Sofar: one-period (static) model

This week: focus on a some dynamics

Intertemporal decisions: economic trade-offs across
A Two-Period Model: time
Dynamic consumption-saving decision
The Consumption-Saving Decision Consumption smoothing
and Ricardian Equivalence Ricardian equivalence
Two period model

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 1 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 2

Two-period Model Basic Idea

Trade off between consuming now or future (Discounted) Life time total consumption can not
exceed (discounted) life time total income
Saving/borrowing
However in period by period terms, income does not
Simple model, but captures important aspects necessarily has to match consumption
of dynamic decision making Real interest rate determines the relative price future
Several issues to be addressed among others C in terms of current C
consumption smoothing i.e.
c y t
c1 + 2 = y1 t1 + 2 2
1+ r 1+ r

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 3 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 4

Consumers Consumers

m consumers (m being large) If s1>0, consumer is lender at period 1

Live only two periods (current and future)
no work-leisure decision, but receive
exogenous income (apple trees)
Focus on consumption/saving decision
Consumer budget constraint at period 1
c1 + s1 = y1 - t1
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy
If s1<0, consumer is borrower
trade one type of financial asset, bond (that can be
issued by government or consumer)
Assumptions regarding bond holding:
No risk associated with holding bonds, no default risk
Direct trading of bonds in the financial market, no
intermediaries
Bond pays of 1+r units of consumption good next
period
r, real interest rate is the same for lenders and
borrowers
Slide 5 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 6

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Consumers Life-time Budget constraint

Consumer budget constraint at period 2 Then substitute s1 into period 1 BC and rearrange to
obtain life-time BC
c2 = y2 t2 + (1+r) s1 Present value of lifetime consumption is equal to PV
of lifetime disposable income!!
Solve for s1 in period 2 BC c y t
c1 + 2 = y1 t1 + 2 2

1+r 1+r

c2 y2 + t2
s1 =
1+ r
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 7 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 8

Lifetime wealth Next step:

Bring intertemporal budget constraint together

y t2 with the preferences of the consumers!!
W = y 1 t1 + 2
1+ r The same logic as earlier lectures will apply
or
c2
W = c1 +
1+ r

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 9 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 10

Recall from Week 4 assumptions for consumers! Figure 6 Consumers Lifetime Budget Constraint

A1. More is always preferred than less!

A2. Diversity is important
A3b. Current and future consumption are normal goods!

Write the Wealth equation in slope-intercept form!

c2
W = c1 +
1+ r
= = > c 2 = (1 + r ) c1 + W (1 + r )
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 11 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 12

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Figure 2 A Consumers Indifference Curves Table 1

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 13 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 14

Consumer Optimization Figure 3 A Consumer Who Is a Lender

Optimal consumption bundle is at the tangency of

indifference curve to budget constraint

At Figure 3, endowment point is at E, but consumer

chooses point A..
At Point A
MRSc1,c2=1+r

Consumer lends distance DB that is s1=y1-t1-c1*>0

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 15 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 16

A Consumer Who Is a Borrower Figure 4 A Consumer Who Is a Borrower

s1=y1-t1-c1*<0

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 17 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 18

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The Effects of an Increase in Current Income for a Lender The Effects of an Increase in Current Income for a Lender

Lifetime wealth increases from

In a static setting we showed earlier that an y t
= +
increase in income (dividend income or a
2 2
W 1 y 1 t 1
1 + r
reduction in taxes) will increase consumption t o
y t 2
and will reduce labour supply (pure income W 2 = y '
1 t 1 +
1
2
+ r
effect) t h e c h a n g e i n w e a l t h
W = W W = y '
y
Here, how does an increase in income affect t h e c h a n g e i n
2 1

s a v i n g s
1 1

intertemporal consumption/saving decisions?? s = y 1 t c > 0

i.e. an increase in y1 leads to an increase in

consumption in both periods and an increase in
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 19 savings
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 20

Figure 5 The Effects of an Increase in Current Figure 6 Percentage Deviations from Trend in
Income for a Lender GDP and Consumption, 1982-1999

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 21 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 22

Theory meets Data Some explanations

Theory predicts consumption smoothing 1 Imperfect credit markets

Aggregate consumption data very strongly 2. Market prices move along the business
favours smoothing cycle
If you take out durable goods (say cars, fridges
that yield utility for very long periods of time)
results are even stronger
Still data exhibits a bit more consumption
variability than the theory would predict.
Why?

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 23 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 24

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Figure 7 An Increase in Future Income Figure 8 Temporary Versus Permanent
Increases in Income

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 25 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 26

Figure 11 An Increase in the Real Interest Rate Figure 12 An Increase in the Real Interest Rate
for a Lender

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 27 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 28

Figure 13 An Increase in the Real Interest Rate Table 2

for a Borrower

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 29 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 30

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Table 3 Figure 14 Example with Perfect Complements
Preferences

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 31 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 32

Consumers Demand for Current Consumption Figure 15 A Consumers Demand for Current Consumption
Goods, cd, as a Function of Current Income

Current consumption is increasing in the

increase in income (current and future)

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 33 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 34

Consumers Demand for Current Consumption Figure 16 A Shift in a Consumers Demand for
Current Consumption

Current consumption demand will shift in

Real interest rates
Future income

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 35 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 36

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Incorporating Government: Assumptions Government Present Value Budget Constraint

Given current and future G, T, assume we are Solve for B1 in G2+(1+r)B1=T2

initially at the competitive eqm with r
B1=(T2-G2)/(1+r)
T is put upon initial T
Current Period Government BC Substitute into current period Gov. BC to obtain
G1=T1+B1 intertemporal Gov BC
Future Period Government BC
G2 T
G2+(1+r)B1=T2 G1 + = T1 + 2
1+ r 1+ r

