Intertemporal Macro: consumption Flashcards
What is the Permanent Income Hypothesis (PIH)?
PIH suggests individuals allocate resources across lifetimes, choosing smooth consumption compared to fluctuating income
What does intergenerational altruism imply in the intertemporal model?
Individuals care for their offspring, intending to leave bequests, knowing their offspring will do the same (Barro, 1974)
What is intertemporal separability/additivity?
It means instantaneous utility is independent of consumption in other periods
What is the No Ponzi Game condition?
It assumes a single interest rate and perfect capital markets; households cannot perpetually roll over debt
What is the Elasticity of Intertemporal Substitution (EIS)?
It measures how MRS varies over time and is the inverse of CRRA; higher EIS means more consumption smoothing
EIS = - u’(c) / cu“(c)
What is exponential discounting (beta^t)?
It implies intertemporally consistent choices—planned actions remain optimal unless new info arrives
What does the Euler Equation show in intertemporal consumption?
It describes how consumption growth changes over time and depends on the interest rate and EIS
Does not itself determine the level of C
Euler equation: u’(ct) = beta (1 + r) E [ u’ (ct + 1) ]
What is the implication when (1+r) > 1/β in the Euler Equation?
Marginal utility is decreasing, so consumption is increasing
= is flat path for consumption
< is decreasing consumption
What is Hall’s Random Walk hypothesis?
Consumption follows a random walk: ct+1 = ct + εt, where E(εt) = 0, meaning changes in consumption are unpredictable
Only the present value of income matters, the profile of income over time does not
What does certainty equivalence mean in the context of consumption?
Volatility in income does not affect consumption choices; the household acts as if future income is certain
What does excess sensitivity mean in consumption?
Consumption responds to predictable income changes, which contradicts the PIH (permanent income hypothesis = consumption smoothing)
What is the effect of unanticipated income on consumption?
It causes changes in consumption due to recalculation of lifetime wealth
What is the typical consumption response to a temporary income increase?
Consumption rises only slightly, as the increase is spread over the lifetime
What is the typical consumption response to a permanent income increase?
Consumption rises proportionally for all future periods
What are common explanations for failure of the PIH?
Credit constraints, impatience, and uncertainty about future income
How do credit constraints impact consumption smoothing?
They prevent borrowing by households who lack wealth / collateral, so consumption rises only when income actually increases
Because of information problems facing banks in assessing creditworthiness, banks are not always willing to lend to households without the wealth or collateral to secure a loan in order than that they can smooth consumption
- Mariger (1986) uses household data to estimate that around 20% of the population in the USA is credit-constrained; Gross and Souleles (2002) use data on credit card limits to give a higher estimate of 2/3
Faced with news of a future rise in income:
- PIH households borrow to raise consumption as soon as the news of future income is received which allows them to smooth consumption
- Credit-constrained households do not have this option, so consumption only rises when income does
How does impatience affect consumption behavior?
Impatient households may not save in anticipation of future income falls as would be indicated by PIH, leading to consumption drops
Faced with news of a future fall in income:
- PIH households start saving as soon as the news of the fall in future income is received which allows them to smooth consumption
- Impatient households fail to reduce current consumption upon receipt of the news, meaning consumption falls dramatically when income actually falls
What is precautionary saving?
Saving driven by income uncertainty beyond PIH predictions
- linked to risk aversion
Happens when there is uncertainty about future incomes
What does hyperbolic discounting suggest / what is the solution?
People have self-control issues and time inconsistency - will discount future more and consume more today
- when the agent is aware of these inconsistencies they may use commitment devices to manage consumption
- limiting their temptation for instant gratification by purchasing assets that are difficult to liquidise eg put savings in places that penalise early withdrawals
