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Intermediate Macroeconomics


3. Consumption and Saving Decisions


We return to the utility maximizing representative consumer and examine how consumers make optimal choices for consumption and saving when they consider having enough income and saving to support future consumption. We build an intertemporal two-period model, with periods associated with the present and the future. For simplicity, we focus on an endowment model where consumers' incomes are predetermined, and given these income levels we derive consumers' budget constraints for each period and combine these into a lifetime budget constraint. We derive consumers' utility maximizing choices for present consumption, future consumption, and saving. We also introduce a government that collects taxes and uses it for government spending, and look at some of the effects that fiscal policy has on optimal consumer choices.


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Budget Constraint

In our representative agent model, our consumer gets utility from consumption today and consumption in the future. We treat consumption at each one of these time periods as two separate goods. In this first Pencast, we focus on the budget constraint, which is a mathematical and a graphical representation for what choices of consumption in the present and the future that the consumer can afford, with given values for present and future income. [Play Pencast]


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Graphical Budget Constraint

Here we graph the budget constraint that we discussed in our previous Pencast. We show the different areas of the budget constraint where the representative consumer is saving and where he/she is borrowing. We discuss the meaning of the slope of the budget line, and an important point along the budget line - the endowment point - where consumers decide to neither save nor borrow, but consume exactly their income in the present and in the future. [Play Pencast]


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Optimal Consumer Behavior

Here we introduce consumer utility and indifference curves into our two period model, and combine it with the budget constraint to graphically illustrate consumers' optimal choices for consumption today and consumption in the future. We conclude the Pencast with consumers' optimal condition, an equation that finds consumers' utility maximizing choices by setting the slope of the budget line equal to the slope of the indifference curve. [Play Pencast]


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Optimal Consumer Behavior: Increase in Future Income

We use our two-period utility maximizing model to predict the change in consumer behavior when there is an expectation for higher income in the future. We find that consumers "smooth" over their consumption over the present and the future, that is, they increase their consumption in both periods even though the increase in income comes only in the future period. Consumers manage this by decreasing their level of saving or increasing the level of borrowing in the present period. [Play Pencast]


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Optimal Behavior for Borrowers: Increase in Interest Rate

We use our two-period utility maximizing model to predict the change in consumer behavior when there is an increase in interest rates. Outcomes for consumer well-being and choices for consumption today and tomorrow turn out to be different depending on whether the consumer is a saver/lender or a borrower. In this Pencast, we focus on the effects on a borrower. [Play Pencast]


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Optimal Behavior for Lenders/Savers: Increase in Interest Rate

We use our two-period utility maximizing model to predict the change in consumer behavior when there is an increase in interest rates. Outcomes for consumer well-being and choices for consumption today and tomorrow turn out to be different depending on whether the consumer is a saver/lender or a borrower. In this Pencast, we focus on the effects on a lender. [Play Pencast]


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Ricardian Equivalence

We use our two-period utility maximizing model to predict the effect a cut in taxes has on consumption choices. In particular, we focus on lump sum taxes, and we assume that the tax cut is not accompanied with any announcements to change government spending either in the present or the future. We find that because the net present value of government spending over the lifetime is unchanged, so is the net present value of tax revenue unchanged over the lifetime when the government meets its own budget constraint. The result, termed Ricardian equivalence, is that tax cuts (or tax increases) have no impact on consumption choices. [Play Pencast]


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