Lecture 2

The Consumption Function II

Changes in the Real Rate of Interest and Consumption

Introduction
The effect of a change in the real interest rate on consumption of an individual
depends upon whether the consumer is a saver or a borrower.

When analysing the effect of a change in the interest rate on consumption we must
take into account two effects, i.e. the price effect and the income effect.

The Price Effect A change in the real interest rate will bring about a change in the
relative price of consumption in period 1 in terms of consumption in period 2. Thus an
increase in the real interest rate, r, will cause (1 + r) to increase. Let us assume that the
real rate of interest is 10%. By consuming GH¢1 in period 1 our consumer is giving
up GH¢1.10 of consumption in period 2. If the real rate of interest rises to 15% this
means that by consuming GH¢1 in period 1 our consumer is giving up GH¢1.15 of
consumption in period 2. Thus an increase in the real interest will cause the relative
price of consumption in period 1 in terms of consumption in period 2 to increase.
When the real rate of interest rises consumption in period 1 will decline because the
relative price of consumption in period 1 has increased.

The relative price of consumption in period 2 in terms of period 1, i.e., 1/(1 + r) will
decline when there is an increase in the real interest rate. Our consumer will have to
give up less in period 1 in order to consume GH¢1 in period 2. When the real interest
is 10% rate our consumer will have to give up GH¢0.909 in period 1 to be able to
consume an additional GH¢1 in period 2. If, however the real rate of interest rises to
15% our consumer will have to give up less, i.e. GH¢0.869 in order to consume GH¢1
in period 2. When the real rate of interest rises consumption in period 2 will
increase because the relative price of consumption in period 2 has fallen.

A fall in the real interest rate will cause (1 + r) to decrease. Again let us assume that
the real interest rate is 10%. We have already established that the price of
consumption in period 1 in terms of consumption in period 2 is GH¢1.10. Now let us
assume that the real rate of interest declines to 5%. Consumption of GH¢1 in period 1
will mean giving up less consumption in period 2 (i.e. GH¢1.05) compared to when
the rate of interest was 10%. The relative price of consumption in period 1 in terms of
consumption in period 2 has fallen. When the real rate of interest falls consumption
in period 1 will increase because the relative price of consumption in period 1 has
fallen.

A fall in the real interest rate will cause the relative price of consumption in period 2
in terms of consumption in period 1, i.e., (1/(1 + r) to rise. To consume GH¢1 in
period 2, the consumer in period 1 will have to give up GH¢0.909 when the real rate
of interest is 10%. When the real rate of interest declines to, for example, 5%, the
consumer will have to give up GH¢0.952 in period 1 in order to consume GH¢1 in
period 2. The relative price of consumption in period 2 has become more expensive.
When the real rate of interest falls consumption in period 2 will decline because the
relative price of consumption in period 2 has risen.

The Income Effect The income effect may be positive or negative depending on
whether the consumer is a saver or a borrower. Since consumption in period 1 and
consumption in period 2 are normal goods if the present value of lifetime income
should increase due to a change in the rate of interest consumption in both periods will
rise. If the income effect of the interest rate change is negative consumption in both
periods will decline.

The Effect of an Increase in the Real Interest when the consumer is a saver.
The Price Effect Consumption in period 1 will decline and consumption in period 2
will increase. This is because when there is an increase in the real interest the relative
price of consumption in period 1 increases and the relative price of consumption in
period 2 declines.
The Income Effect If the consumer is a saver s/he will benefit from the increase in the
interest rate. For each GH¢1 that was saved in period 1 when the real interest rate was
10%, the consumer expected to receive GH¢1.10 in period 2. When the interest rate
rises to 15% the consumer will receive more in period 2 for each cedi that was saved
in period 1. Income in period 2, i.e. Y1 + Y2(1 + r) will rise. Consumption in both
period 1 and period 2 will increase.

The Effect on Consumption The effect of an increase in the interest rate on

consumption in period 1 and consumption in period 2 is the sum of the price and
income effects.

Consumption in period 1: The price effect will work to reduce consumption in period
1. The income effect will have a positive effect. The net effect of an increase in the
real interest rate in period 1 will depend on which effect dominates.

Consumption in period 2: Both price and income effects have a positive impact on
consumption. Consumption in period 2 will increase.

The Effect of an Increase in the Real Interest when the consumer is a lender.
The Price Effect The Price effect will be the same as in the case of the saver. The
increase in the interest rate will have a negative impact on consumption in period 1
and a positive impact of consumption in period 2.

The Income Effect A consumer who has borrowed in period 1 against income in period
2 will suffer a decline in lifetime income when the rate of interest increases. When the
interest rate was 10% the lender would have had to repay GH¢1.10 in period 2 for
each GH¢1 borrowed in period 1. When the rate of interest increases to 15% the
 borrower will have to pay back more on each cedi that was borrowed. The income
effect is therefore negative. Consumption in both period 1 and period 2 will decline.

The Effect on Consumption The effect of a decline in the interest rate on consumption
in period 1 and consumption in period 2 is the sum of the price and the income effects.

Consumption in period 1: The price effect will work to reduce consumption in period
1. The income effect will have a negative effect. The net effect is for consumption in
period 1 to fall.

Consumption in period 2: The price effect will cause consumption in period 1 to

increase. The income effect will cause consumption in period 2 to decline. Whether
consumption in period 2 will increase or decrease will depend on which effect is the
stronger.

