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CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings

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Macroeconomics ECO 403
VU
LESSON 38
CONSUMPTION (Continued...)
Consumer's Budget Constraint
Irving Fisher's generalization:
C2
Y2
C1 + r
+
1+r
= Y1 +
1
So we can say that
·
·  The consumer's budget constraint implies that if the interest rate is zero, the budget
constraint shows that total consumption in the two periods equals total income in the
two periods. In the usual case in which the interest rate is greater than zero, future
consumption and future income are discounted by a factor of 1 + r.
·  This discounting arises from the interest earned on savings. Because the consumer
earns interest on current income that is saved, future income is worth less than current
income.
·  Also, because future consumption is paid for out of savings that have earned interest,
future consumption costs less than current consumption.
·  The factor 1/(1+r) is the price of second-period consumption measured in terms of first-
period consumption; it is the amount of first-period consumption that the consumer
must forgo to obtain 1 unit of second-period consumption.
Second-period
consumption
B
Consumer's budget
constraint
Saving
Vertical intercept is
(1+r)Y1 + Y2
A
Borrowing
Y2
Horizontal intercept is
C
Y1 + Y2/(1+r)
Y1
First-period consumption
If he chooses a point between A and B, he consumes less than his income in the first period
and saves the rest for the second period. If he chooses between A and C, he consumes more
that his income in the first period and borrows to make up the difference.
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Consumer Preferences
The consumer's preferences regarding consumption in the two periods can be represented by
indifference curves.
An indifference curve shows the combination of first-period and second-period consumption
that makes the consumer equally happy.
·
The slope at any point on the indifference curve shows how much second-period
consumption the consumer requires in order to be compensated for a 1-unit reduction in
first-period consumption. This slope is the marginal rate of substitution between first-period
consumption and second-period consumption. It tells us the rate at which the consumer is
willing to substitute second-period consumption for first-period consumption.
Second-period
consumption
Y
Z
IC2
X
IC1
W
First-period consumption
Higher indifferences curves such as IC2 are preferred to lower ones such as IC1. The consumer
is equally happy at points W, X, and Y, but prefers Z to all the others-- Point Z is on a higher
indifference curve and is therefore not equally preferred to W, X and Y.
Optimization
The consumer achieves his highest (or optimal) level of satisfaction by choosing the point on
the budget constraint that is on the highest indifference curve. At the optimum, the indifference
curve is tangent to the budget constraint.
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Second-period
consumption
O
IC3
IC2
IC1
First-period consumption
How changes in income affect consumption
An increase in either first- or second-period income shifts the budget constraint outward. If
consumption in period one and consumption in period two are both normal goods- those that
are demanded more as income rises, this increase in income raises consumption in both
periods.
Second-period
consumption
(1+r)Y1 + Y2
O
IC2
IC1
First-period consumption
Y1 + Y2/(1+r)
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How changes in real interest rate affect consumption
·  Economists decompose the impact of an increase in the real interest rate on
consumption into two effects: an income effect and a substitution effect.
·  The income effect is the change in consumption that results from the movement to a
higher indifference curve.
·  The substitution effect is the change in consumption that results from the change in the
relative price of consumption in the two periods.
Second- period
consumption
(1+r)Y1 + Y2
New budget
constraint
B
Old budget constraint
A
C
Y2
IC2
IC1
Y1
Y1 + Y2/(1+r)
First-period consumption
An increase in the interest rate rotates the budget constraint around the point C, where C is
(Y1, Y2).
The higher interest rate reduces first period consumption (move to point A) and raises second-
period consumption (move to point B).
·
Irving Fisher's Model shows that depending on the consumer preferences, changes in real
interest rate could either raise or lower consumption.
·
So, economic theory alone cannot predict how interest rate influences consumption.
Therefore economists have studied the empirics of interest rate affecting the consumption
and saving.
Savings and the Real Interest Rate
·  Data shows that there's no apparent relationship between the two variables. Or,
savings does not depend on interest rate.
·  Economists claim that income and substitution effects of higher interest rates
approximately cancel each other.
Constraints on Borrowings
·
The inability to borrow prevents current consumption from exceeding current income. A
constraint on borrowing can therefore be expressed as C1 Y1.
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·
This inequality states that consumption in period one must be less than or equal to income
in period one. This additional constraint on the consumer is called a borrowing constraint,
or sometimes, a liquidity constraint.
·
The analysis of borrowing leads us to conclude that there are two consumption functions.
For some consumers, the borrowing constraint is not binding, and consumption in both
periods depends on the present value of lifetime income.
·
For other consumers, the borrowing constraint binds. Hence, for those consumers who
would like to borrow but cannot, consumption depends only on current income.
·
If the consumer cannot borrow, he faces the additional constraint that 1st period
consumption cannot exceed 1st period income.
2nd period consumption,
C2
Budget Constraint
Borrowing Constraint
1st period consumption, C1
Y1
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a: borrowing constraint is
b: borrowing constraint is
not binding
binding
2nd period
2nd period
consumption
consumption
, C2
, C2
E
D
1st period
1st period
Y1
Y1
consumption, C1
consumption, C1
High Japanese Savings Rate
·
Japan has one of the world's highest savings rate.
·
On one hand, many economists believe that this is a key to the rapid growth Japan
experienced in the decades after World War II, The Solow growth model also shows that
saving rate is a primary determinant of a country's steady state level of income.
An increase in the saving rate raises investment causing the capital stock to grow toward a
new steady state
Investment
δk
and
depreciation
s2 f(k)
s1 f(k)
k
k *
k *
2
1
·
On the other hand, some economists say that high savings rate has contributed to Japan's
slump during 1990s.High savings means lower consumption which according to IS-LM
model translates into low aggregate demand and reduced income.
·
Why Do Japanese consume so less or save so much?
­  It is harder for households to borrow in Japan
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­  In case of borrowing to purchase a house (the most common cause of borrowing), down
payment rates are very high (up to 40%)
­  Japanese Tax system encourages saving by taxing capital income very lightly
­  Japanese are more risk averse and patient.
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand