Consumption

InLecturenote#3,weassumedthatconsumptiondependedonlyon
currentdisposable income,butitistoosimpletoprovideacomplete
explanationofconsumerbehavior.Inthisnoteweexaminethe
consumptionfunctioningreaterdetailanddevelopamorethorough
explanationofwhatdeterminesaggregateconsumptionbyshowing
diverseapproachestoexplainingconsumption.

IrvingFisherandIntertemporalChoice
Keynessconsumptionfunctionrelatescurrentconsumptionto
currentincome.However,whenpeopledecidehowmuchtoconsume
andhowmuchtosave,theyconsiderboththepresent andthe
future.Themoreconsumptiontheyenjoytoday,thelesstheywillbe
abletoenjoytomorrow.Makingthistradeoff enableshouseholdsto
lookaheadtotheincometheyexpecttoreceiveinthefutureandto
theconsumptionofgoodsandservicestheyhopetobeableto
afford.

TheIntertemporalBudgetConstraint
TheeconomistIrvingFisherdevelopedthemodelwithwhich
economistsanalyzehowrational,forwardlookingconsumersmake
intertemporalchoices thatis,choicesinvolvingdifferent periodsof
time.
Q:Whydopeopleconsumeless thantheydesire?
A:Becausetheirconsumptionisconstrainedbytheirincome.
Toputanotherway,consumersfacealimitonhowmuchtheycan
spend,calledabudget constraint.

TheIntertemporalBudgetConstraint
Def.(3B.1):Intertemporalbudgetconstraint
Thelinethatmeasuresthetotalresourcesavailablefor
consumptiontodayandinthefuture
Theconstraintconsumersfacewhendecidinghowmuchto
consumetodayversushowmuchtosaveforthefuture
DevelopmentofFishersModel:
Assumptions:(i)Aconsumerlivesfortwoperiods;periodone
representstheconsumersyouth,andperiodtworepresentsthe
consumersoldage.
(ii)Allvariablesarereal thatis,adjustedforinflation.

TheIntertemporalBudgetConstraint
(iii)Theinterestrateforborrowingisthesame astheinterestratefor
saving.
:Aconsumersincomeinperiod1
:Aconsumersconsumptioninperiod1
:Aconsumersincomeinperiod2
:Aconsumersconsumptioninperiod2
Q:Howdoestheconsumersincomeinthetwoperiodsconstrain
consumptioninthetwoperiods?

TheIntertemporalBudgetConstraint
Inthefirstperiod,
3 .1 :
,where canrepresent
eithersavingorborrowing.
Aconsumerissaving,and ispositive.

Aconsumerisborrowing,and isless thanzero.

Inthesecondperiod,
3 .2 :
1
,where isthe
realinterestrate.
Meaning:Consumptioninthesecondperiodequalstheaccumulated
saving,includingtheinterestearnedonthatsaving,plussecond
periodincome.

TheIntertemporal BudgetConstraint
From
3 .2 ,
1
1
1
Bydividingbothsidesby 1

since
;

3 .3 :

Meaning:Thepresent value ofconsumption mustequalthepresent

value ofincome.Itistheconsumersintertemporal budgetconstraint.
Notethat futureconsumptionandfutureincomearediscounted by
afactor 1
.Thisdiscounting arisesfromtheinterest earnedon
savings.

Present(Discounted)Value
Recall theconceptofpresentvalue:Ifyouput$100todayinabank
accountearning5percentinterestayear,in10yearsyouwouldhave

$ 1 0.05
$100 $162.89.
$162.89;
Thus,thepresentvalue of$162.89received10yearsfromnowis
$100.Formally,

where $ is the dollar amount received in year and is

theinterestrate.

