dynamic model Flashcards
endowment economy
no production
types of agents/sectors (2)
- consumers
- government
describe two-period economy
- consumers’ choice between current & future consumption via saving
- the government’s choice between current and future taxes
exogenous income variables (2)
- y: consumer’s real income in current period
- y’: consumer’s real income in future period
tax variables (2)
- t: lump-sum taxes in current period
- t’: lump-sum taxes in future period
consumption variables (2)
- c: current consumption
- c’: future consumption
formula for what consumer saves in current period
s = y - t - c
if y - t > c…?
consumer saves (is a lender); s > 0
if y - t < c…?
consumer borrows; s < 0
equation for budget constraint
c + s = y − t
lending & borrowing is done by…?
issuing bonds
a bond issued today pays…?
(1+r) units of consumption in the future
consumer’s future-period budget constraint
c’ = y’ − t’ + (1+r)s
lifetime budget constraint
c + c’/(1+r) = y - t + (y’ - t’)/(1 + r)
lifetime wealth
we = y - t + (y’ - t’)/(1 + r)
utility function (U(c, c’))
captures consumer preferences over c and c’
properties of consumer’s preferences (3)
- more is always preferred to less
- the consumer likes diversity in his or her consumption bundle
- current and future consumption are normal goods
an increase in consumer’s current income causes…? (4)
- lifetime wealth increases
- parallel shift of BC to the right
- current & future consumption increase
- savings increases
aggregate consumption of non-durables and services
smooth relative to aggregate income
aggregate consumption of durables
more volatile than income because durables consumption is economically more like investment than consumption
an increase in consumer’s future income causes…? (4)
- lifetime wealth increases
- parallel shift of BC to the right
- current & future consumption increase
- savings decreases
permanent increase in consumer’s income causes…? (3)
- lifetime wealth increases
- horizontal increase in BC in current period; vertical increase in BC in future period
- current consumption increase
temporary increase in consumer’s income causes…?
consumer will tend to save most of a purely temporary income increase
increase in the real interest rate causes…?
- affected tradeoff between current & future consumption
- steeper BC line
how does an increase in the real interest rate affect a borrower? (2)
- current consumption decreases
- savings increases
how does an increase in the real interest rate affect a lender?
- future consumption increases
assumption about government consumption
government purchases G consumption goods in the current period and G′ in the future (exogenous)
variables w/ government shi (4)
- G: government expenditures in current period
- N: consumers who pay current taxes
- T: total taxes collected in the current period
- B: the quantity of government bonds issued in the current period
government’s CURRENT period budget constraint
G = T + B
describe government’s CURRENT period budget constraint
government spending financed w/ taxes and issuance of bonds
government’s FUTURE budget constraint
G′ + (1 + r)B = T’
describe government’s FUTURE period budget constraint
future government spending & the principal and interest on the government bonds issued in the current period are financed through future taxes
present value of government purchases must equal…?
the present value of taxes
what happens in competitive equilibrium? (3)
- each consumer optimizes given the budget constraint
- government’s present value budget constraint hold
- credit market clears (S = B)
(credit market equilibrium) aggregate quantity of private savings is equal to…?
quantity of debt issued by the government in the current period
ricardian equivalence theorem
government deficit spending is counter balanced by increased private saving, as individuals anticipate future tax hikes to repay the debt
effect of ricardian equivalence theory
- lifetime wealth (we) remains unchanged, as the PV of taxes has not changed
- budget constraint is unaffected
why might ricardian equivalence fail in practice? (4)
- tax changes affect the wealth of different consumers differently
- the government can postpone the taxes required to pay off the debt
- all taxes are distortionary (based on individual actions)
- consumers face constraints on how much they can borrow
assumptions of ricardian equivalence (4)
- taxes change by the same amount for all consumers
- any debt issued by government is paid off during lifetimes of people alive when debt was issued
- taxes are lump sum
- perfect credit markets
discount factor
rate at which the consumer
discounts future consumption
