Consumption

Question 1

What is the core idea behind Irving Fisher’s model of intertemporal choice, and how does it differ from Keynes’ model of consumption?

Answer 1

Fisher’s model assumes that a rational and forward-looking consumer maximizes lifetime utility by choosing consumption in both the present and future, based on total lifetime resources (wealth + future income).. In contrast, Keynes’ model assumes that current consumption depends only on current disposable income.

Question 2

Draw the Graph for a Two Period Model. Explain the steps to the Two Period Model

Answer 2

PV = Y1 + Y2(1+ r)
PV = Y2(1+r) + Y2

When there is equal Y in both periods ($100): Set Budget Constraint as C + C(1+r) = PV. If Y is different in both periods: Period 1>Period 2, lending. Put the budget constraint negative for P1 (C1 constraint). If Period 2>Period 1. Borrowing. Put the budget constraint negative for P2 (C2 constraint)
Set C1 = C2 and solve. If both incomes go up, use a, C2 negative. When lending,with a borrowing constrained person, optimal consumption the same. If borrowing, with a borrowing constraint person, optimal consumption is lower (graph).

Question 3

What is Modigliani Life Cycle Hypothesis?

Answer 3

Consumption depends on lifetime wealth: Ct = αWt​+βYt​, Ct​ = consumption at time t, Wt​ = wealth at time t, Yt​ = income at time t, α = marginal propensity to consume of wealth, β = marginal propensity to consume out of income. Or C = ( W + RY)T, R is a working period.
In the short run, temporary increase in income wealth is almost fixed (Ct =C0+ C1Yt) . In the long run, permanent increase in income, wealth is proportional to income (Ct = CYt).

Question 4

What is Friedman Permanent Income Hypothesis?

Answer 4

Consumption depends on permanent income, not current income. Income has 2 parts: Permanent income Expected to persist, Transitory income, Temporary/random changes. Consumption Equation: Ct​=αYtp.

Permanent Income Updates Over Time: So consumption becomes:Ct = αβ(Yt−Ypt-1​) + αYpt-1. Short Run: MPC=αβ reflects response to transitory income Long Run: MPC=α, reflects response to permanent income.