TheIntertemporal BudgetConstraint

isthepriceof2ndperiodconsumptionmeasuredintermsof

1stperiodconsumption:itistheamountof1stperiodconsumption
thattheconsumermustgiveuptoobtain1unitof2ndperiod
consumption.
From

3 . 3 ,

Figure 3B.1:ConsumersBudgetConstraint

TheIntertemporal BudgetConstraint
Point :Theconsumerconsumesexactlyhis/herincomeineach
and
,sothereisneither saving nor
period
borrowing betweenthetwoperiods.
Point :Theconsumerconsumesnothinginthe1st period
0
andsaves allincome,sothe2nd periodconsumption is
1
.
Point :Theconsumerplanstoconsumenothinginthe2nd period
0 andborrows asmuchaspossibleagainst2ndperiodincome,

so1stperiodconsumption

is

ConsumerPreference
Theindifference curve representstheconsumerspreference
regardingconsumptioninthetwoperiods;i.e.,itshowsthe
combinationsof1stperiodand2ndperiodconsumptionthatmake
theconsumerequally happy.
Def.(3B.2):Indifferencecurve
Thecurvethatshowsdifferentcombinationsof and
tothesame levelofoverallhappiness(utility orwelfare)

thatlead

Figure3B.2:ConsumersPreferences

ThreeCharacteristicsofIndifferenceCurves
(i)Thefarther anindifferencecurveisfromtheorigin,thehigher its
utility.
Theconsumerisindifferent amongcombinations , , and
Becausetheyareallonthesame curve .
Becauseweareassumingthatmore consumptionisalwaysbetter,it
mustbetruethateverypointon
musthaveahigher utilitythan
everypointon .
(ii)Indifferencecurvesslopedown.

ThreeCharacteristicsofIndifferenceCurves
Tokeepaconsumerjustashappy,alossofhappinessfromlower
2ndperiodconsumptionmustbeoffsetbyhigherconsumptionin
period1,andviceversa.Indifferencecurvesarethereforedownward
sloping,illustratingthetradeoff betweenconsumingtodayversus
consumingtomorrow.
(iii)Indifferencecurvesarebowedin towardtotheorigin.
Thebowedinshapeoftheindifferencecurves,referredtoas
convexity,resultsfromthetypicalconsumersdislikeoflarge
fluctuationsinconsumptionfromoneperiodtothenext.Ingeneral,
peopleprefersmooth consumptionovertime.

ThreeCharacteristicsofIndifferenceCurves
The3rd characteristiccanbedescribedthroughtheconceptofthe
marginalrateofsubstitution (MRS)alsocalledtheintertemporal
marginalrateofsubstitution.
Def.(3B.2):Marginalrateofsubstitution
Therateatwhichaconsumeriswillingtogiveup(substitute)
consumptioninperiod2foradditionalconsumptioninperiod1
Theslopeoftheindifferencecurve

ThreeCharacteristicsofIndifferenceCurves
Sinceconsumersprefertosmooth consumptionovertime(andthus
becomesincreasinglyaversetogivingupconsumptioninperiod2),
themarginalrateofsubstitutionbecomessmaller as2ndperiod
consumptionfalls,givingtheindifferencecurveaconvex shape:
InFigure 3B.2,
issmaller than
,sothattheslopeofthe
indifferencecurvebecomesless negative.

Optimization
Usingbothanintertemporal budgetlineandasetofindifference
curves,wecanidentifytheoptimallevelofconsumptionforboth
periods.

Figure 3B.3:ConsumerOptimization

Optimization
Theoptimumindifferencecurvegiventheconsumersbudget
constraintis ,whichistangent totheintertemporal budgetlineat
pointO.AtpointO,consumptioninperiod1is andconsumption
inperiod2is .
1
1
From
3 . 3 ,
Theslopeoftheintertemporal budgetline:
AtpointO,theoptimumforaconsumeris:
TheslopeoftheIC =TheslopeoftheIBL

3 .4 :

Example (3B.1):Optimization
SupposeatypicalconsumernamedJenniferlivesfortwoconsumption
periods.Herrealincomeineachofperiods1and2, and ,equals
12.Designateconsumptionduringperiods1and2as and ,
respectively.Assumethatanysavingfromperiod1earnsinterestata
realinterestrateof50%,or0.50.SinceJenniferknowsshewilldieat
theendofperiod2,shedoesnotsaveinthesecondperiod.
a)WritedownJennifersintertemporal budgetconstraint,i.e.,the
budgetconstraintthatrelatesherlifetimeincomewithherlifetime
consumption.
(Ans.)

