Consumption - savings decision Flashcards
Why do we need intertemporal models?
Consumption today is not the same as tomorrow.
Governments often spend today and tax tomorrow
Consumers future-period budget constraint
c’ = y’ - t’ + (1+r)s
Consumers current-period budget constraint
c + s = y - t
Lifetime wealth equation
we = y - t + (y’ - t’)/ (1 + r)
Lifetime budget constraint
c’ = - (1 + r)c + we(1 + r)
Slope of the budget constraint
- (1 + r)
Endowment point
Determined by current and future disposible income
Utility maximisation takes place where
MRS = 1 + r
Effect of an increase in current income
Raises y-t, therefore shifts out budget constraint.
The increase in consumption is less than the increase in the endowment point.
This is because HH want to smooth consumption
Effect of an increase in future income
Consumption smoothing leads to HH savings fall as they borrow some of the increase in the future
What happens if current income and future income rises
Less need for smoothing out consumption, however depends which has a greater weight.
What is the interest rate in terms of current and future consumption
Price you’re willing to pay to transform one unit of future consumption into 1 / (1 + r) units of current consumption
How does the interest rate affect the consumption graph
It pivots the budget constraint around the endowment point
Graphically line becomes more vertical
Effect of increase in interest rates for lender
IE is positive
SE increases future consumption and decreases current consumption
Effect of increasing interest rates for a borrower
IE is negative
Current consumption falls
Future consumption could rise or fall
