Podcast
Questions and Answers
What does the Euler equation for consumption imply about the economic agent's preferences?
What does the Euler equation for consumption imply about the economic agent's preferences?
In the expression $cfuture = (1 + R) X̄ - ctoday$, what does the term $(1 + R) X̄$ represent?
In the expression $cfuture = (1 + R) X̄ - ctoday$, what does the term $(1 + R) X̄$ represent?
What does the term $β$ signify in the Euler equation?
What does the term $β$ signify in the Euler equation?
Why is the derivative of utility with respect to $ctoday$ set equal to zero during optimization?
Why is the derivative of utility with respect to $ctoday$ set equal to zero during optimization?
Signup and view all the answers
Which of the following statements about the utility function is correct based on the given framework?
Which of the following statements about the utility function is correct based on the given framework?
Signup and view all the answers
What did S. Kuznets find regarding the ratio of consumption to income over time?
What did S. Kuznets find regarding the ratio of consumption to income over time?
Signup and view all the answers
According to the Keynesian consumption function, what happens to the fraction of income consumed as income grows?
According to the Keynesian consumption function, what happens to the fraction of income consumed as income grows?
Signup and view all the answers
What are the two main elements of the neoclassical consumption model developed by I. Fisher?
What are the two main elements of the neoclassical consumption model developed by I. Fisher?
Signup and view all the answers
What does the consumption puzzle refer to in the context of Keynes's conjecture?
What does the consumption puzzle refer to in the context of Keynes's conjecture?
Signup and view all the answers
How does the Keynesian consumption function perform when analyzing short time-series data?
How does the Keynesian consumption function perform when analyzing short time-series data?
Signup and view all the answers
What is the significance of the intertemporal budget constraint in the neoclassical consumption model?
What is the significance of the intertemporal budget constraint in the neoclassical consumption model?
Signup and view all the answers
In the context of household data, how did the Keynesian consumption function perform?
In the context of household data, how did the Keynesian consumption function perform?
Signup and view all the answers
What financial components make up the financial wealth of a consumer in the neoclassical consumption model?
What financial components make up the financial wealth of a consumer in the neoclassical consumption model?
Signup and view all the answers
What does diminishing marginal utility suggest about consumption?
What does diminishing marginal utility suggest about consumption?
Signup and view all the answers
What role does the discount parameter β play in the lifetime utility function?
What role does the discount parameter β play in the lifetime utility function?
Signup and view all the answers
Under what condition does β equal 1 in the lifetime utility function?
Under what condition does β equal 1 in the lifetime utility function?
Signup and view all the answers
How do favourable supply conditions impact credit to households?
How do favourable supply conditions impact credit to households?
Signup and view all the answers
What does the intertemporal budget constraint signify in the maximization problem?
What does the intertemporal budget constraint signify in the maximization problem?
Signup and view all the answers
What options does a household have to avoid cutting consumption during financial stress?
What options does a household have to avoid cutting consumption during financial stress?
Signup and view all the answers
How does the utility function change as consumption increases?
How does the utility function change as consumption increases?
Signup and view all the answers
What effect does high leverage have on a household's ability to adjust by borrowing?
What effect does high leverage have on a household's ability to adjust by borrowing?
Signup and view all the answers
In the maximization problem, what is denoted by $ar{X}$?
In the maximization problem, what is denoted by $ar{X}$?
Signup and view all the answers
What was the difference in spending cuts between households with high debt-to-income ratios and those with low ratios during 2007-2009?
What was the difference in spending cuts between households with high debt-to-income ratios and those with low ratios during 2007-2009?
Signup and view all the answers
How does using debt to finance illiquid wealth affect household consumption?
How does using debt to finance illiquid wealth affect household consumption?
Signup and view all the answers
What does the term 'utility' represent in the context of consumption?
What does the term 'utility' represent in the context of consumption?
Signup and view all the answers
What effect does a discount parameter β being less than 1 have on the agent's consumption preference?
What effect does a discount parameter β being less than 1 have on the agent's consumption preference?
Signup and view all the answers
What characteristic of a household's liabilities can increase the impact on consumption?
What characteristic of a household's liabilities can increase the impact on consumption?
Signup and view all the answers
What is the result of heightened competition among lenders in the banking sector?
What is the result of heightened competition among lenders in the banking sector?
Signup and view all the answers
Which of the following best describes lending standards?
Which of the following best describes lending standards?
Signup and view all the answers
What does an unexpected promotion likely lead to in terms of consumption?
What does an unexpected promotion likely lead to in terms of consumption?
Signup and view all the answers
According to the life-cycle hypothesis, what factor primarily influences consumption?
According to the life-cycle hypothesis, what factor primarily influences consumption?
Signup and view all the answers
What does the permanent income hypothesis argue in comparison to the life-cycle hypothesis?
What does the permanent income hypothesis argue in comparison to the life-cycle hypothesis?
Signup and view all the answers
Which of the following is true about consumption patterns during the life-cycle according to the model?
Which of the following is true about consumption patterns during the life-cycle according to the model?
Signup and view all the answers
If a consumer wishes to maintain smooth consumption over their lifetime, what is the consumption level based on?
