Chapter 7 Consumption Saving and Investment Consumption over

Chapter 7 Consumption, Saving, and Investment

Consumption over two years n Budget constraints in each year ¨ w 1 and r 0 are determined by factor inputs in year 1. ¨ w 2 and r 1 are determined by factor inputs in year 2.

Consumption over two years n Transforming the budget constraints

Consumption over two years n Transforming the budget constraints

Consumption over two years n Intertemporal budget constraint ¨ Present value of life-time consumption: ¨ Present value of initial assets: ¨ Present value of wage income: ¨ Present value of final assets:

Consumption over two years Income effect: an increase in V leads to higher C 1 and C 2. n Substitution effect: an increase in r 1 leads to higher C 2 but lower C 1. n

Consumption over Many Years n Budget constraint in finite horizon

Consumption over Many Years n Budget constraint in infinite horizon Permanent income: n Consumption smoothing: given permanent income, households prefer similar levels of consumption in each year. n

Consumption over Many Years Response to different income shocks (no variations in the interest rate) Propensity to consume save Temporary shocks 0 1 n Permanent shocks 1 0

Equilibrium n Household budget constraint n Market clearing conditions n Equilibrium budget constraint