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Lecture 5

# ECON 222 Lecture Notes - Lecture 5: Real Interest Rate, Consumption SmoothingPremium

Department
Economics
Course Code
ECON 222
Professor
Mike Kennedy
Lecture
5

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ECON 222 Lecture 5 Consumption
âš« Consumption & Saving
Desired national consumption: C^d
Desired national saving: S^d
Recall for Chapter 2: If net factor payment (NFP)is zero, the national saving
S equals to Y-C-G (note: Y-output; C-consumption; G-government spending)
Therefore, we can deduce the following function: S^d=Y-C^d-G (note: S^d
is the total of private and government saving)
âš« The consumption and saving decision of individual
Assume the real interest rate is r. Then for 1 dollar today will worth 1+r in
next time period.
If a person borrows 1 dollar this year, he has to pay 1+r dollar next time
period. Similarly, if that person saves 1 dollar this year, he can get 1+r dollar
next time period. Therefore, 1+r is the price of a dollar current consumption
is terms of future consumption.
*Two ways of choice making:
1. Borrow heavily and consume more than the personâ€™s income today
2. Save nearly all of the income
What most people do?
Avoid periods of very high or very low consumption which is known as
consumption- smoothing motive.
âš« Effect of changes in current income
Marginal propensity to consume (MPC):
The fraction of additional current income that is consumed in the current
period
When Y rises by 1, the C^d typically rise less than 1. S^d also increases as
Y increases. If the money does not spend on consumption, S^d rises by the
fraction of 1.
Prof. Kennedy, Lecture 5, Slide 11