Chapter 9

1. What are inter-temporal decisions? Why do consumers save? How do consumers

save in the two-period model?

Inter-temporal decisions how individuals current decisions affect what options become
available in the future. Inter-temporal decisions involve economic trade-offs across periods.
Consumers save so that they can smooth their consumption over time. Consumption smoothing
is the economic concept used to express the desire of people to haves a stable path of
consumption. Let y be a consumers real income in the current period, and y be real income in
the future period. Each consumer pays lump-sum taxes t in the current period and toe in the
future period. Suppose that incomes can be different for different consumers, but that all
consumers pay the same taxes. If we let a consumers savings in the current period be s, then the
consumers budget constraint in the current period is:

c + s = y - t,

Consumers save by issuing bonds. If s > 0, then the consumer is a lender on the credit market,
and if s < 0, the consumer is a borrower. We suppose that the financial asset that is traded in the
credit market is a bond. In the model, bonds can be issued by consumers as well as by the
government. If a consumer lends, he or she buys bonds; if he or she borrows, there is a sale of
bonds. There are two important assumptions here. The first is that all bonds are indistinguishable,
because consumers never default on their debts, so that there is no risk associated with holding a
bond. In practice, different credit instruments are associated with different levels of risk. Interest-
bearing securities issued by the U.S. government are essentially riskless, while corporate bonds
may be risky if investors feel that the corporate issuer might default, and a loan made by a bank
to a consumer may also be quite risky. The second important assumption is that bonds are traded
directly in the credit market. In practice, much of the economys credit activity is channeled
through financial intermediaries, an example of which is a commercial bank. For example, when
a consumer borrows to purchase a car, the loan is usually taken out at a commercial bank or other
depository institution; a consumer typically does not borrow directly from the ultimate lender. In
our model, one bond issued in the current period is a promise to pay 1+r units of the
consumption good in the future period, so that the real interest rate on each bond is r. Because
this implies that one unit of current consumption can be exchanged in the credit market for 1+r
units of the future consumption good, the relative price of future consumption in terms of current
consumption is 1/1 + r. A key assumption here is that the real rate of interest at which a consumer
can lend is the same as the real rate of interest at which a consumer can borrow. In practice,
consumers typically borrow at higher rates of interest than they can lend at. For example, the
interest rates on consumer loans are usually several percentage points higher than the interest
rates on bank deposits, reflecting the costs for the bank of taking deposits and making loans.

In the future period, the consumer has disposable income y t and receives the interest and
principal on his or her savings, which totals (1 + r) s. Because the future period is the final
period, the consumer chooses to finish this period with no assets, consuming all disposable
income and the interest and principal on savings. We then have:

c = y t + (1 + r) s,

The consumer chooses current consumption and future consumption, c and c, respectively, and
savings s to make himself or herself as well off as possible while satisfying the budget
constraints.

2. How is the lifetime budget constraint represented algebraically?

From the formulas:

c = y t + (1 + r) s,
We can express s:

S = c y + t
1+r
Substitute s at:
c+s=y+t
We get:

Rearranging:

3. If y=110 y=120 t=20 t=10 r=10%. Write the lifetime budget constraint.
In this example, the relative price of future consumption goods in terms of current consumption
goods is 1/1 + r = 0.909. Here, when we discount future income and future taxes to obtain these
quantities in units of current consumption goods, we multiply by the discount factor 0.909. The
fact that the discount factor is less than 1 indicates that having a given amount of income in the
future is worth less to the consumer than having the same amount of income in the current
period. The present discounted value of lifetime income is

y +y/1+r = 110 + (120 * 0.909) = 219.1,

and the present value of lifetime taxes is

t + t/1+ r = 20 + (10 * 0.909) = 29.1.

Then, in this example, we can write the consumers lifetime budget constraint

c + 0.909c = 190.

4. How is the lifetime budget constraint represented graphically? What do you

understand by lifetime wealth? What is the Endowment point? lf a consumer
chooses the endowment point, how much does he or she consume in each period, and
how much does he or she save?

