Chapter 9
A Two-Period
Model: The
Consumption-
Savings Decision
and Credit
Markets
Lecture Part II
Copyright © 2014 Pearson Education, Inc.
Figure 9.2
A Consumer’s Indifference Curves
Consumer has well-behaved
preferences:
• More is preferred to less;
• The consumer wishes to have a
smooth consumption pattern over
time (dislikes large differences in
consumption over time). But this
does not imply equal consumption
every period;
• Current and future consumption are
normal goods
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Consumer optimization
• Consumer’s utility maximization problem
Lagrangean of the consumer’s problem.
Consumer optimization
• First order necessary conditions for a maximum:
• These first order necessary conditions imply
• That is, in the consumer’s equilibrium, the marginal rate of substitution
between current and future consumption is equal to the relative price of
current consumption in terms of future consumption, 1+r, which is the
absolute value of the slope of the budget line.
Figure 9.3
A Consumer Who Is a Lender
At point A, the consumer maximizes
utility and bundle A is the
equilibrium bundle.
The consumer’s choice of bundle is
such that the consumer is a lender:
The endowment is at point E,
Point A implies that and
Since the consumer optimally
consumes less than the endowment
in the current period, the consumer
is saving, s>0, hence is a lender
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Figure 9.4
A Consumer Who Is a Borrower
At point A, the consumer maximizes
utility and bundle A is the
equilibrium bundle.
The consumer’s choice of bundle is
such that the consumer is a
borrower: The endowment is at point
E,
Point A implies that and
Since the consumer optimally
consumes more than the endowment
in the current period, the consumer
is dissaving, s<0, hence is a borrower
1-6
Example
First order necessary conditions:
Example
• Rearranging the first two first order necessary conditions, we get
or,
We replace this solution in the intertemporal budget constraint:
Example
• The equilibrium solution is then
• Check that it satisfies the budget constraint:
Example
Note that unless we
know the endowment
point E, we cannot tell
whether the consumer
is saving or borrowing.
We need to know
where the point E is
along the budget line.
Comparative Dynamics-An Increase in
Current Income for the Consumer
• Let
• Since there is no change in the slope of the budget line, there is a parallel
shift in the budget constraint.
Figure 9.5
The Effects of an Increase in Current Income
for a Lender (s>0)
Endowment moves from
Equilibrium moves from A to B
(both goods are normal goods)
or
Since s increases, c’ also increases
for given (y’-t’)
1-12
Comparative Dynamics-An Increase in
Current Income for the Consumer
• Both c and c’ are normal goods; an increase in the lifetime income raises
consumption in both periods, not only in the current period.
• The equilibrium bundle moves from A to B,
• The consumer is a lender, and with the increase in current income, the
saving in the current period also rises.
• Why do we get this result? Because the consumer wishes to smooth
consumption over time.
• The consumer does not spend all of the increase in current income on
current consumption, saves some of the increase in current income for
future consumption.
• Exercise: Try the same experiment for a borrower (s<0)
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Comparative Dynamics-An Increase in
Future Income for the Consumer
• In this case, the consumer for sure knows that there will be an increase in
the future income, there is no uncertainty about this change;
• Since the consumer knows that there will be a certain increase in future
income, he/she does not have to save as much as he/she did, and is able to
increase current consumption with less saving.
• Hence with this certain information that future income rises, the current
consumption as well as the future consumption rises. Also, there will not
be a sharp rise in future consumption (desire to smooth consumption over
time)
Figure 9.8
An Increase in Future Income
Endowment moves from
Equilibrium moves from A to B
or
Future consumption does not rise 1-to-1
with future income
The consumer saves less, so current
period c also rises with the future
income
1-15
Comparative Dynamics-An Increase in
Future Income for the Consumer
• Also,
• Hence the consumer must be saving as smaller amount.
• Not only future consumption increases with the increase in future
income, current consumption also increases (by saving less than before)
Temporary vs. Permanent Changes in
Income
• As we see from the previous analyses, the timing of the change in income
matters for the changes in saving in order to smooth the pattern of
income (saving rises with the increase in current income, decreases with
the rise in future income);
• This is also important if the change in income is only temporary or
permanent;
• Milton Friedman’s Permanent Income Hypothesis: Changes that are
temporary yield small changes in permanent income (lifetime wealth),
which have small effects on current consumption, whereas changes in
income that are permanent have large effects on permanent income
(lifetime wealth) and current consumption
Figure 9.9
Temporary Versus Permanent
• If theIncreases inisIncome
income change only
temporary (such as a one time
bonus), the consumer will save
some of the increase in income
and the current consumption
will not rise as much as the rise
in income;
• But if the income change is
permanent (such as a raise in
permanent wages), the
consumer does not have to save
as much, knowing that the
change in income is permanent,
and hence the increase in
current c is higher.
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Temporary vs. Permanent Changes in
Income
• This can be applied to the tax cuts: Whether the tax cut is only temporary
or permanent (raising disposable income);
• If the consumers know that the tax cut is a one-time occurrence, they will
not raise their consumption as much as the tax cut itself;
• But if they know that the tax cut is permanent, this will increase
aggregate consumption as they know that they will have higher
disposable income in the future, so they do not need to save as much.
