SEM 1 - LEC 1 - CONSUMPTION Flashcards
what’s the national income identity given by
Y = C + I + G + NX
where: Y = GDP C = Consumption I = Investment G = Government purchases NX = Net exports = Exports − Imports
what’s the definition of consumption
Household final consumption expenditure covers all purchases made by resident households (home or abroad) to meet their everyday needs: food, clothing, housing services (rents), energy, transport, durable goods (cars), spending on health, on leisure and on miscellaneous services.
what was Keynes general theory and what were his conjectures about the consumption function that were based on introspection and casual observation
1 The marginal propensity to consume (the amount consumed out of an additional dollar of income) is between zero and one.
2 The ratio of consumption to income, called the average propensity to consume falls as income rises.
3 Income is the primary determinant of consumption and interest rate does not have an important role.
how can you write the Keynesian consumption function
c = c ̄ + βy
where:
c is consumption, y is disposable income, c ̄ is a
constant and β is the marginal propensity to consume.
how do you work out the average propensity to consume
what does the Keynesian consumption function look like diagrammatically
MPC is slope of line
APC is slope of a line drawn from the origin to a point on the consumption function
what were the two anomalies that arose with the Keynesian consumption function
secular stagnation. - as incomes in the economy grow over time, households would consume a smaller and smaller fraction of their incomes → the low consumption would lead to an inadequate demand for goods and services resulting in a long depression of indefinite duration.
In reality, the conjecture of Keynes that the average propensity to consume would fall as income rose appeared not to hold.
Second anomaly: Kuznets found that the ratio of consumption to income was remarkably stable from decade to decade, despite the large increases in income over the period he studied.
Again, the conjecture of Keynes that the average propensity to consume would fall as income rose appeared not to hold.
what is the starting point of the neoclassical consumption model
people may earn income today and in the future, they consume today and in the future, and a key decision they have to make is how much to consume today versus how much to consume in the future.
what is the two main elements of the neoclassical consumption model
1 intertemporal budget constraint;
2 utility function.
what do these two budget constraints show us (neoclassical)
Both the equations have the form “consumption plus savings equals income”.
Assume that as of this moment a consumer has financial wealth equal to ftoday .
This financial wealth includes the agent’s savings account balance and all their holdings of stocks and bonds.
The agent earns labour income today, ytoday , and in the future, yfuture . Letting c and R denote consumption and interest rate,
what’s the intertemporal budget constraint of an agent
do it by combining ytoday (2) and cfuture equations. (3)
- rearrange cfuture so you get ffuture= cfuture - yfuture over 1+R
- substitute that expression into the ytoday expression and rearrange to get the following
why does the agent chooses her consumption today and in the future in terms of utility
to maximize her utility. If the agent consumes some amount c in a given period, we assume that she receives u(c) units of utility
assume that the agent gets more utility whenever her consumption is higher, but that consumption runs in diminishing returns → consumption exhibits diminishing marginal utility.
(Diminishing marginal utility is reflected in the curvature of the utility function, which gets flatter and flatter as consumption increases.)
what does the utility function relative to consumption look like diagrammatically
what’s the lifetime utility function
solve the utility maximisation problem given the utility function and intertemporal constraint
if you rearrange this equation what do you get
the Euler equation for consumption - explains how interest rates and growth rates are linked.
how do you solve the Euler equation
Equation (9) says that the agent chooses her consumption so that the growth rate of consumption is the product of the discount parameter and the interest rate that she can earn on her savings.
If the agent is very impatient, she places less weight on future utility (a lower β), and consumption growth is lower.
In contrast, a higher interest rate raises the return to saving, and consumption growth is higher.
how do you solve the two unknowns in the Euler equation Ctoday and Cfuture
The agent consumes one-half of her wealth today and saves the other half and, in the future, she can consume the remainder of her wealth together with the interest it has earned.
How does consumption respond to a rise in the interest rate?
what are the substitution and income effect of a rise in R on consumption
The substitution effect of a higher interest rate is that current consumption is now more expensive (because saving will lead to even more consumption in the future), so consumers will tend to reduce their consumption today and increase it tomorrow.
The income effect means that the consumers are now richer (because their current saving leads to more income in the future), which makes them want to consume more today and tomorrow.
Because both effects increase the amount of future consumption, we can conclude that an increase in the real interest rate raises future consumption. However, these two effects have opposite impacts on current consumption, so the increase in the interest rate could either lower or raise it.
what’s the permanent income hypothesis theory on consumption
the PIH is one implication of the neoclassical consumption model.
The intuition behind the permanent-income result is that consumers wish to smooth their consumption over time.
show the permanent income hypothesis diagrammatically
Assume that β = 1 and R = 0.
Assume that the agent could consume c1 today and c2 in the future
or could consume the average of these two values in both periods.
Because of diminishing marginal utility, the agent prefers to smooth consumption and take the average in both periods.
in the PIH theory what happens if the interest rates increases
From the Euler equation, we know that this change leads
consumption to grow over time.
Because of the agent’s desire to smooth consumption, she must be paid a positive interest rate not to keep consumption constant.
How does the agent respond to a temporary increase in income? (PIH THEORY)