To consume the endowment point, the consumer consumes y t in the first period, and consumes
y' t' in the second period. The consumer neither lends nor borrows.
 5. What are the three assumptions made in this model?

a. More is always preferred to less. Here, this means that more current consumption or more
future consumption always makes the consumer better off.

b. The consumer has a dislike for having large differences in consumption between the current
period and the future period. Note that this does not mean that the consumer would always
choose to have equal consumption in the current and future periods.

b. Current consumption and future consumption are normal goods. This implies that if there is a
parallel shift to the right in the consumers budget constraint, then current consumption and
future consumption both increase. If there is a parallel shift to the right in the consumers budget
constraint, this is because lifetime wealth we has increased. Given the consumers desire to
smooth consumption over time, any increase in lifetime wealth implies that the consumer
chooses more consumption in the present and in the future.

6. How is graphically represented the consumption bundle? How is the consumers motive
to smooth consumption captured by the shape of an indifference curve?
The preference for a smooth consumption stream implies a declining marginal rate of
substitution, and so indifference curves are bowed toward the origin. The consumers optimal
consumption bundle here is determined by where an indifference curve is tangent to the budget
constraint. At point A, it is then the case that:

MRS c, c = 1 + r,

that is, the marginal rate of substitution of current consumption for future consumption (minus
the slope of the indifference curve) is equal to the relative price of current consumption in terms
of future consumption (1 + r, which is minus the slope of the consumers lifetime budget
constraint). Here, the consumer optimizes by choosing the consumption bundle on his or her
lifetime budget constraint where the rate at which he or she is willing to trade off current
consumption for future consumption is the same as the rate at which he or she can trade current
consumption for future consumption in the market (by saving)

When he is a lender: c < y t, therefore he saves-so he consumes less today in order to consume
more in the future then he if he wouldnt save consume more today and less tomorrow.
When he is a borrower: c > y t, therefore I cannot save I borrow in order to consume more
today and as a result less tomorrow.

7. What are the effects of an increase in current income on consumption in each period, and
on savings?

Suppose that, holding the interest rate, taxes in the current and future periods, and future income
constant, a consumer receives an increase in period 1 income. Asking the consumers response to
this change in income is much like asking how an individual would react to winning a lottery. In
Figure 9.5 the initial endowment point is at E, and the consumer initially chooses the
consumption bundle represented by point A.

The effect is that the budget constraint shifts to the right by the amount y2-y1, which is the
distance E1E2, where E2 is the new endowment point. The slope of the budget constraint
remains unchanged, as the real interest rate is the same. Because current-period consumption and
future consumption are normal goods, the consumer now chooses a consumption bundle
represented by a point like B, where consumption in both periods has risen from the previous
values. Current consumption increases from c1 to c2, and future consumption increases from c1
to c2. Thus, if current income increases, the consumer wishes to spread this additional income
over both periods and not consume it all in the current period. In Figure 9.5 the increase in
current income is the distance AD, while the increase in current consumption is the distance AF,
which is less than the distance AD. The change in the consumers savings is given by

s =y -t -c, (9-9)

and because t = 0, and y 7c 7 0, we have s 7 0. Thus, an increase in current income causes

an increase in consumption in both periods and an increase in savings.

8. What are the effects of an increase in future income on consumption in each period, and
on savings?

Suppose, for example, that Jennifer is about to finish her college degree in four months, and she
lines up a job that starts as soon as she graduates. On landing the job, Jennifers future income
has increased considerably. How would she react to this future increase in income? Clearly, this
would imply that she would plan to increase her future consumption, but Jennifer also likes to
smooth consumption, so that she should want to have higher current consumption as well. She
can consume more currently by borrowing against her future income and repaying the loan when
she starts working.
In Figure 9.8 we show the effects of an increase for the consumer in future income, from y1 to
y2. This has an effect similar to the increase in current income on lifetime wealth, with lifetime
wealth increasing from we1 to we2, and shifting the budget constraint up by the amount y2- y1.
Initially, the consumer chooses consumption bundle A, and he or she chooses B after the increase
in future income. Both current and future consumptions increase; current consumption increases
from c1 to c2, and future consumption increases from c1 to c2. The increase in future
consumption, which is the distance AF in Figure 9.8, is less than the increase in future income,
which is the distance AD. This is because, as with the increase in current income, the consumer
wants to smooth consumption over time. Rather than spend all the increase in income in the
future, the consumer saves less in the current period so that current consumption can increase.

9. What produces a larger increase in a consumers current consumption, a permanent

increase in the consumers income or a temporary increase?

