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Questions and Answers
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?
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?
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Which of the following statements about the utility function is correct based on the given framework?
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What did S. Kuznets find regarding the ratio of consumption to income over time?
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According to the Keynesian consumption function, what happens to the fraction of income consumed as income grows?
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What are the two main elements of the neoclassical consumption model developed by I. Fisher?
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What does the consumption puzzle refer to in the context of Keynes's conjecture?
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How does the Keynesian consumption function perform when analyzing short time-series data?
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What is the significance of the intertemporal budget constraint in the neoclassical consumption model?
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In the context of household data, how did the Keynesian consumption function perform?
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What financial components make up the financial wealth of a consumer in the neoclassical consumption model?
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What does diminishing marginal utility suggest about consumption?
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What role does the discount parameter β play in the lifetime utility function?
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Under what condition does β equal 1 in the lifetime utility function?
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How do favourable supply conditions impact credit to households?
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What does the intertemporal budget constraint signify in the maximization problem?
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What options does a household have to avoid cutting consumption during financial stress?
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How does the utility function change as consumption increases?
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What effect does high leverage have on a household's ability to adjust by borrowing?
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In the maximization problem, what is denoted by $ar{X}$?
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What was the difference in spending cuts between households with high debt-to-income ratios and those with low ratios during 2007-2009?
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How does using debt to finance illiquid wealth affect household consumption?
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What does the term 'utility' represent in the context of consumption?
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What effect does a discount parameter β being less than 1 have on the agent's consumption preference?
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What characteristic of a household's liabilities can increase the impact on consumption?
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What is the result of heightened competition among lenders in the banking sector?
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Which of the following best describes lending standards?
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What does an unexpected promotion likely lead to in terms of consumption?
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According to the life-cycle hypothesis, what factor primarily influences consumption?
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What does the permanent income hypothesis argue in comparison to the life-cycle hypothesis?
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Which of the following is true about consumption patterns during the life-cycle according to the model?
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If a consumer wishes to maintain smooth consumption over their lifetime, what is the consumption level based on?
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What does the life-cycle model suggest about the consumption of a retired individual?
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What is one implication of the life-cycle model regarding younger consumers?
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Under the life-cycle model, when does an individual typically start saving more?
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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.
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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.