If a consumer wishes to maintain smooth consumption over their lifetime, what is the consumption level based on?
Signup and view all the answers
What does the life-cycle model suggest about the consumption of a retired individual?
What does the life-cycle model suggest about the consumption of a retired individual?
Signup and view all the answers
What is one implication of the life-cycle model regarding younger consumers?
What is one implication of the life-cycle model regarding younger consumers?
Signup and view all the answers
Under the life-cycle model, when does an individual typically start saving more?
Under the life-cycle model, when does an individual typically start saving more?
Signup and view all the answers
Study Notes
Consumption Puzzle
- Keynes originally hypothesized that households would consume a smaller percentage of their income as their incomes grew, leading to a long depression due to insufficient demand.
- Kuznets' examination of historical data from 1869 indicated that the ratio of consumption to income remained remarkably constant, despite significant increases in income, refuting Keynes' assumption.
- There appears to be two consumption functions:
- The Keynesian consumption function seems to work well when analyzing short-term household data and time series.
- For longer time series, the consumption function exhibits a stable average propensity to consume.
- These conflicting findings created a puzzle for economists, prompting them to investigate the discrepancies.
- The Neoclassical consumption model provides insights into why the two consumption functions might exist.
Intertemporal Budget Constraint (Neoclassical Consumption Model)
- Consumers make choices regarding their consumption levels today and in the future, considering their present and future income.
- This model is built upon the concept of an intertemporal budget constraint that relates consumption to:
- Existing financial wealth (ftoday) = savings, stocks, bonds
- Current income (ytoday)
- Future income (yfuture)
- The formula: Current Consumption + (Future Consumption / (1+R)) = Total wealth
Utility Function (Neoclassical Consumption Model)
- Utility is derived from consuming goods and services.
- Utility functions are assumed to exhibit diminishing marginal utility, meaning each additional unit of consumption provides a smaller increase in utility.
- The agent seeks to maximize lifetime utility:
- Lifetime Utility (U) = Utility from consumption today (u(ctoday)) + Discount factor (β) * Utility from consumption tomorrow (u(cfuture)).
- The discount factor (β) reflects the weight an agent places on future. If β = 1, the agent values future utility equally to present utility. However, β is typically less than 1, implying that a given utility flow is more valuable if received today.
- The agent maximizes lifetime utility subject to the intertemporal budget constraint.
Euler Equation (Neoclassical Consumption Model)
- The Euler equation represents the condition for optimal consumption allocation over time.
- It states that the marginal utility of consuming one more unit today equals the discounted marginal utility of consuming (1+R) units in the future.
- This signifies that the agent is indifferent between consuming an extra unit today or saving it and deferring consumption to the future.
- The equation: u 0 (ctoday ) = β(1 + R)u 0 (cfuture ).
Consumption as a Random Walk
- Changes in consumption are driven by unpredictable changes in lifetime income.
- Consumers are assumed to be rational and use all available information.
- Therefore, changes in consumption should be unpredictable, as they reflect surprises about lifetime income.
The Life-Cycle Model of Consumption
- Developed by F. Modigliani, it suggests that consumption is based on an individual's average lifetime income rather than their income at any particular age.
- This model complements Friedman's Permanent Income Hypothesis, both using Fisher's theory of the consumer to demonstrate that consumption is not solely determined by current income.
- The Life-Cycle Model emphasizes the predictable pattern of income over a lifetime, whereas the Permanent Income Hypothesis focuses on the unpredictable, temporary fluctuations in income from year to year.
The Life-Cycle Model of Consumption, Intuition
- Young individuals, often in school, may consume more than they earn, relying on financial support from their parents.
- As individuals age and income rises, their consumption increases at a slower pace, allowing them to save more for retirement.
- Upon retirement, income declines, but consumption remains relatively stable, relying on accumulated savings from their middle-aged years.
Credit Demand vs Credit Supply
- Factors affecting credit demand:
- Increases in housing prices and interest rates.
- Rise in household income.
- Growth in credit availability.
- Factors affecting credit supply:
- Increased competition among lenders, leading to relaxed lending standards and lower interest rates.
Household Debt and Macroeconomic Stability
- A household's debt level impacts its ability to navigate unexpected negative events.
- To avoid reducing consumption (cutbacks), households can:
- Draw down their savings, particularly liquid assets like stocks.
- Adjust their debt through refinancing, renegotiations, default, or seeking additional credit.
- The effectiveness of these options is influenced by:
- Leverage: Households with high leverage face tighter borrowing constraints and experience more significant cuts to consumption.
- Illiquidity of financed wealth: Greater reliance on illiquid assets like housing (mortgage debt) results in larger consumption reductions.
- Sensitivity to interest rate changes: A greater sensitivity of liabilities to interest rate fluctuations compared to assets leads to a bigger impact on consumption.
Studying That Suits You
Use AI to generate personalized quizzes and flashcards to suit your learning preferences.
Related Documents
Description
Explore the intriguing relationship between income and consumption based on Keynesian and Kuznetsian theories. This quiz delves into the conflicting consumption functions and their implications on economic modeling. Test your understanding of the intertemporal budget constraint and its relevance in consumption theory.