A permanent increase in income produces a larger increase in current consumption, because it is

unnecessary to smooth the increase over time. When a consumer receives a change in his or her
current income, it matters a great deal for his or her current consumption savings choice
whether this change in income is temporary or permanent. For example, Allen would respond
quite differently to receiving a windfall increase in his income of $1,000, say by winning a
lottery, as opposed to receiving a $1,000 yearly salary increase that he expects to continue
indefinitely. In the case of the lottery winnings, we might expect that Allen would increase
current consumption by only a small amount, saving most of the lottery winnings to increase
consumption in the future. If Allen received a permanent increase in his income, as in the second
case, we would expect his increase in current consumption to be much larger.

In Figure 9.9 the budget constraint of the consumer is initially AB, and he or she chooses the
consumption bundle represented by point H, on indifference curve I. Then, the consumer
experiences a temporary increase in income, with current income increasing from y1to y2, so
that the budget constraint shifts out to DE. The distance HL is equal to the change in current
income, y2-y1. Now, the consumer chooses point J on indifference curve I2. The increase in
current consumption, c2- c1, is less than the increase in current income, y2-y1. as saving
increases due to consumption-smoothing behavior.

Now, suppose that the increase in income is permanent. We interpret this as an equal increase of
y2- y1 in both current and future income. That is, initially future income is y1and it increases to
y2 with y2- y1= y2- y1. Now, the budget constraint is given by FG in Figure 9.9, where the
upward shift in the budget constraint from DE is the distance LM, which is y2- y1= y2- y1. The
consumer now chooses point K on indifference curve I3. At point K, current consumption is c3.
Given that current and future consumption are normal goods, current consumption increases
from point H to point J and from point J to point K. Therefore, if income increases permanently,
this has a larger effect on current consumption than if income increases only temporarily. If
income increases only temporarily, there is an increase in saving, so that consumption does not
increase as much as does income. However, if there is a permanent increase in income, then there
need not be an increase in saving, and current consumption could increase as much as or more
than does income.

11. How does the government finance its purchases in the two-period model?

We suppose that the government wishes to purchase G consumption goods in the current period
and G. The aggregate quantity of taxes collected by the government in the current period is T.
Recall that there are N consumers who each pay a current tax of t, so that T = Nt. Similarly, in
the future-period total taxes are equal to T, and we have T= Nt. The government can borrow in
the current period by issuing bonds. Recall that government bonds and private bonds are
indistinguishable, with these bonds all bearing the same real interest rate r. Letting B denote the
quantity of government bonds issued in the current period, the governments current-period
budget constraint is

G = T + B,

that is, government spending is financed through taxes and the issue of bonds. Put another way,
the current-period government deficit, G-T, is financed by issuing bonds. In the future period, the
governments budget constraint is

G+ (1 + r)B = T

The governments budget constraints allow for the possibility that B 6 0. If B 6 0 this would
imply that the government was a lender to the private sector, rather than a borrower from it. In
practice, the government engages in direct lending to the private sector, and it issues debt to
private economic agents, so that it is a lender and a borrower.
12. State the Ricardian equivalence theorem.

Holding current and future government spending fixed, a change in the timing of taxation has no
effect on the equilibrium interest rate, and no effect on any consumers choice of current and
future consumption. A tax cut is not a free lunch.

Now, suppose there is a tax cut in the current period, so that t 6 0. Therefore, the government
must borrow Nt more in period 1 to finance the larger current government deficit, and taxes
must rise for each consumer by -t(1 + r) in the future period to pay off the increased
government debt. The effect of this on the consumer is that lifetime wealth we remains
unchanged, as the present value of taxes has not changed. The budget constraint is unaffected,
and the consumer still chooses point A in Figure 9.16. What changes is that the endowment point
moves to E; that is, the consumer has more disposable income in the current period and less
disposable income in the future period due to the tax cut in the current period.
13. Give four reasons that the burden of the government debt is not shared equally in
practice.

First, changes in taxes are not shared equally by all consumers. Second, debt issued to finance
current deficits may not be repaid during the lives of all current consumers. Third, taxes are not
lump sum. Fourth, in practice there are credit market imperfections.

The first key assumption is that when taxes change, in the experiment we considered above, they
change by the same amount for all consumers, both in the present and in the future. For example,
when a particular consumer received a tax cut in the current period, this was offset by an equal
and opposite (in present value terms) increase in taxes in the future, so that the present-value tax
burden for each individual was unchanged. Now, if some consumers received higher tax cuts
than others, then lifetime wealth could change for some consumers, and this would necessarily
change their consumption choices and could change the equilibrium real interest rate.

