Review of the Previous

Lecture
• Consumption
– The Consumption Function, APC & MPC
– Consumption Puzzle
– Intertemporal Choice
– Consumer’s Budget Constraints
 Topics under Discussion
• Consumption
– Consumer’s Budget Constraint (cont.)
– Consumer Preferences
– Optimization
– Income Effect and Substitution Effect
• Role of Real Interest Rate
– Constraints on Borrowings
 Consumer’s Budget
Constraint
• Irving Fisher’s generalization:

C2 Y2
C1 + = Y1 +
1+r 1+r
 Consumer’s Budget
Constraint
• So we can say that
• The consumer’s budget constraint implies
that if the interest rate is zero, the budget
constraint shows that total consumption in
the two periods equals total income in the
two periods. In the usual case in which the
interest rate is greater than zero, future
consumption and future income are
discounted by a factor of 1 + r.
 Consumer’s Budget
Constraint
• This discounting arises from the interest
earned on savings. Because the consumer
earns interest on current income that is saved,
future income is worth less than current income.
• Also, because future consumption is paid for out
of savings that have earned interest, future
consumption costs less than current
consumption.
 Consumer’s Budget
Constraint
• The factor 1/(1+r) is the price of second-period
consumption measured in terms of first-period
consumption; it is the amount of first-period
consumption that the consumer must forgo to
obtain 1 unit of second-period consumption.
 Consumer’s Budget
Constraint
If he chooses a point
between A and B, he
consumes less than his
income in the first Second-period
consumption
Consumer’s budget
constraint
period and saves the B
rest for the second Saving
period. If he chooses Vertical intercept is
(1+r)Y1 + Y2
between A and C, he A
consumes more that his Borrowing
Y2
income in the first C
Horizontal intercept is
Y + Y /(1+r)
period and borrows to Y1
1 2

First-period consumption
make up the difference.
 Consumer Preferences
• The consumer’s preferences regarding
consumption in the two periods can be
represented by indifference curves.
• An indifference curve shows the
combination of first-period and second-
period consumption that makes the
consumer equally happy.
 Consumer Preferences
• The slope at any point on the indifference curve
shows how much second-period consumption the
consumer requires in order to be compensated for
a 1-unit reduction in first-period consumption. This
slope is the marginal rate of substitution
between first-period consumption and second-
period consumption. It tells us the rate at which
the consumer is willing to substitute second-
period consumption for first-period consumption.
 Consumer Preferences
Higher indifferences
curves such as IC2 are
preferred to lower ones Second-period
consumption
such as IC1. The
consumer is equally
happy at points W, X,
and Y, but prefers Z to Y Z
all the others-- Point Z IC2
X
is on a higher IC1
W
indifference curve and First-period consumption
is therefore not equally
preferred to W, X and Y.
 Optimization
The consumer achieves
Second-period
his highest (or optimal) consumption
level of satisfaction by
choosing the point on
the budget constraint
that is on the highest
indifference curve. At O
the optimum, the IC3
indifference curve is IC2
tangent to the budget IC1
First-period consumption
constraint.
How changes in income affect
consumption
An increase in either first-
or second-period income
Second-period
shifts the budget constraint consumption
outward. If consumption in
period one and (1+r)Y + Y
1 2

consumption in period two

are both normal goods- O
those that are demanded IC2
more as income rises, this IC1
increase in income raises
consumption in both Y1 + Y2/(1+r)
First-period consumption
periods.
 How changes in real interest
rate affect consumption
• Economists decompose the impact of an
increase in the real interest rate on consumption
into two effects: an income effect and a
substitution effect.
• The income effect is the change in consumption
that results from the movement to a higher
indifference curve.
• The substitution effect is the change in
consumption that results from the change in the
relative price of consumption in the two periods.
 How changes in real interest
rate affect consumption
An increase in the
interest rate rotates the
Second- period
budget constraint consumption
around the point C, (1+r)Y + Y1 2
New budget
where C is (Y1, Y2). constraint

