Intermediate macro-economics

Consumption
A key point is that decisions regarding current consumption are influenced by expectations about the future.

Inter temporal opportunities

Inter temporal: decision involving more than one period of time such barrowing and lending

Some simplifying assumptions

There are essentially only three things you can do with your income You can consume it You can save You can pay taxes with it In the real world, there are many ways to save a portion of your income. You can lend it to a friend or to a financial institution. Putting money in a saving account is a form of lending; you lend to the bank, and you are repaid (with interest) and another way to save is to purchase a productive asset such a apple tree or land

Income streams
Income changes over time. When people are young, their income tends to rise as they gain job experience. When people are older, they retire and their income is likely to fall. Income also gets up and down unexpectedly. Endowment point or income stream point: a point representing a persons income for each period Exogenous variable: a variable determined outside the model; its value is taken as a constant in the model Endogenous variable: a variable determined within the mode; its value changes when other variables in the model change

If a persons income is rising over time, his or her endowment point is above the 45 degree line. If income remains constant over time, the endowment point is on the 45 degree line. If income is declining over time, the endowment point is below the 45 degree line

lecturer: Ahmed Moussa

Intermediate macro-economics

The intertemporal budget line

Credit market: the market for borrowing1 and lending2, or for exchanging present consumption and future consumption.

Depicting borrowing and lending

Suppose Sandys income stream consists of 10 apples this year and 10 next year. Figure 4.2 depict Sandys endowment point labeled Y Consumption stream: the series of quantities of consumption in each period of time Consumption stream point: a point representing a persons consumption for each period Inter temporal budget line: a line that contains all the possible consumption stream points available to a consumer.

The Relation between borrowing and consumption

An increase in current consumption, an increase in (net) borrowing, and a decrease in future consumption Similarly A decrease in current consumption, an increase in (net) lending, and an increase in future consumption

The slope of the intertemporal budget line

If r is the interest rate, then the slope of the intertemporal budget line is (1+r) In our example r= 10 percent; then the intertemporal budget line must have slope (1+0.10) = 1.1

Drawing the intertemporal budget line

To draw a line, it suffices to have two pieces of information; the slope of the line and the coordinates of one point on that line

Intertemporal choice
When people faced with making decisions today that take into account the future consequences of those decisions, we say they are faced with a problem of intertemporal choice.

1 2

Borrowing: Trading future goods for current goods Lending: Trading current goods for future goods

lecturer: Ahmed Moussa

Intermediate macro-economics

Optimum: an individuals favorite among available options. For an individual deciding how much to consume each period, his favorite among the points on the intertemporal budget line

The gains form trade in bonds

Bonds are promissory notes issued by corporations when they borrow money. The opportunity to participate in a credit market to borrow or lend at some interest rate, expands the opportunity sets of the individuals in the economy to include many more possibilities

Effects of changes in the interest rate The intertemporal budget line provides the consumer with a menu of opportunities. Which point on the menu does the consumer select? So far, our answer has been that the consumer selects his favorite, or optimum, point. But things get more interesting when there is a change in the economic environment. A change in the interest rate or in the consumers endowment point causes the budget line to shift.

Economic shocks
A change in an exogenous economic variable is called a shock; an economic shock need not be either unexpected or undesirable.

Rise in the interest rate

If the interest rate increases the consumption in the present will decrease Substitution effect: an individual response to changes in the terms of trade. When interest rate goes up, the substitution effect leads to consume less today and more in the future Income effect: an individuals response to changes in wealth. When the interest rate goes up, the income effect leads to consume less both today and in the future. An increase in the interest rate causes the budget line to become steeper by pivoting clockwise about the endowment point A drop in the interest Rate When the interest rate fall, the present consumption increases while the future consumption decrease. The substitution effect and income effect leads to increase current consumption and reduce future consumption Representative agent: a fictional character who is average in every way. The behavior of this individual may be used as a tool for characterizing aggregate behavior
lecturer: Ahmed Moussa 3

Intermediate macro-economics

A rise in the interest rate

When the interest rate rises, what happens to the representative agents consumption? Substitution effect leads to consume less in the present and more in the future and no income effect.

A fall in the interest rate

When the interest rate fall, the representative agent always wants to consume more now and less in the future

Consumption demand curve

A consumption demand curve is a means for keeping track of how an individual changes her or his consumption in response to changes in the interest rate. The demand curve for current consumption slopes downward to the right for a net borrower. It may slope downward or upward for a net lender. It slopes downward for the representative agent

Aggregate demand
Aggregate demand curve: a curve showing how much all the members of society wants to consume in the present as a function of the interest rate Aggregate demand curves for current and future consumption slope downward to the right The open economy In a closed economy, the representative agent neither borrows nor lends and therefore feels no income effects But open economy, some borrowing comes from foreigners and some lending goes to foreigners, so aggregate net lending (and the representative agents net lending) need not be zero

Effects of changes in the endowment point

Any change in consumption behavior must be trace able to either a change in preference or a change in the menu of opportunities. The slope, which is determined by the interest rate, and the endowment point, which is determined by the individuals current and future incomes are determined the budget line

lecturer: Ahmed Moussa

Intermediate macro-economics

Shocks to current income

A change in the endowment point must be caused by a change in current income, a change in future income, or a change in both. Recall that such changes are called shocks.

A rise in current income

An increase in current income shifts the endowment point to the right. The budget line shifts rightward parallel to itself until it passes through the new endowment point Consumption smoothing: responding to a change in one periods income by adjusting consumption in all periods, thus avoiding big changes in consumption across periods A drop in current income A decrease in current income shifts the endowment point to the left. The budget line shifts leftward parallel to itself until it passes through the new endowment point. More on consumption An increase in current income causes an increase in current consumption, but consumption increase by less than income does. A decrease in current income causes a decrease in current consumption, but consumption decreases by less than income does

Shocks and demand curve

An increase in current income causes the consumption demand curve to shift rightward. The amount of the shift is less than the increase in income A change in the interest rate is reflected by a movement along the consumption demand curve (to a new point on the same curve). A change in the endowment point is reflected by a shift of the entire consumption demand curve to a new location.

The marginal propensity to consume out of current income

When current income increases by a dollar, current consumption increases only by some fraction of a dollar because of consumption smoothing. The name of that fraction is the Marginal propensity to consume out of current income(MPC). Marginal propensity to save out of current income (MPS): the fraction of a dollar increase in current income that an individual chooses to save for future consumption

Shocks to future income

Marginal propensity to consume out of future income: the fraction of a dollar increase in future income that an individual chooses to spend in the current period.

lecturer: Ahmed Moussa

Intermediate macro-economics

Permanent income shocks

A permanent increase in income causes the demand curves for current and future consumption to shift rightward. They shift by the full amount of the increase in income A permanent decrease in income causes the demand curves for current and future consumption to shift leftward. They shift by the full amount of the decrease in income Marginal propensity to consume out of permanent income: The fraction of a dollar increase in permanent income that an individual chooses to spend in the current period.

The role of wealth

Wealth: the present value of an individuals income stream
$10 $10 $19 1.10

For a given interest rate, any two individuals with the same wealth face the same budget line, even if their income streams are not identical.

lecturer: Ahmed Moussa