A second key assumption in the model is that any debt issued by the government is paid off
during the lifetimes of the people alive when the debt was issued. In practice, the government
can postpone the taxes required to pay off the debt until long in the future, when the consumers
who received the current benefits of a higher government debt are either retired or dead. That is,
if the government cuts taxes, then the current old receive higher disposable incomes, but it is the
current young who will have to pay off the government debt in the future through higher taxes.
In this sense, the government debt can be a burden on the young, and it can involve an
intergenerational redistribution of wealth.

A third assumption made above was that taxes are lump sum. All taxes cause distortions, in that
they change the effective relative prices of goods faced by consumers in the market. These
distortions represent welfare losses from taxation.

A fourth key assumption made above is that there is a perfect credit market, in the sense that
consumers can borrow and lend as much as they please, subject to their lifetime budget
constraints, and they can borrow and lend at the same interest rate. In practice, consumers face
constraints on how much they can borrow; for example, credit cards have borrowing limits, and
sometimes consumers cannot borrow without collateral (as with mortgages and auto loans).
Consumers also typically borrow at higher interest rates than they can lend at. For example, the
gap between the interest rate on a typical bank loan and the interest rate on a typical bank deposit
can be 6 percentage points per annum or more. Further, the government borrows at lower interest
rates than does the typical consumer. While all consumers need not be affected by credit market
imperfections, to the extent that some consumers are credit-constrained, these credit-constrained
consumers could be affected beneficially by a tax cut, even if there is an offsetting tax liability
for these consumers in the future. In this sense, the government debt may not be a burden for
some segments of the population; it may in fact increase welfare for these groups.
Exercise 1

A consumers income in the current period is y = 100, and income in the future period is y =
120. He or she pays lump-sum taxes t = 20 in the current period and t = 10 in the future period.
The real interest rate is 0.1, or 10%, per period.

(a) Determine the consumers lifetime wealth.

(b) Suppose that current and future consumptions are perfect complements for the consumer
and that he or she always wants to have equal consumption in the current and future periods.
Draw the consumers indifference curves.

(c) Determine what the consumers optimal current-period and future-period consumptions
are, and what optimal saving is, and show this in a diagram with the consumers budget
constraint and indifference curves. Is the consumer a lender or a borrower?

(d) Now suppose that instead of y = 100, the consumer has y = 140. Again, determine
optimal consumption in the current and future periods and optimal saving, and show this in a
diagram. Is the consumer a lender or a borrower?

(e) Explain the differences in your results between parts (c) and (d).

Solution:
Exercise 2

Consider the following effects of an increase in taxes for a consumer.

(a) The consumers taxes increase by t in the current period. How does this affect current
consumption, future consumption, and current saving?

(b) The consumers taxes increase permanently, increasing by t in the current and future
periods. Using a diagram, determine how this affects current consumption, future consumption,
and current saving. Explain the differences between your results here and in part (a)

Solution:

a. The increase in first-period taxes induces a parallel leftward shift in the budget line. The
original budget line passes through the initial endowment, E1. The new budget line passes
through E2. The consumer reduces both current and future consumption. In the figure below the
consumers optimum point moves from point A to point B. First - period consumption falls by
less than the increase in taxes and so savings falls.

b. Next consider a permanent increase in taxes. A permanent tax increase adds a second tax
increase to the first tax increase, the current-period tax increase. The increase in second-period
taxes induces a parallel downward shift in the budget line. The new budget line passes through
E2 in the figure above. The second part of the tax increase also reduces both first-period and
second period consumption. The consumer moves from point B to point D. Because the second
tax increase reduces first-period consumption holding first-period disposable income fixed,
savings must rise. Since the permanent tax increase is the sum of the two individual tax
increases, the permanent tax increase reduces both first-period and second-period consumption,
but on net, savings may either rise, fall, or remain unchanged

Exercise 3

A consumer receives income y in the current period, income y in the future period, and pays
taxes of t and t in the current and future periods, respectively. This consumer faces a constraint
on how much he or she can borrow, much like the credit limit typically placed on a credit card
account. That is, the consumer cannot borrow more than x, where x < we - y + t, with we
denoting lifetime wealth. Use diagrams to determine the effects on the consumers current
consumption, future consumption, and savings of a change in x, and explain your results.