The higher interest rate B Old budget constraint

reduces first period
consumption (move to A
point A) and raises Y2 C IC2
second-period IC1
consumption (move to Y1 Y1 + Y2/(1+r)

point B). First-period consumption

 Consumption and the Real
Interest Rate
• Irving Fisher’s Model shows that depending on
the consumer preferences, changes in real
interest rate could either raise or lower
consumption.
• So, economic theory alone cannot predict how
interest rate influences consumption. Therefore
economists have studied the empirics of
interest rate affecting the consumption and
saving.
 Savings and the Real
Interest Rate
Saving rate
• Data shows that 10
there’s no apparent
relationship between 8
the two variables. Or,
savings does not 6
depend on interest
rate.
4

• Economists claim
that income and 2
substitution effects of -6 -4 -2 0 -2
Real after-tax interest rate
higher interest rates
approximately cancel Data collected from 1959 to 1997 for US economy

each other.
 Constraints on Borrowings
The inability to borrow prevents current
consumption from exceeding current income. A
constraint on borrowing can therefore be
expressed as C1 ≤ Y1.
This inequality states that consumption in period
one must be less than or equal to income in
period one. This additional constraint on the
consumer is called a borrowing constraint, or
sometimes, a liquidity constraint.
 Constraints on Borrowings
The analysis of borrowing leads us to conclude
that there are two consumption functions. For
some consumers, the borrowing constraint is not
binding, and consumption in both periods
depends on the present value of lifetime income.
For other consumers, the borrowing constraint
binds. Hence, for those consumers who would
like to borrow but cannot, consumption depends
only on current income.
 Constraints on Borrowings
2nd period
• If the consumer consumption,
C2
cannot borrow,
Budget Constraint
he faces the
additional
constraint that
1st period Borrowing Constraint
consumption
cannot exceed
1st period
income.
Y1 1st period
consumption, C1
 Constraints on Borrowings
a: borrowing constraint b: borrowing constraint
is not binding is binding
2nd period 2nd period
consumption consumption
, C2 , C2

E
D

Y1 1st period Y1 1st period

consumption, C1 consumption, C1
High Japanese Savings Rate
• Japan has one of the world’s highest
savings rate.
• On one hand, many economists believe
that this is a key to the rapid growth Japan
experienced in the decades after World
War II, The Solow growth model also
shows that saving rate is a primary
determinant of a country’s steady state
level of income.
 Saving rate and the Steady
State
Investment
and k
depreciation s2 f(k)
An increase in s1 f(k)
the saving rate
raises
investment
causing the
capital stock to k
k *
1
k *
2
grow toward a
new steady state
 High Japanese Savings Rate
• On the other hand, some economists say
that high savings rate has contributed to
Japan’s slump during 1990s.High savings
means lower consumption which
according to IS-LM model translates into
low aggregate demand and reduced
income.
 The IS-L Model
r LM
r1
S  C r2 IS1
 IS shifts left IS2
Y1 Y
 Y at each P
Y2

value of P
P1

AD1
AD2
Y2 Y1 Y
 High Japanese Savings Rate
• Why Do Japanese consume so less or save so
much?
– It is harder for households to borrow in Japan
– In case of borrowing to purchase a house
(the most common cause of borrowing),
down payment rates are very high (up to
40%)
– Japanese Tax system encourages saving by
taxing capital income very lightly
– Japanese are more risk averse and patient.
 Summary
• Consumption
– Consumer Preferences
– Optimization
– Income Effect and Substitution Effect
• Role of Real Interest Rate
– Constraints on Borrowings
 Upcoming Topics
• Franco Modigliani and the life-cycle
Hypothesis
– Life-cycle consumption Function
– Solving the Consumption Puzzle
• Milton Friedman and the Permanent-Income
Hypothesis
• Robert Hall and the Random-Walk Hypothesis
• David Laibson and the Pull of Instant
Gratification