14 Consumption Flashcards
What proportion of GDP does consumption account for?
More than 2/3.
What is the neoclassical consumption model?
Individuals choose their consumption at each moment in time to maximise a lifetime utility function that depends on current and future consumption.
First insight of the neoclassical model
Two periods only: today and the future.
Income is received today and in the future, consumption happens today and in the future.
What are the two main elements of the neoclassical consumption model?
- The inter-temporal budget constraint
- A utility function
Derive the intertemporal budget constraint
Utility in the neoclassical consumption model. What does it exhibit?
+ diagram
Utility given as a function of consumption.
It exhibits diminishing marginal utility.
How can we express utility as a function of the two time periods?
What does β represent and what does it value indicate?
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.
How do we choose consumption to maximise utility?
What is Euler’s equation? What does it say?
The individual must be indifferent between consuming today or saving it to consume later.
If u(c) = log(c) then what does the Euler equation look like?
What does the Euler equation with logs indicate?
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.
Steps in solving for ctoday and cfuture
What effect does a rise in R have on consumption?
Remember that total wealth also depends on R.
Higher interest rate reduces the present value, therefore reducing consumption in the case of log utility.
How do the income and substitution effects play into a rise in R?
(log utility)
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.
How do the income and substitution effects play into a rise in R?
(non-log utility)
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.
Permanent-income hypothesis and the neoclassical model
We see that consumption is proportional to overall wealth.
Although, total wealth depends on interest rates too.
Marginal propensity to consume and the neoclassical model
Ricardian equivalence and the neoclassical model
Does it hold?
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
Precautionary saving
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.
Main determinant of consumption according to Keynes
Income
General formula for Keynesian consumption function
How is the average propensity to consume related to Keynesian production functions?
Effect of an increase in income diagrammatically
Effect of an increase in the real interest rate diagrammatically
Effect of borrowing constraints diagrammatically
Empirically, how do low income households behave?
- Behave as if borrowing constrained
- Engage in precautionary saving
- MPC from income boost is high