Solution:

The consumer faces a borrowing constraint that places a ceiling on the level of current
consumption. The consumer may consume more than the current endowment, y - t but less than
the amount of the lifetime endowment, we. The consumers budget line is as in the first figure
below. The budget line becomes vertical at c = x. An example of such a budget line is depicted in
the two panels of the figure as ABD. As one possibility, the constraint is nonbinding as in the
figure below. The consumer chooses point H. A change in the level of x has no effect on such a
consumer.

Alternatively, the consumer depicted in the second figure below originally chooses the corner
solution, point B. The consumer achieves the level of utility corresponding to indifference curve,
I1. An increase in x produces the new budget line, ACJ. This consumer now chooses point G.
She increases current consumption and decreases both current saving and future consumption.
This consumer is able to improve her level of utility to that corresponding to indifference curve,
I2.
Exercise 4

Assume a consumer who has current-period income y = 200, future-period income y= 150,
current and future taxes t = 40 and t= 50, respectively, and faces a market real interest rate of r =
0.05, or 5% per period. The consumer would like to consume equal amounts in both periods; that
is, he or she would like to set c = c, if possible. However, this consumer is faced with a credit
market imperfection, in that he or she cannot borrow at all, that is, s > 0.

(a) Show the consumers lifetime budget constraint and indifference curves in a diagram.

(b) Calculate his or her optimal current-period and future-period consumption and optimal
saving, and show this in your diagram.

(c) Suppose that everything remains unchanged, except that now t = 20 and t= 71. Calculate the
effects on current and future consumption and optimal saving, and show this in your diagram.

(d) Now, suppose alternatively that y = 100. Repeat parts (a) to (c), and explain any differences.

Solution:
a.

In the figure below, the initial budget constraint is given by BED. The budget constraint has a
kink at the initial endowment point E1 = (160,100), because the consumer cannot borrow, and
therefore cannot consume more than 160 in the first period. Because the consumer has perfect-
complements preferences, the indifference curves are kinked at c=c
b. With perfect-complements preferences, the consumer picks point A in figure on the previous
page. Plugging in c = c into the budget constraint and solving, we find that c = c = 130.7 and so
s=y-t-c=16-130.7=29.3 In this case, the fact that the consumer cannot borrow does not matter for
the consumers choice, as the consumer decides to be a lender.

c. When t = 20 and, t' = 71 the consumers lifetime wealth remains unchanged at 255.2.
However, the budget constraint shifts to BEF, figure on the previous page, with the new
endowment point at E2 = (180,79). This change does not matter for the consumers choice, again
because he or she chooses to be a lender. Consumption is still 130.7, but now savings is s-y-t-
c=180-130.7=49.3

d. Now first-period income falls to 100. Wealth is now equal to w = 155.2. In the figure above,
the budget constraint for the consumer is AE1D, so when the consumer chooses the point on his
or her budget constraint that is on the highest indifference curve, any point on the line segment
BE1 will do. Suppose that the consumer chooses the endowment point E1, where c = 60 and
c=100. This implies that s = 0, and the consumer is credit-constrained in that he or she would
like to borrow, but cannot. Now with the tax change, the budget constraint shifts to AE2G, with
the endowment point E2 = (80,79). Thus the consumer can choose c = c on the new budget
constraint, and solving for consumption in each period using the budget constraint:

c + 0.95 c'=155.2

we get c = c = 79.5, and s = 0.5. Here, notice that first-period consumption increased by almost
the same amount as the tax cut, although lifetime wealth remains unchanged at 155.2.
Effectively, the budget constraint for the consumer is relaxed. Therefore, for tax cuts that leave
lifetime wealth unchanged, lenders will not change their current consumption, but credit
constrained borrowers will increase current consumption.

Exercise 5

Assume an economy with 1,000 consumers. Each consumer has income in the current period of
50 units and future income of 60 units and pays a lump-sum tax of 10 units in the current period
and 20 units in the future period. The market real interest rate is 8%. Of the 1,000 consumers,
500 consume 60 units in the future, while 500 consume 20 units in the future.

(a) Determine each consumers current consumption and current saving.

(b) Determine aggregate private saving, aggregate consumption in each period, government
spending in the current and future periods, the current-period government deficit, and the
quantity of debt issued by the government in the current period.

(c) Suppose that current taxes increase to 15 units for each consumer. Repeat parts (a) and (b)
and explain your results.

Solution:
a.