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ECON2102 Macroeconomics 2
1 Introduction
• In this lecture, we learn (Jones chapter 16):
The neoclassical consumption model
I Individuals choose the time path of their consumption to max-
imize utility
I How this model leads to a solution in which consumption is
proportional to an individual’s total wealth
Introduction - 1
• Heterogeneity in consumer behavior at the microeconomic level
Some individuals (rich) tend to follow the permanent-income
hypothesis
Others (poor) respond to changes in current income
• The decline in the personal saving rate and the rise in the debt-
income ratio in recent decades
Introduction - 2
• Neoclassical consumption model
Individuals choose consumption at each moment in time
Goal: maximize a lifetime utility function
I function depends on current and future consumption
People recognize that income in the future may differ from in-
come today
I such differences influence consumption today
2 The Neoclassical Consumption Model
• Two time periods: today and the future
People earn income and consume in both periods.
• Key decision to make
How much to consume today versus how much to consume in
the future
• The consumption model is based on two main elements:
An intertemporal budget constraint
A utility function
The Intertemporal Budget Constraint - 1
• Two budget constraints, each with the form “consumption
equals income less saving”
(1) ctoday = ytoday −
(
ffuture − ftoday
)
(2) cfuture = yfuture = (1 +R)ffuture
where
c = consumption
y = income
f = financial wealth
The Intertemporal Budget Constraint - 2
• Combine the two, get the intertemporal budget constraint
ctoday +
cfuture
1 +R
= ftoday + ytoday +
yfuture
1 +R
where ytoday =
yfuture
1 +R
The Intertemporal Budget Constraint - 3
• Human wealth is the present discounted value of labor income
present value of consumption = financial wealth + human wealth︸ ︷︷ ︸
total wealth
• Consumption in a given year can be different from income
• PDV of consumption must equal lifetime resources
Utility - 1
• Utility depends on consumption today and in the future
• More consumption means more utility
U = u(ctoday) + βu(cfuture)x
Weight placed on future consumption
• Diminishing Marginal Utility
Each additional unit of consumption raises utility by a smaller
amount
Utility - 2
• If β = 1
Current and future treated equally
• If β < 1
Future consumption is discounted
Today’s consumption is valued more than future consumption
Flow Utility u(c)
Choosing Consumption to Maximize Utility - 1
• Maximize utility subject to a budget constraint
maxU
ctoday, cfuture
= u(ctoday) + βu(cfuture)
subject to
ctoday +
cfuture
1 +R
= X¯ ←− total wealth
where
X¯ ≡ ftoday + ytoday + yfuture
1 +R
Choosing Consumption to Maximize Utility - 2
• Solution requires calculus, but we can walk through the intu-
ition
Want to make ourselves as happy as possible, but we have a
limited income
• Marginal utility of today’s consumption: u′(ctoday)
• Marginal utility of future consumption: u′(cfuture)
Choosing Consumption to Maximize Utility - 3
• Agents can either:
Consume today
OR
Save and consume 1 +R units in the future
• Utility maximized when agents are:
indifferent between consuming more today or more tomorrow
Choosing Consumption to Maximize Utility - 4
• Euler Equation:
u′(ctoday) = β(1 +R)u′(cfuture)
MU of consuming 1 more unit today = discounted consumption
of 1 +R units in the future.
• Intuition
Must be indifferent between consuming today and tomorrow
Solving the Euler Equation - 1
• Log Utility: u(c) = log(c)
• Calculus derivative rule: u′(c) = 1
c
• The Euler equation in this case is then:
1
ctoday
= β(1 +R)
1
cfuture
Solving the Euler Equation - 2
• Rearranging the Euler equation:
cfuture
ctoday
= β(1 +R)
• Left side is growth rate of consumption (plus 1)
• Consumption is chosen such that:
The growth rate of consumption is a product of the discount
parameter and the interest rate.
Solving the Euler Equation - 3
• Lower β
Impatient, consumption growth is lower
• Higher β
Patient, consumption growth is faster
• Euler Equation
Explains how interest rates and growth rates are related
Solving for Ctoday, Cfuture with Log Utility and β = 1 (1)
• To solve for consumption today and in the future (two vari-
ables), we need:
Euler equation
Intertemporal budget constraint
cfuture
ctoday
= β(1 +R)
If β = 1:
ctoday +
cfuture
1 +R
= X¯
Solving for Ctoday, Cfuture with Log Utility and β = 1 (2)
• If β = 1
• Plug into the budget constraint