DEPARTAMENTO DE ECONOMÍA

Macroeconomics II
Grado en Economía y Negocios Internacionales

Microfoundations: Consumption

1) Peter and Neville consumption decisions in two periods are based on Fisher’s intertemporal
decision model. Peter earns 100 euro in the first period and 100 euro in the second period. Neville
does not earn anything in the first period but earns 210 euro in the second period. Both can ask for
credit to the bank at an interest rate r. You observe that both Peter and Neville consume a 100
euro in the first and in the second period.

a) What is the interest rate r?

b) Represent Peter’s and Neville’s intertemporal budget constraints in two adequate graphs.
c) Suppose that the real interest rate grows, changing the relative cost of consumption in one
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period versus the other. Even if you do not know Peter’s and Neville’s exact utility functions:
a. Is consumption in the second period more expensive or cheaper now? Why?
b. How will Peter’s consumption change in the first period? Will he enjoy a higher
wellbeing than before the interest rate grew? Are you able to know if his consumption
tomorrow will increase or decrease? Justify your answers both with words and
graphically.
c. How will Neville’s consumption change in the first period? Will he enjoy a higher
wellbeing than before the interest rate grew? Are you able to know if his consumption
tomorrow will increase or decrease? Justify your answers both with words and
graphically.

2) Consider a two-period consumption allocation problem to be solved with Fisher’s intertemporal

decision analysis. For simplicity, assume that the discount rate (ρ) and the interest rate (r) are both
equal to zero so that β is equal to 1. The household maximizes utility U(c1; c2) = u(c1) + βu(c2)
subject to its intertemporal budget constraint, which now includes T1 and T2 taxes in each
corresponding period.

a. Deduce the reaction of household consumption in the first period to this tax increase.

b. Distinguish the two cases in which the household believes that the tax increase is
temporary (taxes increase only in the first period) and the case in which the household
believes that the tax increase is going to be permanent (taxes increase in the first period
and continue to be at that same level in the second period).

3) Consider a situation in which a household has the following utility function in relation to the level
of consumption in the two periods in which it lives:

𝑢𝑢(𝑐𝑐𝑡𝑡 ) = 𝑐𝑐1𝜎𝜎 × 𝑐𝑐21−𝜎𝜎 , ∀𝜎𝜎 ≠ 1

The household has an income Y1 in the first period and Y2 in the second period and savings in the
first period imply an interest rate r.

a. Derive the household’s optimal consumption demand in the two periods.

b. How does expected savings depend on the market interest rate?

c. What are the policy implications of this result?

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4) A consumer has a non-human wealth equal to 100,000 euros. She earns 40,000 this year and
expects her salary to go up 5% in real terms during the next two years. She will then retire. The real
interest rate is 0% and it is expected to stay at that level in the future. Labour income is taxed at a
rate of 25%.
a. What is this consumer’s human wealth?
b. What is her total wealth?
c. If she expects to live for 7 more years after retirement (10 years in total), and wants her
consumption to remain stable in real terms, how much can she consume each year?
d. If she received a bonus of 20,000 € this year only with all future payments remaining as said
above, by how much could this consumer increase her consumption now and in the future?
e. Suppose now that at retirement Social Security will start paying benefits equal to 60% of this
consumer’s earnings during her last working year. Assume that benefits are not taxed. How
much can she consume each year to maintain consumption constant over her lifetime?
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5) Suppose that at age 22 you have just finished college and have been offered a job with a starting
salary of 40,000 €. Your salary will remain constant in real terms. However, you have also been
admitted to a professional school that can be completed in two years. Upon completion you expect
your salary to go up by 10% at to remain constant thereafter at that level in real terms. The tax rate
on labour income is 40%.
a. If the real interest rate is zero and you plan to retire at 60, what is the maximum you
would be willing to pay for tuition to attend the professional school?
b. What would be your answer to part a if you expect to pay 30% of your wage in taxes?

6) Consider a consumer who lives for three periods: youth, middle age and old age. When young, the
consumer earns 20,000€ in labour income. Earnings during middle age are uncertain: there is a 50%
chance that the consumer will earn 40,000€ and a 50% chance that he will earn 100,000€. When
old, the consumer spends the money accumulated during the previous periods. Assume that
inflation, expected inflation, and the interest rate are equal to zero. Ignore taxes for this problem.

c. What is the expected value of his earnings in the middle period of his life? Given this
number, what is the present discounted value of expected lifetime earnings? If the
consumer wishes to maintain constant expected consumption over his lifetime, how
much will he consume in each period? How much will he save each period?

d. Now suppose the consumer wishes, above all else, to maintain a minimum
consumption level of 20,000€ in each period of his lifetime. To do so, he must
consider the worst possible outcome. If earnings during middle age turn out to be
40,000€ how much can this consumer spend during his youth to guarantee
consumption of at least 20,000 in each period? How does this level of consumption
compare to the level you obtained for the young period in part (a)

e. Given your answer in part (b), suppose that the consumer’s earning during the
middle age turn out to be 100,000€. How much will he spend in each period of his
lifetime? (hint: when the consumer reaches the middle age, he will try to maintain
consumption constant for the last two periods as long as he can consume at least
20,000€ each period).

f. How does uncertainty on future labour income affect savings (or demand for loans)
of young consumers?