W7P2 - Notebook LM Flashcards
What happens to consumption when there is a temporary increase in income?
Consumption increases by less than the income increase. People save some of the income for future consumption, which is known as consumption smoothing. The average propensity to consume (APC) will change.
What happens to consumption when there is a permanent increase in income?
Consumption changes by roughly the same amount as the income increase, with no need to save. The APC would not change.
How does an increase in interest rates affect consumption through the substitution effect?
It reduces period one consumption (C1) and increases period two consumption (C2).
How does an increase in interest rates affect consumption for a net borrower through the income effect?
It decreases overall lifetime income, leading to a reduction in both period one consumption (C1) and period two consumption (C2).
How does an increase in interest rates affect consumption for a net lender through the income effect?
It increases overall lifetime income, leading to an increase in both period one consumption (C1) and period two consumption (C2).
What is the overall effect on C1 and C2 for a net borrower when interest rates increase?
C1 decreases. The effect on C2 is uncertain because the income and substitution effects go in opposite directions.
What is the overall effect on C1 and C2 for a net lender when interest rates increase?
The effect on C1 is uncertain because the income and substitution effects go in opposite directions. C2 increases.
What happens when there are borrowing constraints?
Current consumption depends on current income. This can lead to lower utility compared to a situation where borrowing is possible. Models may predict too much consumption smoothness if they do not account for borrowing constraints.
