Week 18 - Consumption

Question 1

What were Keynes’ key conjectures in his theory of consumption?

Answer 1

• MPC was between 0 and 1.
• APC falls as income rises (consumers spend a smaller proportion of their income when their income increases).
• Consumption decisions are based on current income.

Question 2

What was the key problem for Keynes’ theory?

Answer 2

Keynes predicted that over a long period of time, as Y increased, C would grow more slowly. Kuznets found that, over a long period of time this was not the case - as Y grew, APC didn’t fall and C grew just as fast.
This was known as Kuznets consumption puzzle.

Question 3

What is the inter temporal budget constraint ?

Answer 3

A measure of the total resources available for present and future consumption.
FORMULA: c1 + c2 / (1 + r) = y1 + y2 / (1 + r). The current value of consumption equals the current value of income.

Question 4

What is the endowment point on the budget constraint?

Answer 4

The point where the consumer consumes exactly his income in period 1, and exactly his income in period 2.

Question 5

What is the slope of the budget constraint?

Answer 5

• The relative price of consumption in period 1 compared to consumption in period 2.

Question 6

Whats the marginal rate of substitution?

Answer 6

• The amount of c2 a consumer is willing to give up for one unit of c1.

Question 7

What is the equilibrium condition in Fisher’s model?

Answer 7

• Where MRS = 1 + r

Question 8

How does consumption change in response to an increase in Y?

Answer 8

• Assuming c1 and c2 are normal goods, a rise in Y c1 and c2 will both rise.

Question 9

What are the key differences between Keynes and Fisher’s models?

Answer 9

• Keynes: Consumption depends only on current income.
• Fisher: Consumption depends on the present value of lifetime income. Current income is irrelevant because consumers can borrow and save to alter current consumption.

Question 10

How does the budget line move when r changes?

Answer 10

Pivots around the endowment point

Question 11

How does consumption change when r increases?

Answer 11

Depends on whether the consumer is a borrower or a saver! Need to consider substitution and income effect.
INCOME EFFECT: increase lifetime income if a saver, reduces it if a borrower. Thus, consumption in both periods will increase for savers, decrease for borrowers.
SUB EFFECT: Changes the relative price of consumption in both periods. For a saver, c1 becomes relatively more expensive.

Question 12

How does constraints on borrowing effect consumption?

Answer 12

Makes the budget constraint kinked. The effect on consumption depends on the individual preferences of the consumer.

• If he/she is a saver, borrowing constraint isn’t binding, and thus he consumes as before.
• If he/she is a borrower, the borrowing constraint is binding, and he has to consume sup-optimally.