L 11200 Introduction to Macroeconomics 200910 Lecture 11

L 11200 Introduction to Macroeconomics 2009/10 Lecture 11: Consumption, Saving and Investment II Reading: Barro Ch. 7 16 February 2010

Introduction • Last time: – Modelled household consumption and saving decision – Examined impact of changing income and interest rates on household consumption • Today – Consumption decisions imply a level of saving – What does this imply for capital accumulation?

Consumption Over Many Periods • Considered a 2 -period consumption decision: • Assumed that period 2 was the last period – Now extend to many periods – So end-of-period two assets no longer fixed

Beyond Two Periods • If we extend l. h. s beyond two periods: • And extend rhs beyond two periods: • Final term there is no ‘end’ period disappears because

Multiyear Budget Constraint • So the ‘multiyear’ constraint is: present value of consumption = value of initial assets + present value of wage increases • This constraint covers multiple periods: ultimately covers a household’s lifetime

Temporary vs Permanent Changes • Over the lifetime of a household, temporary vs permanent changes in income will have different effects – A temporary change in income (e. g. in period 2 only) raises overall resources by a small amount – The household wants to keep consumption smooth, so it spreads the extra resource over all time periods – So the impact on consumption now is small, the propensity to consume is less than 1

Temporary vs Permanent Changes • Permanent changes in income have a much bigger effect on current consumption – Income rises in all periods – So consumption rises in all periods in line with the increase in income – The propensity to consume now out of the increase in income is 1. – Key issue: an increase in income of £ 100 today doesn’t raise consumption today by £ 100 unless it is permanent.

Expected vs Unexpected Income • Whether income is expected also matters – If households expect a higher future income, they will factor this into their borrowing decisions and plan for higher income. – So when income increases between periods, if it was expected it has no impact on consumption – But if households receive an unexpected increase in income, this will impact of consumption.

Consumption and Investment • One-period budget constraint • Interest rate • This is true for all households – Across all households, B and ΔB must sum to zero – So can drop from this equation in aggregate

Consumption and Investment • Also, know that in equilibrium all income is paid to labour and capital: – So can reduce to consumption + net investment = real GDP - depreciation – Net investment depends on consumption. If consumption is lower, investment will be higher – This is crucial: it completes the picture of how household choices determine investment

Review of Macro Model • Brief review of last 4 lectures • Want a model of the macroeonomy in order to understand what might drive fluctuations and how they impact on the economy • Model based on ‘microfoundations’ of how consumers, producers, workers and capital owners behave

Review I • Constructed model based on ‘household’ – Household owns a small business, supplies labour, supplies capital and consumes – So captures all the essential elements of the economy – Households are price takers: markets are perfectly competitive and continually in equilibrium

Review II • We setup what households ‘do’ in via the budget constraint • They earn profit, wage income, rental income and income from bonds • They use it to consume, save for the future and invest in more capital

Review III • We then set out to explain how much income they earn and what they do with it – Production: by profit-maximisation, households combine factors of production to produce output – In perfectly competitive market the business makes no profit, but factors of production (supplies by the household) earn rents – Exactly the same as in microeconomic model

Review IV • … and what they do with it – They spend some and save some, aiming to smooth their consumption – This decision is made over many periods – So consumption depends on overall lifetime wealth, not just wealth today – How much they save determines how much is invested in capital (and so how much output is produced in the future)

Review V • Does this model explain reality? – Sounds plausible, consistent with microeconomics – Has implications for what will happen in the economy when variables change • Next step: incorporate changes in technology – We found they explained long-run growth – Maybe changes in technology could also explain fluctuations – But only if our model’s predictions are supported by data

Summary • Completed the macro model – Has some limitations (fixed labour and capital supply) – But now used to address the data • Next time: have a closer look at the data on fluctuations – Are the prediction of our model consistent with what we see in the data?