A Two-Period Model: The

Consumption-saving Decision
(Part II Permanent Income Hypothesis and
Responses to Real Interest Rate Changes)
Motivation: Macroeconomic models and their use

• Economic models help economists to

– Understand how the economy works
– Make predictions about future economic behaviour
– Design policies to improve the welfare

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Motivation: What determines consumption?

• In
  the Keynesian IS-LM model, the key determinant of
consumption is current disposable income:
– ), where MPC = the marginal propensity to consume
– Difficult to explain why consumption is less volatile than
income in the data
• According to our two-period consumption-saving model,
consumption is mainly determined by
– the life-time wealth
– the real interest rate r

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Learning objectives for today’s class

• Explain consumption smoothing and permanent income

hypothesis
• Identify how changes in temporary and permanent
income affect the consumer’s choice
• Discuss empirical evidence related to consumption
smoothing and the permanent income hypothesis
• Analyze how a borrower and a lender respond to
changes in the real interest rate.

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Outline for today’s class

• Review of the consumer optimization

• Effects of income changes on the consumer’s
consumption and saving
– An increase in current-period income
– An increase in future income
– Temporary and permanent changes in income
• Effects of interest rate changes on the
consumer’s consumption and saving

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References

• Required textbook readings:

– Chapter 9
– Math. Appendix to Ch. 9

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 MRSc,c’ = 1 + r
REVIEW: Consumer Optimization
c’ = - (1+r) c + (1+r) we

A Consumer is a Lender A Consumer is a Borrower

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Review: Consumer Optimization

• The
  consumer’s optimal consumption bundle (c*, c’*)
satisfies
MRSc,c’ = 1 + r
c’* = - (1+r) c* + (1+r) we
where

• The optimal saving is

s* = y – t – c*

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How can we use the model to make predictions?

• Comparative statics tell us how exogenous variables

will change in response to changes in exogenous
variables.
• In the context of our model, we can analyze the
responses of c, c’ and s to
– changes in current disposable income, y-t
– changes in future disposable income, y’-t’
– permanent changes in income, y-t and y’-t’
– changes in the real interest rate r

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Application: If I had a million dollars …

• What would you do with a $1 million windfall, from

whether a jackpot or a large inheritance?

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What do lottery winners do with their money?

Source: https://www.thelotter.com/lottery-winners-money/
Based on a 2012 study of 3,000 millionaires conducted by Camelot, operators of
the National Lottery in the UK
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 What do lottery winners do with their money?

How the winnings Amount Percent

got spent (bill. of £) of total Composition of lottery
winnings between
Management property 2.7 32% consumption and saving
Co
nsu
Investments for mpt
ion
income 2.1 25% [PE
RC
EN
TA
Investments for future GE
]
of children 1.6 19%
Sa
Gifts to family and vin
g
friends 1.2 14% [PE
RC
EN
Holidays, card, etc. 0.7 8% TA
GE
]
Paying debts 0.17 2%
Total 8.47 100

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Worksheet: Effects of an increase in current
income for a lender
. y increases from y1 to y2.

Questions
• Determine the effects on c, c’, s;
• Illustrate the effects graphically;
• Explain the economic reasons
behind the consumer’s response;
• Relate your response to the
assumptions about the consumer’s
preferences.

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Worksheet: Effects of an increase in current
income for a lender
. y increases from y1 to y2.
What is the impact on the
optimal choice?
MRSc,c’ = 1 + r
c’ = - (1+r) c + (1+r) we

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Summary: Effects of an increase in current
income for a lender
• Current and future
consumption increase, since
the life-time wealth is higher
and both goods are normal.
• Saving increases.
• Consumption is smoothed
forward, by means of higher
saving.

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Worksheet: Effects of an increase in current
income for a borrower
y increases from y1 to y2.
What is the impact on the
optimal choice?

Show that the predictions of the

model on response lenders and
borrowers are identical.

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Application: You got your dream job. Now what?

• Imagine an employment contract 4 months before

graduating from the University of Ottawa

• Would you change your spending habits?

– Buy new cloths?
– Rent a new apartment?

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Worksheet: Effects of an increase in future
income for a borrower
y’ increases from y1’ to y2’.

Questions
• Determine the effects on c, c’, s;
• Illustrate the effects graphically;
• Explain the economic reasons
behind the consumer’s response;
• Relate your response to the
assumptions about the consumer’s
preferences.

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Worksheet: Effects of an increase in current
income for a borrower
y’ increases from y1’ to y2’.
What is the impact on the
optimal choice?
MRSc,c’ = 1 + r
c’ = - (1+r) c + (1+r) we

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Summary: Effects of an increase in future income

• Current and future

consumption increase,
since the life-time wealth
is higher and both goods
are normal.
• Saving declines.
• Consumption is smoothed
backward, by means of
decreasing saving
(increasing borrowing)

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Temporary versus permanent tax changes

• Economists find that temporary cuts to income taxes

are substantially less effective in creating economic
stimulus that permanent tax cuts.
• For a discussion of corporate income taxes see Alan Cole, “Why Temporary
Corporate Income Tax Cuts Won’t Generate Much Growth,” Tax Foundation,
June 12, 2017, https://taxfoundation.org/temporary-tax-cuts-corporate/.
• In the IS-LM model a distinction between transitory and
permanent income tax changes cannot be made.
• In our two-period model: temporary tax cut = t,
a permanent tax cut = t and t’
• Is our model consistent with the tax effects findings?