.
.

Example (3B.1):Optimization
Slope:

. ,indicatingthateachunitofconsumptionin

period1canbetransformedinto1.5unitsofconsumptioninperiod2
becauseanysavingearnsinterestattherateof50percent.
b)DrawJennifersintertemporal budgetconstraintandlocatethe
point onthegraphatwhichsheconsumesallofhercurrentincome
ineachofthetwoperiods,thepoint atwhichshesavesallofher
incomeinperiod1inordertomaximize ,andthepoint atwhich
shemaximizes byborrowingagainstallofherincomeinperiod2.
(Ans.)

Example (3B.1):Optimization
c)Furthermore,assumethattheamountofJenniferstotalsatisfaction
isgivenbythisutilityfunction:
.Findtheoptimal
consumptionof and ,locatethispointonthegraphinpart(b),
andlabelitpoint .Findherutilityattheoptimum.
(Ans.)
(i)Findthemarginalrateofsubstitution(MRS):

and

(ii)SetMRS equaltotheslopeofthebudgetline:

Example (3B.1):Optimization

1.5

.
.

By(1)and(2),

10

15 and
10
15 150.

HowChangesinIncomeorWealthAffectConsumption
Letsexaminehowconsumptionrespondstoanincreaseinincomeor
.Anincreaseineither or orwealthshifts
wealth
thebudgetconstraintoutward.

Figure 3B.4:ResponsetoaRiseinCurrentIncome,Future
Income,orWealth

HowChangesinIncomeorWealthAffectConsumption
TheindifferencecurvesinFigure 3B.4aredrawnunderthe
assumptionthatconsumptioninperiod1andconsumptioninperiod
2arebothnormal goods.Becausetheconsumercanborrowandlend
betweenperiods,thetimingoftheincomeorwealthisirrelevant to
howmuchisconsumedtoday(exceptthatfutureincomeorwealthis
3 . 3 ,consumption
discounted bytheinterestrate).From

dependsonthepresentvalueofcurrentandfuture

incomeorwealth,lifetimeresources,
initialwealth.

where

is

HowChangesinIncomeorWealthAffectConsumption
NoticethatthisisquitedifferentfromKeynes.Keynespositedthat
apersonscurrentconsumptiondependslargelyonthecurrent
income.Fishersmodelsaysthatconsumptionisbasedontheincome
theconsumerexpectsovertheentire lifetime.
Consumptionriseswhenthepresentvalueoflifetimeresources
increases,regardlessofitssource(currentincome,futureincome,or
wealth).
Consumerswillspreadoutanyincreaseinconsumptionovertoday
andtomorrow,eveniftheincreasestemssolelyfromanincreasein
current income.Thisbehaviorisknownasconsumption smoothing.

HowChangesinIncomeorWealthAffectConsumption
Consumptionsmoothingisalogicalconsequenceoftwoelementsof
theintertemporal choicemodel:theconvexity ofindifferencecurves
andtheabilityofconsumerstoborrow orsave.
Indeed,consumptionsmoothingisastrongfeatureofthedata
becauseconsumptionfluctuatesmuchless thanGDP.

HowChangesintheRealInterestRateAffectConsumption
LetsnowuseFishersmodeltoconsiderhowachangeinthereal
interestratealterstheconsumerschoices.
Therearetwocasestoconsider:
Case1:Theconsumerisinitiallysaving
Case2:Theconsumerisinitiallyborrowing
Case1:Seewhathappenswhentheinterestraterisefrom

to .

