W7P1 - Notebook LM Flashcards
What determines the optimal level of consumption in the intertemporal budget constraint model?
Households’ preferences in addition to the intertemporal budget constraint. Households want to maximize utility subject to the budget constraint.
How does the volatility of consumption compare to the volatility of output?
Consumption is significantly less volatile than output. During a recession, consumption declines less than income, and during a boom, consumption increases less than income.
What is a key problem with the Keynesian consumption function?
It is incompatible with empirical facts. It suggests the average propensity to consume depends on the level of output and predicts that output is as volatile as consumption, which contradicts observed data.
How do households make consumption choices?
By maximizing utility through intertemporal consumption choices, considering consumption in the current and future periods, subject to their budget constraint.
What is the condition for optimal consumption?
The slope of the intertemporal budget constraint equals the slope of the indifference curve. The marginal rate of substitution (MRS) equals 1 + r, where ‘r’ is the interest rate.
What does it mean if a household’s marginal rate of intertemporal substitution is larger than 1 + r?
The household will borrow in period one and pay back in period two.
What is the marginal rate of intertemporal substitution?
The ratio of the partial derivatives of the utility function with respect to C1 and C2.
What is the Euler equation and what does it tell us?
Setting the marginal rate of intertemporal substitution equal to the slope of the budget constraint (1 + r) gives the Euler equation. It tells you about the gross rate of consumption across periods.
What does the parameter beta represent?
Beta represents that future utility from consumption is valued less than current utility. It is typically between 0 and 1.
What happens when beta equals 1 / (1 + r)?
Time preferences offset the interest rate, and consumption in both periods is equal. The interest rate rewards delaying consumption, while the time preference parameter penalises future consumption.
