3 - Consumption Flashcards
(19 cards)
What are the three theories of consumption?
- Lifecycle model
- Permanent Income Hypothesis (PIH)
- Keynesian consumption function
What does the lifecycle model and PIH help show?
The relative smoothness of consumption.
Draw a diagram where current income falls, but future income remains constant.
If the interest rate is greater, will people consume more today than at a low interest rate?
No.
They will consume less.
What is the highest point on this graph, algebraically?
Yt + yt-1(1+r)
If you save everything this period, you are going to get yt next period alongside the amount you’ve saved yt-1 multiplied by interest rate (1+r)
What happens at the lowest point on the graph, algebraically?
Yt/(1+r) + Yt-1.
Borrowing against future income Yt will be done at the current interest rate (1+r), so you’ll have to pay it back, hence the division.
Also known as the present value of lifetime income.
Assuming a negative income shock, draw a graph that shows the effects of current and future incomes.
Draw the path of consumption smooting over lifetime (PIH).
What is the equation of Friedman’s PIH?
Current income = permanent income + transitory shock
Current consumption = constant fraction of permanent income
Main ways for households to smooth consumption.
- self-insurance (build up savings when you can, run down savings when needed)
- co-insurance (taxation giving benefits (healthcare, pensions etc.) => risk-sharing
What is the Keynesian consumption function?
C = a0 + a1Yd
a0 roughly equal to PIH, a1Yd = percentage consumption of current income
If MRS > 1 + r, how should you adjust consumption today?
Increase consumption, decrease saving.
Same is true vice-versa.
How does the Keynesian consumption function include demand shocks as an effect on income?
Demand shocks have large (i.e. greater than 1) effects on income.
i.e. multiplier effect, so governments should attempt to stabilise business cycle fluctuation.
What does the PIH predict?
Anticipated changes in income will have no effect on consumption when they occur.
Unanticipated changes in income will change consumption as they require a recalculation of expected lifetime wealth.
Why might households not be able to smooth their consumption?
Credit constraints and present-bias.
If you can’t borrow money, you can’t borrow against future earnings, so you can’t smooth in the same way.
If you are sufficiently biased to the present, you won’t save when expected shocks are announced, causing drastic falls in consumption.
Diagram is the same for present-biased households, but the other way around, i.e. with a downward sloping curve.
What is the MPC for HTM household?
1.
They don’t save anything, they spend what they get.
Suppose r = 0.05 and there is an unanticipated increase in the income of a household of $100 today. Which statements are correct?
The MPC of a PIH household is equal to one.
Consumption of a PIH household will increase by $4.8 today.
The MPC of a HTM household is equal to one.
Consumption of a HTM household will increase by $4.8 today.
B, C.
r/(1+r)(100) = 4.8.
What is a coordination game?
Where there are two Nash equilibria, and in which one may be Pareto superior to the other.
Label each of the Nash equilbria here and which one is Pareto efficient.
Top left is pareto efficient Nash.
Bottom right is pareto-inefficient Nash.
You can only get to top left if you’re currently at bottom right with some form of coordination to develop trust.