The effect of a change in the interest rate on aggregate consumption is difficult to

determine a priori. It depends on:
· The proportion of consumers that are borrowers/lenders.
· Which effect, i.e. the income or price effect, dominates

Introducing a Borrowing Constraint

The model of inter-temporal consumption choice assumes that there is a perfectly
functioning credit market. Consumers are able to borrow against expected income in
the next period to achieve their preferred consumption given the lifetime budget
constraint. However, in the real world consumers may be faced with a borrowing
constraint. They may not be able to borrow against expected income.

If there are borrowing constraints then a consumer who would wish to maximise
welfare by consuming more than period 1’s income will not be able to do so. When
the borrowing constraint is binding the consumer will consume the entire of his or her
income in period 1. When there is a binding borrowing constraint, consumption at
time t is a function of income at time t.

Ricardian Equivalence
We know that consumption is a function of real disposable income. This relationship
has been assumed throughout the discussions in lectures 1 and 2. We are now going to
explicitly introduce government into the discussion on consumption and ask what
happens when there is a change in the tax rate.

Let us assume that Government lives for two periods. At the end of the second period
there is no outstanding budget deficit or surplus. Government spends in both periods,
i.e. G1 and G2 and government can finance its spending by raising taxes, T1 and T2 and
by borrowing and incurring debt, B.
Let us assume that in period 1 Government runs a budget deficit that is financed by
borrowing:

G 1 – T1 = B [1]

In period 2 government must raise enough tax revenue to finance spending in that
period and pay off its debt from period 1.

T2 = G2 + (1 + r) B [2]

Substituting for B in equation 1

T2 = G2 + (1 + r)( G1 – T1) [3]

When we collect the Government revenue terms on the left hand side we obtain

T2 + (1+r) T1 = G2 + (1+r) G1 [4]

Dividing equation 4 through by (1 + r) gives us the lifetime budget constraint of

Government

T1 + T2/(1 + r)= G1 + G2/(1 + r) [5]

The present value of government spending must equal the present value of tax
revenue.

If we assume that each individual pays tax, t, and there are N individuals then:

T = tN [6]

We can then re-write the lifetime budget constraint of Government as:

G1 + G2/(1 + r) = t1N + t2N/(1 + r) [7]

The lifetime government budget constraint per capita is given by:

1/N[G1 + G2/(1 + r)] = t1 + t2/(1 + r) [8]

Thus the individual’s lifetime budget constraint is given by:

C1 + C2/(1+r) = Y1 + Y2 –t1 – t2/(1+r) [9]

Let us assume that Government spending remains unchanged in period 1 and in period
2. However, Government decides to reduce taxes in period 1 by ∆t and increase it in
period 2 by ∆t/(1+r). Thus -∆t = ∆t/(1+r).
 The effect of the change in the pattern of taxation is to leave the present value of the
lifetime income of the consumer unchanged. Since consumption is a function of
lifetime income there will be no change in consumption in period 1 or in period 2
because of the decline in taxes in period 1 and the increase in period 2.

The effect of the reduction in the tax rate in period 1 is for disposable income in
period 1 to increase. The result of the decrease in taxes in period 1 is therefore to bring
about an increase in saving. This is because disposable income in period 1 rises but
there is no change in consumption. The increase in private saving is matched by the
increase in the budget deficit in period 1. There will be no change in the rate of
interest.

When there is a change in current taxes that is matched by an equivalent change in the
present value of future taxes and there is no change in consumption and the rate of
interest rate the Ricardian equivalence is said to hold.

Assumptions behind the Ricardian Equivalence

1. Taxes change by the same amount in the current period and the future for each
person. If the tax change is not the same for each person the lifetime income of some
may change and this will bring about a change in consumption. The Ricardian
Equivalence will not hold.
2. Consumers are forward looking. If consumers are not forward looking then an
increase in real disposable income in the current period due to the tax cut will induce
an increase in consumption. If however, consumers are forward looking and anticipate
an increase in taxes in the future to repay the government debt they will not increase
consumption in the current period when the tax is cut. This is because since they
expect taxes to be increased in the future and have a preference for smoothing
consumption over time they will build up savings so that they can maintain
consumption in the next period when taxes are raised and there is a decline in real
disposable income.
3. The debt issued by Government in the current period to finance the budget deficit will
be repaid in the lifetime of the consumer. If Government does not raise taxes in the
lifetime of consumers to repay the debt lifetime income will increase as a result of the
tax cut. Consumption will increase as disposable income rises and the Ricardian
equivalence will not hold.
4. There is no borrowing constraint. When there is a borrowing constraint consumers
are not able to maximise welfare. They are not able to consume their preferred bundle
of consumption in period 1 and consumption in period 2. Consumption in period 1 is
constrained to income earned in period 1. When there is a tax cut the increase in
disposable income will make it possible for the consumer to move towards its
preferred consumption bundle and will thus increase consumption in period 1. The tax
cut – depending on the resulting change in disposable income - relaxes the borrowing
constraint. Thus when there is a borrowing constraint the Ricardian equivalence
breaks down.
5. The consumer does not care about future generations. If the consumer does not care
about future generations then consumption will increase when there is a tax cut and it
is not anticipated that taxes will be raised during the lifetime of the consumer. If on
the other hand the consumer cares about future generations then even if the debt is not
repaid in his or her lifetime the consumer will not increase consumption when there is
a decline in taxes. This is because the consumer would want to leave a bequest to
future generations to help them pay for the debt that was incurred during the lifetime
of a previous generation.