A Two-Period Model: The Consumption - Savings Decision and Credit Markets

Chapter 9
A Two-Period
Model: The
Consumption
-Savings
Decision and Macroeconomics
6th Edition
Credit
Stephen D. Williamson
Markets
Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.
Learning Objectives, Part I
9.1 Construct a consumer’s lifetime budget

constraint and preferences in the two-period
model, and solve his or her optimization problem.
9.2 Show how the consumer responds to changes

in his or her current income, future income, and
the market real interest rate.
9.3 Construct the government’s present-value

budget constraint.
Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved. 9-2
Learning Objectives, Part II
9.4 Show how a competitive equilibrium is

constructed in the two-period model.
9.5 Explain the Ricardian Equivalence Theorem.
9.6 Discuss how the Ricardian Equivalence

Theorem helps us understand the burden of the
government debt.
Budget Constraints
The consumer’s current-period budget constraint:
c s  y t
Budget Constraints
The consumer’s future-period budget constraint:
c'  y 't ' (1  r ) s
Simplify
Solve the future-period budget constraint for s:
c' y 't '

s
1 r
Next,
• Substitute in the current-period budget

constraint obtaining lifetime budget constraint:
c' y 't '

c  y t
1 r
Consumer’s Lifetime Budget Constraint
• Substitute in the current-period budget

constraint obtaining lifetime budget constraint:
c' y 't '

c  y t 
1 r 1 r
Consumer’s Lifetime Wealth
y 't '
we  y  t 
1 r
Simplified Lifetime Budget Constraint
c'
c  we
1 r
Simplified Lifetime Budget Constraint:
Slope-Intercept
c'  (1  r )c  we(1  r )
Figure 9.1
Consumer’s Lifetime Budget Constraint
Figure 9.2
A Consumer’s Indifference Curves
Optimization
• Marginal condition that holds when the

consumer is optimizing:
MRS c ,c '  1  r
Figure 9.3
A Consumer Who Is a Lender
Figure 9.4
A Consumer Who Is a Borrower
An Increase in Current Income for the
Consumer
• Current and future consumption increase.

• Saving increases.
• The consumer acts to smooth consumption
over time.
Figure 9.5
The Effects of an Increase in Current
Income for a Lender
Observed Consumption-Smoothing
Behavior
• Aggregate consumption of non-durables and

services is smooth relative to aggregate income,
but the consumption of durables is more volatile
than income.
• This is because durables consumption is
economically more like investment than
consumption.
Figure 9.6
Percentage Deviations from Trend in
Consumption of Durables and Real GDP
Figure 9.7
Percentage Deviations from Trend in
Consumption of Nondurables and
Services and Real GDP
An Increase in Future Income for the
Consumer
• Aggregate consumption of non-durables and

services is smooth relative to aggregate income,
but the consumption of durables is more volatile
than income.
• This is because durables consumption is
economically more like investment than
consumption.
Figure 9.8
An Increase in Future Income
Temporary and Permanent Increases in
Income
• As a permanent increase in income will have a

larger effect on lifetime wealth than a
temporary increase, there will be a larger effect
on current consumption.
• A consumer will tend to save most of a purely
temporary income increase.
Figure 9.9
Temporary Versus Permanent Increases
in Income
Figure 9.12
An Increase in the Real Interest Rate
An Increase in the Market Real Interest
Rate
• An increase in the market real interest rate

decreases the relative price of future
consumption goods in terms of current
consumption goods – this has income and
substitution effects for the consumer.
Figure 9.13
An Increase in the Real Interest Rate for a
Lender
Figure 9.14
An Increase in the Real Interest Rate for a
Borrower
Effects of an Increase in the Real Interest
Rate for a Lender
Effects of an Increase in the Real Interest
Rate for a Borrower
Perfect Complements Example
• With perfect complements, the ratio of future

consumption to current consumption is
constant.
c'  ac
• The consumer’s budget constraint must hold.

c'
c  we
1 r
• With perfect complements we can solve

explicitly for current and future consumption:
we(1  r )
c
1 r  a
awe(1  r )
c' 
1 r  a
Substituting for lifetime wealth gives:
( y  t )(1  r )  y 't '

c
1 r  a
 ( y  t )(1  r )  y 't ' 

c'  a  
 1  r  a 
Figure 9.15
Example with Perfect Complements
Preferences
Government Budget Constraints
• The government’s current-period budget

constraint:
G T B
• The government’s future-period budget

constraint:
G ' (1  r ) B  T '
• The government’s present-value budget

constraint:
G' T'
G T 
1 r 1 r
Credit Market Equilibrium Condition
• Total private savings is equal to the quantity of

government bonds issued in the current period.
Sp  B
Income-Expenditure Identity
• Credit market equilibrium implies that the

income-expenditure identity holds.
Y  C G
Ricardian Equivalence
• The Ricardian Equivalence Theorem is

illustrated algebraically, numerically, and in
two graphs.
• Key equation: The consumer’s lifetime tax

burden is equal to the consumer’s share of the
present value of government spending – the
timing of taxation does not matter for the
consumer.
t' 1 G' 
t  G  
1 r N  1 r 
• Then, substitute in the consumer’s budget

constraint – taxes do not matter in equilibrium
for the consumer’s lifetime wealth, just the
present value of government spending.
Figure 9.16
Ricardian Equivalence with a Cut in
Current Taxes for a Borrower
Figure 9.17
Ricardian Equivalence and Credit Market
Equilibrium
Why Might Ricardian Equivalence Fail in
Practice?
• Redistributional effects of taxes: tax changes

affect the wealth of different consumers
differently.
• Intergenerational redistribution: debt issued by
the government today is paid off by future
generations.
• Taxes are not lump sum; they cause
distortions.
• Credit market frictions: Chapter 10.

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Chapter 9

9.1 Construct a consumer’s lifetime budget

9.2 Show how the consumer responds to changes

9.3 Construct the government’s present-value

9.4 Show how a competitive equilibrium is

9.5 Explain the Ricardian Equivalence Theorem.

9.6 Discuss how the Ricardian Equivalence

The consumer’s current-period budget constraint:

The consumer’s future-period budget constraint:

c'  y 't ' (1  r ) s

Solve the future-period budget constraint for s:

c' y 't '

• Substitute in the current-period budget

c' y 't '

• Substitute in the current-period budget

c' y 't '

c'  (1  r )c  we(1  r )

• Marginal condition that holds when the

• Current and future consumption increase.

• Aggregate consumption of non-durables and

• Aggregate consumption of non-durables and

• As a permanent increase in income will have a

• An increase in the market real interest rate

• With perfect complements, the ratio of future

• The consumer’s budget constraint must hold.

• With perfect complements we can solve

Substituting for lifetime wealth gives:

( y  t )(1  r )  y 't '

 ( y  t )(1  r )  y 't ' 

• The government’s current-period budget

• The government’s future-period budget

• The government’s present-value budget

• Total private savings is equal to the quantity of

• Credit market equilibrium implies that the

• The Ricardian Equivalence Theorem is

• Key equation: The consumer’s lifetime tax

• Then, substitute in the consumer’s budget

• Redistributional effects of taxes: tax changes

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