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Ps2 Income Subsitution Wealth Effects

The document discusses the optimal consumption level in dynamic macroeconomics, focusing on the effects of interest rate changes on first period consumption. It outlines the Wealth Effect, Substitution Effect, and Income Effect, explaining how these factors influence consumption decisions. The relationship between the elasticity of utility and the interest rate is also examined, highlighting different scenarios based on the value of σ.

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11 views1 page

Ps2 Income Subsitution Wealth Effects

The document discusses the optimal consumption level in dynamic macroeconomics, focusing on the effects of interest rate changes on first period consumption. It outlines the Wealth Effect, Substitution Effect, and Income Effect, explaining how these factors influence consumption decisions. The relationship between the elasticity of utility and the interest rate is also examined, highlighting different scenarios based on the value of σ.

Uploaded by

manckadal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Dynamic Macroeconomics

Problem Set 2
c1−σ −1
The optimal consumption level for the first period (with the utility function 1−σ ) is given by
 
1 y2
c1 = 1/σ 1/σ−1
a0 + y1 + .
1 + (β) [(1 + r)] 1+r

When the interest rate increases, three things happen to first period consumption. The Wealth Effect,
which shows the effect of interest rates on overall life-time wealth, and the Income Effect and Subsi-
tuition Effect, which influences how the share of wealth devoted to first period consumption reacts to
changes in the interest rate.
h i
y2
Wealth Effect When the interest increase, then life-time wealth a0 + y1 + 1+r decreases. This tends to lower
first consumption.
Substitution Effect When the interest rate increases, saving becomes more attractive and people reduce first period
consumption. Expressed alternatively, a rise in the interest rate increases the relative price of
current consumption (relative to future consumption), hence people should substitute away from
current consumption and to future consumption.
Income Effect When the interest rate increases, one can consume more in the second period for any given level of
savings. For a given second period consumption level, consumers could thus reduce savings (since
the higher interest rate balances the reduction in savings). This would induce a increase in current
consumption.
1/σ−1
The income and subsitution effect are, in our setup, combined in the expression [(1 + r)] . If 1/σ >
1 ↔ σ < 1 this expression increase, if r increases. In this case the substitution effect dominates. If
1/σ = 1 ↔ σ = 1 (the case of logarithmic utility) income and substitution effects offset each other (and
the share of income devoted to first period consumption becomes independent of the interest rate). If
1/σ < 1 ↔ σ > 1 , the income effect dominates and the share of consumption devoted to first period
consumption increases if the interest rate increases.

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