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CONSUMPTION-SAVINGS
FRAMEWORK CHAPTER 3 2BASICS Introduction Consumption-Savings Framework – provides foundation for Goods-market demand function (again…but w/different interpretation) Financial-market supply function Two time periods Important: all analysis will be conducted from the perspective of the very beginning of period 1… …so a “future” (period 2) for which to save Dynamic models are the staple of modern macroeconomic analysis An explicit accounting of time Two periods are sufficient to illustrate the basic principles Soon will extend beyond two periods (Chapter 8) 3BASICS Introduction Timeline of events Notation c1: consumption in period 1 c2: consumption in period 2 P1: nominal price of consumption in period 1 P2: nominal price of consumption in period 2 Y1: nominal income in period 1 (“falls from the sky”) Y2: nominal income in period 2 (“falls from the sky”) A0: nominal wealth at the beginning of period 1/end of period 0 A1: nominal wealth at the beginning of period 2/end of period 1 A2: nominal wealth at the beginning of period 3/end of period 2 i: nominal interest rate between periods r: real interest rate between periods π2: net inflation rate between period 1 and period 2 y1: real income in period 1 ( = Y1/P1) y2: real income in period 2 ( = Y2/P2) 2 1 2 2 1 1 1 P P P P P Period 1 Period 2 A0 A2Economic events during period 1: income, consumption, savings A1 Economic events during period 2: income, consumption, savings Start of the world End of the worldStart of economic planning horizon End of economic planning horizon 4STOCKS VS. FLOWS Macro Fundamentals Stock variables, aka accumulation variables Quantity variables whose natural measurement occurs at a particular moment in time Checking account balance Credit card indebtedness Mortgage loan payoff Flow variables Quantity variables whose natural measurement occurs over the course of a given interval of time Income Consumption Savings The two broad categories of income Labor income Asset income (generated by interest rate(s) on (components of) wealth) Economic examples Economic examples Interpret A in our framework as net wealth ( = total assets – total debts) All income is a FLOW regardless of source 5BASICS Macro Fundamentals Building blocks of consumption-savings framework Utility Describes the benefits of engaging in financial market (and other) activities Budget constraint Describes the costs of engaging in financial market (and other) activities Utility and budgets two DISTINCT concepts As in basic consumer analysis (Chapter 1) Only after describing utility and budgets separately do we bring the two together to obtain predictions from the framework 6UTILITY Model Structure Preferences u(c1, c2) with all the “usual properties” Lifetime utility function Strictly increasing in c1 Strictly increasing in c2 Diminishing marginal utility in c1 Diminishing marginal utility in c2 Plotted as indifference curves Utility side of consumption-savings framework identical to Chapter 1 framework c1 u(c1,c2) c2 u(c1,c2) c2 c1 7BUDGET CONSTRAINT(S) Model Structure Suppose again Y “falls from the sky” Y1 in period 1, Y2 in period 2 Need two budget constraints to describe economic opportunities and possibilities One for each period Period-1 budget constraint Period-2 budget constraint 1 1 1 1 0(1 )Pc A Y i A Total expenditure in period 1: period-1 consumption + wealth to carry into period 2 Total income in period 1: period-1 Y + income from wealth carried into period 1 (inclusive of interest) 2 2 2 2 1(1 )Pc A Y i A Total expenditure in period 2: period-2 consumption + wealth to carry into period 3 Total income in period 2: period-2 Y + income from wealth carried into period 2 (inclusive of interest) 1 1 1 0 1 0Pc A A Y iA 2 2 2 1 2 1Pc A A Y iA Savings during period 1 (a flow) Savings during period 2 (a flow) Asset income during period 1 (a flow) Asset income during period 2 (a flow) DEFINITION: A consumer’s savings during a given period is the change in his wealth during that period can rewrite as can rewrite as 8BUDGET CONSTRAINT(S) Model Structure Adopt a lifetime view of the budget constraint(s) All analysis conducted from perspective of beginning of period 1 Period-1 budget constraint Period-2 budget constraint 1 1 1 1 0(1 )Pc A Y i A 2 2 2 2 1(1 )Pc A Y i A 9BUDGET CONSTRAINT(S) Model Structure Adopt a lifetime view of the budget constraint(s) All analysis conducted from perspective of beginning of period 1 Period-1 budget constraint Period-2 budget constraint 1 1 1 1 0(1 )Pc A Y i A Asset position at end of period 1/beginning of period 2 the key link - will think further about this soon…2 2 2 2 1(1 )Pc A Y i A Assume = 0 (no bankruptcies + strictly increasing utility) 10 BUDGET CONSTRAINT(S) Model Structure Adopt a lifetime view of the budget constraint(s) All analysis conducted from perspective of beginning of period 1 Period-1 budget constraint Period-2 budget constraint Combine into lifetime budget constraint (LBC) Solve period-2 budget constraint for A1… …and substitute into period-1 budget constraint 1 1 1 1 0(1 )Pc A Y i A Asset position at end of period 1/beginning of period 2 the key link - will think further about this soon…2 2 2 2 1(1 )Pc A Y i A 2 2 2 1 1 1 0(1 ) 1 1 Pc Y Pc Y i A i i Present discounted value (PDV) of all lifetime expenditure Present discounted value (PDV) of all lifetime income Assume = 0 (no bankruptcies + strictly increasing utility) 11 BUDGET CONSTRAINT(S) Model Structure Adopt a lifetime view of the budget constraint(s) All analysis conducted from perspective of beginning of period 1 Period-1 budget constraint Period-2 budget constraint Combine into lifetime budget constraint (LBC) Solve period-2 budget constraint for A1… …and substitute into period-1 budget constraint 1 1 1 1 0(1 )Pc A Y i A Asset position at end of period 1/beginning of period 2 the key link - will think further about this soon…2 2 2 2 1(1 )Pc A Y i A 2 2 2 1 1 1 0(1 ) 1 1 Pc Y Pc Y i A i i Present discounted value (PDV) of all lifetime expenditure Present discounted value (PDV) of all lifetime income For graphical simplicity, will often assume A0 = 0 (i.e., consumer begins planning horizon with zero net wealth). Note this is a different assumption than A2 = 0. Assume = 0 (no bankruptcies + strictly increasing utility)