Figure3B.5:ResponsetoaRiseintheInterestRate

HowChangesintheRealInterestRateAffectConsumption
Atpoint ,thecurrentconsumptionisequaltoinitialwealthplus
.Inthisspecialcase,the
1stperiodincome;thatis,
consumerisneitherborrowing norsaving (lending),soconsumption
inthesecondperiodisequaltosecondperiodincome,
.
Whentheinterestraterisesto ,point isstillonthenew
because,withnoborrowing or
intertemporal budgetline
saving,thelevelofinterestratedoesnot matter,leaving
and
.

HowChangesintheRealInterestRateAffectConsumption
Whentheinterestraterisesto ,theslopeofthebudgetline
, sothe
becomessteeper.
becomesmorenegative 1
Becauseitstillgoesthroughpoint ,thismeansthatthenew
pivotsclockwise aroundpoint .
intertemporal budgetline
Sinceconsumersonaveragesavesomeoftheirincome,the
consumersinitialoptimalconsumptionoccursatpoint ,inwhich
.Whentheinterestraterisesto andthe

,thenewoptimallevelof
intertemporal budgetlinepivotsto
consumptionatpoint isonahigher indifferencecurve, .

HowChangesintheRealInterestRateAffectConsumption
Consumptioninperiod1hasfallen to
period2hasrisen to

,whileconsumptionin

Wecandecomposetheimpactofanincreaseintherealinterestrates
onconsumptionintotwoeffects:

Incomeeffect
Thechangeinconsumptionduetochangesinincome
Thechangeinconsumptionthatresultsfromthemovementto
ahigherindifferencecurve

HowChangesintheRealInterestRateAffectConsumption
Theconsumerhassavings,sohe/shelends money(probablyby
depositingthefundsinhis/herbankaccount)fromperiod1toperiod
2.Atahigher interestrate,theconsumerearnsmore interest,which
giveshim/hermore resourceswithwhichtoconsume.Thus,the
consumercanspendmore inbothperiods.Forsavers,theincome
effectincreases consumptioninboth periodswheninterestrates
rise.

Substitutioneffect
Thechangeinconsumptionthatoccursfromthechangeinthe
relative price ofconsumptioninthetwoperiods

HowChangesintheRealInterestRateAffectConsumption
Withahigher interestrate,thepresent(discounted)valueof
consumption

inthesecondperiodfalls,soconsumptioninthe

secondperiodbecomesless expensiverelativetoconsumptioninthe
firstperiod.Asaresult,theconsumerwilldecidetosubstituteaway
andreducefirstperiodconsumptiontoconsumemore inthesecond
period.Thesubstitutioneffectfromhigher interestratesleadsto
less consumptioninperiod1butmore consumptioninperiod2.

HowChangesintheRealInterestRateAffectConsumption
Wecanalsothinkofthesubstitutioneffectintermsofsaving.When
interestraterises,thereturntosavingishigher andsoaconsumer
willsavemore inthefirstperiodbyreducingconsumption,enabling
him/hertospendmore inthesecondperiod(consumptionrises).
Conclusion:Wheninterestratesincrease,bothincomeand
substitutioneffectsshiftsecondperiodconsumptionhigher.Butin
thefirstperiod,thesubstitutioneffecttampsdownconsumption
whiletheincomeeffectliftsconsumption.Hence,theultimate
directionofthechangeintodaysconsumptiondependsonthe
relative sizeofincomeandsubstitutioneffects.

HowChangesintheRealInterestRateAffectConsumption
Assumption:Inpractice,weusuallyassumethatthesubstitution
effectoutweighstheincomeeffect.
InFigure 3B.5,sincethesubstitution effectdominatestheincome
effect,arise ininterestrateslowers todaysconsumption(increases
saving),butboost futureconsumption.
Wemakethisassumptionbecauserealworlddatasupporttheview
thathigher interestratesareassociatedwithhigher savingandlower
consumptiontoday.However,theempiricalevidenceonthe
relationshipofinterestratestoconsumptionandsavingisnot
overwhelminglystrong.

