

Marginal propensity to consume and the neoclassical model

Answer 18

Question 19

Ricardian equivalence and the neoclassical model

Does it hold?

Answer 19

As X (bar) is the total wealth over time, whether there is a tax cut now compensated by a tax increase in the future does not change our maximisation problem, hence timing has no effect on consumption.

Depends. Can break down if tax is progressive, different generations enduring tax burdens

Question 20

Precautionary saving

Answer 20

Uncertain income → consumers save to hedge against the possibility of a large drop in income.

Consumers behave as if they face borrowing constraints even when they do not.

Consumption is especially sensitive to changes in income; marginal propensity to consume can be higher than the permanent-income hypothesis would dictate.

Question 21

Main determinant of consumption according to Keynes

Answer 21

Income

Question 22

General formula for Keynesian consumption function

Answer 22

Question 23

How is the average propensity to consume related to Keynesian production functions?

Answer 23

Question 24

Effect of an increase in income diagrammatically

Answer 24

Question 25

Effect of an increase in the real interest rate diagrammatically

Answer 25

Question 26

Effect of borrowing constraints diagrammatically

Answer 26

Question 27

Empirically, how do low income households behave?

Answer 27

• Behave as if borrowing constrained
• Engage in precautionary saving
• MPC from income boost is high