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Worksheet: Temporary tax cut

An decrease in t

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Worksheet: Permanent tax cut
An decrease in t and t’

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Summary: Temporary versus permanent tax cuts
An decrease in t An decrease in t and t’

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Summary: Temporary versus permanent tax cuts

• According our model, the primary determinant of

current consumption is the life-time wealth
• Temporary changes in income yield small changes in
permanent income and therefore affect current
consumption very little. The consumer will tend to save
most of a purely temporary income increase.
• By contrast, permanent changes in income have large
effects on permanent income and hence on current
consumption

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The Permanent Income Hypothesis (PIH)
• The
  Permanent Income Hypothesis is
a theory developed by Milton
Friedman that implies that the key
determinant of consumer’s current
consumption is his or her permanent
income.
• In our model, permanent income is
the lifetime wealth
ECO 3152
Milton Friedman
received the 1976 
Nobel Memorial Prize in E
conomic Sciences
 for his research on 
consumption analysis, 
monetary history and
theory and the complexity
of stabilization policy
1-26
Three implications of the PIH

• An increase in current and/or future disposable

income increases consumption in both periods
• A permanent increase in income (an increase in both
current and future income) has a larger impact on
current consumption than a temporary increase in
income (only current income increase)
• Consumption should fluctuate more smoothly than
income, since many income fluctuations are
transitory

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Aggregate consumption is smoother than
aggregate income
• Our model predicts that consumption should fluctuate more smoothly
than income, since many income fluctuations are transitory.
• This theoretical prediction has some support in the Canadian data.

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Comparative statics:
Effects of real interest rate changes
• The real interest rate determine the cost of
borrowing and the return on savings.
• How should borrowers and lenders react when the
real interest rate increases?

• We will examine the effects of higher real interest

rate of consumption and savings.
• Exercise: Work out the opposite examples of a
decline in the real interest rate.

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Graphical approach to analyzing the effects of real
interest rate changes
• Consider an increase of r from r1 to r2 (r2>r1).
• Start at the point of the optimality.
• Determine the impact on the budget constraint.
′ ′
  𝑦 − 𝑡
c’ = - (1+r) c + (1+r) we, where 𝑤𝑒 = 𝑦 −𝑡 +
1+𝑟

• Determine the impact on the tangency conditions

between the indifference curve and the budget
constraint MRSc,c’ = 1 + r

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Worksheet: Effects of higher r on the budget
constraint
• c’ = - (1+r) c + (1+r) we
′ ′
  𝑦 − 𝑡
𝑤𝑒 = 𝑦 −𝑡 +
1+𝑟
• What happens to E?
• What happens to the slope of the
budget constraint?
• What happens to the intercepts?

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The substitution effect of higher interest rate

• Recall that (1+r) is the relative price of c in terms of c’.

• When r↑, c becomes more expensive relative to c’.
• Thus, the consumer wants shift from more expensive
good (c) to less expensive good (c’).
• Thus, through the substitution effect, the consumer
wants to ↓ c and ↑c’.
• The substitution effect is identical for borrowers and
lenders.

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The income effect of higher interest rate
• Recall the two period budget constraints:
c+s=y–t
c’ = y’ – t’ +(1+r)s
• Borrower (s<0): pays higher interest on the loan
– The income effect is negative.
– ↓ c and ↓ c’ since both goods are normal.
• Lender (s>0): gets higher interest income.
– The income effect is positive.
– ↑ c and ↑ c’ since both goods are normal.

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SUMMARY: Effects of higher interest rate

BORROWER LENDER
Substitution effect ↓ c and ↑c’ ↓ c and ↑c’
Income effect ↓ c and ↓ c’ ↑ c and ↑ c’

BORROWER LENDER
SE>IE
SE=IE
SE<IE

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Worksheet: Lender, SE = IE
• Determine the effects on
– Current consumption c
– Future consumption
– Savings, s = y-t-c.

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Worksheet: Lender, SE = IE
• A = original point,
• B = new point
• FG = an imaginary line that
takes away the extra income.
• Movement from A to D is the
pure substitution effect.
• Movement from D to B is the
income effect.
• Current consumption and
savings are unchanged
• Future consumption increases.

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Worksheet: Borrower, SE > IE
• Determine the effects on
– Current consumption c
– Future consumption
– Savings, s = y-t-c.

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Worksheet: Borrower, SE > IE
• A = original point,
• B = new point
• FG = an imaginary line that
gives income to bring on the
original indifference curve.
• Movement from A to D is the
pure substitution effect.
• Movement from D to B is the
income effect.

• What happens to the

consumer’s savings?

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Additional scenarios to consider

• There are four additional cases to consider.

• Lender:
– SE>IE
– SE<IE
• Borrower:
– SE=IE
– SE<IE

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SUMMARY: Effects of an increase in the real
interest rate

A lender A borrower

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Example with the logarithmic utility

•  The consumer’s utility is U(c, c’)=ln(c) + β ln(c’)

• The optimal consumption (derived previously)
• c*= we / (1+β) and c’* = β (1+ r) we / (1+β)
• How does the optimal consumption respond to the
increase in the real interest rate?
• <0 For these preferences
• >0 SE > IE

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Example with the perfect complements

• The consumer’s utility is U(c, c’)= min{a1 c, a2 c’}

• Consumption goods are always consumed in fixed
proportions: c’ = a c, where a = a1/ a2
• For these preferences, there is
no substitution.
• The consumer’s choice depends
only on the income effect.

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Comparative statics results: effects of real
interest rate changes

• How do endogenous variables (c, c’ and s) change in

responses to changes in the real interest rate r?
• The model predicts that
– an increase in r decreases the relative price of future
consumption goods c’ in terms of current consumption
goods c (given y, y’, t, and t’)
– an increase in r produces an income effect and a
substitution effect.
– changes in the real interest rate affect the decisions of
lenders and borrowers in different ways

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For the next class

• Chapter 9
– Fiscal policy in an endowment economy: Ricardian
equivalence.
• Quiz 2: Consumption-savings choice (due Sept. 28)

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