Consumption Flashcards
What is the Basic Keynesian Consumption Function?
𝐶t = 𝐶 + 𝑚𝑝𝑐 𝑌𝐷t
What is the Basic Keynesian Consumption Function imply about marginal propensity to consume, and average propensity to consume?
Keynes argues for “fundamental psychological law” of constant marginal propensity to consume 0 < mpc < 1 (rule of thumb)
This implies that average propensity to consume falls with income. In addition the model claims that consumption is not affected by changes in interest rates.
What observation have been made in Noraway that contradicts the Basic Keynesian Consumption Function ?
The model implications for increasing savings rate not consistent with aggregate time series data, which show fairly stable relation between income and savings.
What are the assumptions for the intertemporal consumption choice? ( Irving Fisher (1907) model).
- Individuals live for 2 periods (1,2)
- Consume/save from income y
- Introduce bonds paying interest r
Set up the intertemporal consumtion choice, and explain the meaning of each variable. (when the period utility function is not isoelastic)
u’(c1) = (1+r) Beta u’(c2)
Where Beta = 1/(1+ρ), a discount factor with 0< Beta <1
And ρ is the rate of subjective time preferance. ρ needs to be > 0, which implies that we perfer consumtion today over consumption tomorrow.
Set up the intertemporal budget constraint. Explain it in words.
y1 + y2/(1+r) = c1 + c2/(1+r)
The constraint states that during a lifespand one can only consume as much as one earnes adjusted for interest rates.
Write the Euler equation. Expain the intuition behind the equation. (when the period utility function is not isoelastic)
u’(c1) = (1+r) Beta u’(c2)
reduction in utility in period 1 exactly offset
by increase in utility in period 2 (discounted to period
1) from saving extra unit of consumption at interest
rate r.
Explain the components that are included in the graphical depiction of the optimal consumption graph. What is on the x-axis, what is on the y axis. What makes up the budget constraint, and makes up the indifference curve?
The optimal consumption can be found by setting the Eular equation=0 This yields the following:
Budget constraint: (1+r)
Indifference curve: c1^-θ /(Beta*c2^-θ)
X-axis: Consumption in periode 1
Y-axis: Consumption in periode 2
Explain what “θ” is in the isoelastic consumption function.
1/θ = intertemporal elasticity of substitution (IES)
Write the optimization problem for consumption with a two period model, when the period utility function is isoelastic.
max U(c1, c2) = (c1^(1-θ)-1)/(1-θ) + Beta* (c2^(1-θ)-1)/(1-θ)
write the Euler equation when the period utility function is isoelastic.
c1^-θ = (1+r)Betac2^-θ
By use of the the two period model, what happens to consumtion when the interest rates goes up, if you are a net saver?
The budget constraint -(1+r) gets a steeper decline, as r rises.
The substitution effect drives down consumption in period 1 and drives up consumption in period two
The income effect drives up consumption in period 1 and 2.
The netto effect of period 1 is unsure (depends on whether substitution or income effects dominates), the consumption in period 2 goes up.
By how much does consumption in period 1 increase if we experiance a temporary increase in income in period 1?
Consumption in periode 1 changes with less than the temporary income change, as we wich to smooth consumption.
By how much does consumption in period 1 and period 2 increase if we experiance a permanet increase in income?
The increase in consumption in period 1 is approximatly the same as the increase in income. This is also the case for period 2.
Does MPC depend on whether income shock temporary
or permanent?
Yes, if an income shock is permanet MPC=1.