BorrowingConstraints
Sofarwehaveassumedthatconsumerscanborrowandlendatthe
same interestrate.However,notallconsumersaregodcreditrisks.
Consumerswithlittleornowealthmayfindthattheycannot get
loans.
Iftheconsumerhasno wealthandcannot borrow,he/shecannot
spendmorethanhe/sheearns.Aconstraintonborrowingcan
,indicatingconsumptiontodaymust
thereforebewrittenas:
beless thanorequal toincometoday.Thisadditionalconstrainton
theconsumeriscalledaborrowing constraint (oraliquidity
constraint).

BorrowingConstraints
Toseetheimplicationforconsumptionchoices,letsfirstlookatthe
effectofaborrowingconstraintontheconsumersintertemporal
budgetline.
Intertemporalbudgetlinewithaborrowingconstraint
Supposethatwithoutaborrowingconstraint,theintertemporal
budgetlineisastraightlinewithaslopeof 1
.Witha
borrowingconstraint,theconsumercannot spendmore thanhis/her
currentincome.Thatis, cannot riseabove .Atpoint ,where

,theintertemporalbudgetlinebecomesvertical.

Figure 3B.6:ABorrowingConstraint

BorrowingConstraints
Q:Howwillaborrowingconstraintchangetheconsumers
consumptionchoices?
A:Weconsidertwocases.
Case1:Borrowingconstraintisnotbinding
Sincetheconsumersoptimallevelofconsumptionisless than ,
he/shehasno needtoborrow.Asaresult,he/shewillnot be
constrainedbyhis/herinabilitytoborrow,andwecansaythatthe
constraintisnot binding.

Figure 3B.7:OptimizationwithaBorrowingConstraint

BorrowingConstraints
Case2:Borrowingconstraintisbinding
Theconsumerwouldliketoborrowandchoosepoint .Butbecause
borrowingisnot allowed,thebestavailablechoiceispoint .When
theborrowingisbinding,firstperiodconsumptionequalsfirstperiod
and
.Theslopeoftheindifference
income,so
,sothat
.
curveatpoint issteeper than 1

Figure 3B.8:OptimizationwithaBorrowingConstraint

Example (3B.2):ContinuationofExample (3B.1)

Thecurvelabeled
representsJennifersinitialintertemporal
budgetconstraintorline.SupposethatJennifersincomeinperiod1
risesto12.78,while remainsequalto12.
a)WritedownJennifersnewintertemporal budgetlineorconstraint.
Graphthisnewintertemporal budgetconstraintandlabelit
(Ans.)
.

.
.

.
.

Example (3B.2):ContinuationofExample (3B.1)

b)Findthenewoptimalconsumptionof and ,locatethispointonthe
graphinpart(a),andlabelitpoint .Findherutilityatthenewoptimum.
(Ans.)
SetMRS equaltotheslopeofthebudgetline:

.
.
By(1)and(2),
15.59 and
10.39 and

10.39 15.59 162.

Consumptionduringeachperiodhasincreased.Thechangesin
consumptionbetweenpoint andpoint aretheresultofthe income
effect.

Example (3B.2):ContinuationofExample (3B.1)

c)Finally,supposethatJennifersincomeineachperiodreturnstoits
formerlevelof12andthattherealinterestraterisesto100percent,or
1.0.WritedownJennifersnewintertemporal budgetlineorconstraint.
Graphthisnewintertemporal budgetconstraintandlabelit
.
(Ans.)

d)Findtheoptimalconsumptionof and ,locatethispointonthe

graphinpart(a),andlabelitpoint .Findherutilityattheoptimum.
(Ans.)
SetMRS equaltotheslopeofthebudgetline:

Example (3B.2):ContinuationofExample (3B.1)

18 and
9 and

9 18 162.
By(1)and(2),
Thechangeinconsumptionfrompoint topoint reflectsthe
substitutioneffect.Jenniferrespondstothischangeintherelative
priceofconsumptioninthetwoperiodsbydecreasing and
increasing .Sincethesubstitutioneffectoutweighstheincome
effect inthiscase, obviouslyfallswhile increases.