ECN 600 Lecture Notes - Lecture 6: Ricardian Equivalence, Budget Constraint, Real Interest Rate

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3 Dec 2018

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C s y t y c (1 t r s. Chapter 9 -a two-period model: the consumption-savings decision and credit. Topics: consumer"s consumption/savings decision responses of consumer to changes in income and interest rates, government budget deficits and the ricardian equivalence theorem. Solve the future-period budget constraint for s: s c c c t. Substitute in the current-period budget constraint obtaining lifetime budget constraint: c t. Substitute in the current-period budget constraint obtaining lifetime budget constraint: c r. Slope-intercept: (1 c r c we (1 r. Optimization: marginal condition that holds when the consumer is optimizing: An increase in current income for the consumer: current and future consumption increase. The consumer acts to smooth consumption over time. Observed consumption-smoothing behaviour: aggregate consumption of non-durables and services is smooth relative to aggregate income, but the consumption of durables is more volatile than income.

Related Questions

consider the following two-period model. The consumer has preferences given by: u(c,c')=ln c + Ã ln c' where c is current consumption, c' is future consumption, and Ã >0 is a discount factor. The consumer receives exogenous income y u tge current period and y' in the future period. The consumer pays proportional tax ts on savyings (i.e. the consumer saves s in the current period but only gets (1-ts) tomorrow). The consumer can save at the interest rate r.

a) Write down the consumer's budget constraint for the current period.

b) Write down the consumer's budget constraint for the future period.

c) Combine the two budget constraints above into one lifetime budget constraint

d) Solve the consumer's optimization problem for c and c'

e) Write down the tax revenue the government receives then imposing the tax on savings.

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Consider the two-period intertemporal model that we studied in class.

(a) (5 marks) Discuss the similarities and differences between the drivers of consumption predicted by this model compared to those suggested by the traditional KeynesianconsumptionfunctionC=C(Y âT).

(b) (10 marks) Explain why this model predicts that consumption in the present and future will increase in response to either a rise in current income, or, a rise in future income. What happens to savings in each case?

(c) (15 marks) On a C1 vs. C2 diagram, sketch an indifference curve and budget constraint showing the optimal choice for a borrower. Now show the impact of an increase in the real interest rate r on the borrower, sketching two different cases: (i) where the increase in r results in a rise in period 2 consumption, and (ii) where the increase in r results in a fall in period two consumption. How can the model account for these two different cases? Discuss, what assumption must hold in each case.

1. State the Lifetime Government Budget Constraint

2. Write the Consumers Lifetime BC in real terms with a lump sum tax âtâ

3. Combine BCâs from 1.) and 2.) to form the economy wide BC using the common taxes.

4. Suppose Government holds spending fixed but decides to decrease t1. a. Explain what happens to t2 b. Show what happens to the overall changes in taxes by expressing the change in t2 as a function of the change in t2 c. Consumer has full knowledge of the economy. What does the consumer do with the period 1 tax break? Explain why? d. What is the overall effect on national savings and why?

5. Write the Consumerâs LBC with a consumption tax âtauâ in each period. 6. Solve to express the LBC with c2 as a function of c1 in order to graph it. 7. Suppose first period taxes decrease a. What happens to the slope of the BC? b. What occurs with optimal c1 and c2 and why? c. What occurs with national savings? i. Is there a shift and if so, which direction? ii. Graphically show the change in the funds market iii. What happens to the optimal investment choice of firm and why

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ECN 600 Lecture Notes - Lecture 6: Ricardian Equivalence, Budget Constraint, Real Interest Rate

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