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 37 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 38

Competitive Equilibrium In Equilibrium

Three conditions Recall from National Accounts

Sp+Sg=I+CA
RepCon: Optimal consumption/saving decision
given real interest rates Here I=0, CA=0 Sg=-B
Government BC holds
Credit markets clear! (Sp=B) In equilibrium
Y=C+G

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 39 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 40

Government Ricardian Equivalence

Remember form one-period model that
government expenditures crowds out private
consumption
Need to make a distinction btw decrease in
taxes and an increase in government spending
Now it is possible as we allow governments to
borrow
Def: If current and future government
spending are held constant, then a change in
current taxes with an equal and opposite
change in the present value of future taxes
leaves the equilibrium real interest rate and
the consumptions of individuals unchanged

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 41 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 42

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Step 1 Step 2

Indicate competitive eqm with *

Life time BC of the rep. consumer and government A lump sum increase in taxes t so that t1**=t1*+t in
aggregate T1**=T1*+mt
c2 y2 t 2 *
c1 + = y 1 t *1 +
1 + r * 1 + r * Then Government intertemporal BC is
G 2 T 2*
G 1 + = T 1 +
*
w h ere T *
= m t *

1 + r * 1 + r *

c o m p e titiv e e q ' m c r e d it m a r k e t c le a r s G2 T **
in
G1 + = T **1 + 2 *
Y = C + G *
1+ r *
1+ r
a g g r e g a te p r iv a te s a v in g
S p* = Y C * T
g o v 't b o r r o w in g is
B * = G T *

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 43 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 44

Step 3: showing that r* is still eqm real interest Step 3 contd

rate

Present value of taxes paid by each consumer is After substituting

**
t 2 1 G 1
t1** + = (G1 + 2 * ) c1 +
c2
= y1 +
y2
(G1 +
G2
)
1 + r* m 1+ r 1 + r* 1 + r* m 1 + r*

Present value of taxes for each consumer is the per Substituting present value of G (and remember
capita present value of G. mt*=T* and mt2*=T2*

c2 y t ** t*
c1 + = y1 t **1 + 2 * 2 c1 +
c2 y
= y1 + 2 * t *1 + 2 *
1+ r *
1+ r 1+ r *
1+ r 1+ r

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 45 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 46

Step 3 contd Figure 6-17 Ricardian Equivalence with a Cut in

Current Taxes for a Lender

Since consumers consumption is unchanged in each

period before and after the T, it must be
Y=C*+G

Changes in taxes leave the r* unchanged

Change in private savings thus

Sp=T*-T**=-mt

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 47 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 48

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Ricardian Equivalence and the Burden of Government
Debt: Critically Recalling Assumptions
Tax changes are identical across households: (in
reality life is more distortionary)
All government debt is cleared within the lifetime (in
reality Govt can reallocate the tax burden across
generations)
Lump-sum taxation affects everybody in an identical
way (reality is more distortionary taxation)
Credit markets are perfect (in reality there are credit
market imperfections, limited participation)
There is no inflation (no money)
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 49
Figure 8.18 Pay-As-You-Go Social Security for
Consumers Who Are Old in Period T
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 51
As long as population growth is larger than the
real interest rate pay as you go will deliver a
better outcome for everybody
The smaller the burden on younger generation
(due to population increase) the higher the rate
of return of the system.
Aging population problem in Europe!
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 53
Social Security Programs
Two types
pay as you go
Fully funded
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 50
Figure 8.19 Pay-As-You-Go Social Security for
Consumers Born in Period T and Later
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 52
Fully Funded Social Security
Government invests the proceeds from social
security taxes in the private credit market.
Or people simply save now and invest in the
financial markets to fund their retirement
For simplicity we deal with only one interest
rate r
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 54
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Figure 8.20 Fully Funded Social Security When Credit Market Imperfections and Consumption
Mandated Retirement Saving Is Binding

Assume r2>r1, where r2 is borrowing rate, and r1is lending

rate
Complication in the life time BC
c2 = y2 t2 + s(1+r1) if s0 (consumer is lender)
c2 = y2 t2 + s(1+r2) if s0 (consumer is borrower)
Life time BC then
c2 y 2 t2
W 1 = c1 + = y 1 t1 + if s 0
1 + r1 1 + r1
c2 y 2 t2
W 2 = c1 + = y 1 t1 + if s 0
1 + r2 1 + r2
Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 55 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 56

Figure 6-18 A Consumer Facing Different Figure 6-19 Effects of a Tax Cut for a Consumer
Lending and Borrowing Rates with Different Borrowing and Lending Rates

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 57 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 58

Effects of a Tax Cut In Sum

Ricardian equivalence is violated! Two period macroeconomic model

Tax cut is effecteively low interest loans from Intertemporal consumption/saving decisions
Lifetime BC
the government to the consumers

Consumption smoothing
If there are credit market imperfections Y1 increases both C, C increase and S incraeeses
government deficits maybe useful to give Y2 increases both C, C increase and S decreases
access to credit markets Permamnet income increase has larger consumption
implications than temporary income increase
Monitoring issues
r changes, triggers both substititon and income effect
r changes affect borrowers and lenders differently

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 59 Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 60

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In sum

Consumption smoothing
Initial conditions (borrower or lender) matter if
there is a change in the real interest rate
Fiscal policy: Ricardian equivalence

Copyright 2002 Pearson Education, Inc. and Dr Yunus Aksoy Slide 61

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