Unit 3

Consumption and
Savings Problem

Tyler J Wake Denison University

Macroeconomics
Sixth Edition

Chapter 9
A Two-Period Model: The
Consumption-Savings
Decision and Credit Markets
Households
Budget Constraints (1 of 2)
The Household’s current-period budget constraint:

𝑐 + 𝑠 = 𝑦 − 𝑡
Budget Constraints (2 of 2)
The Household’s future-period budget constraint:

𝑐′ = 𝑦′ − 𝑡′ + 1 + 𝑟 𝑠

Important:
To consume more
tomorrow, you must
lend more today!
Simplify
Solve the future-period budget constraint for s:
 Household’s Lifetime Budget Constraint
• Substitute in the current-period budget constraint
obtaining lifetime budget constraint:
Household’s Lifetime Budget Constraint
• Substitute in the current-period budget constraint obtaining
lifetime budget constraint:

• Define lifetime wealth as we

𝑦 ′ − 𝑡′
𝑤𝑒 = 𝑦 − 𝑡 +
1+𝑟
Household’s Lifetime Budget Constraint
• Then, to simplify, we say consumption is a function of a
household’s lifetime wealth

𝑐′
𝑐+ = 𝑤𝑒
1+𝑟
Simplified Lifetime Budget Constraint:
Slope-Intercept

𝑐 ′ = 𝑤𝑒(1 + 𝑟) − 𝑐(1 + 𝑟)

• If c′ = 0, then c = 𝑤𝑒
• If c = 0, then c ′ = 𝑤𝑒 1 + 𝑟
Figure 9.1 Household’s Lifetime Budget
Constraint

E
Figure 9.1 Household’s Lifetime Budget
Constraint
Figure 9.2 A Household’s Indifference
Curves
Household Optimization - Lending
Household Optimization - Borrowing
End of Class 1

STOP
Increase in the Market Real Interest Rate
• The change of interest rates tilts the budget constraint
and has two effects
• Def – Substitution effect
An increase in the market real interest rate decreases the
relative price of future consumption goods
• Def – Income effect
When interest rates rise, the present value of future
income goes down
 Lifetime Wealth as a function of
the interest rate

• The formula for lifetime wealth is

𝑦 ′ − 𝑡′
𝑤𝑒 = 𝑦 − 𝑡 +
1+𝑟

• When r goes up, lifetime wealth ________

• When r goes down, lifetime wealth ________
Visualization– How an Increase in the
Real Interest Rate affects the BC
𝑤𝑒2 (1 + 𝑟2 )

− 1 + 𝑟2

𝑤𝑒1 (1 + 𝑟1 )

𝑦′ − 𝑡 ′

𝐸
− 1 + 𝑟1

𝑤𝑒2 𝑤𝑒1
𝑦−𝑡
Visualization– How an Increase in the
Real Interest Rate Affects a Lender

Only consider
Substitution Effects
----
Future consumption is
𝐷
relatively cheaper
𝑤𝑒1 (1 + 𝑟1 )

𝐴
𝑦′ − 𝑡′

𝑤𝑒2 𝑤𝑒1
𝑦−𝑡
Visualization– How an Increase in the Real
Interest Rate Affects a Lender
Combines both
𝑤𝑒2 (1 + 𝑟2 ) Income &
Substitution Effects

𝐷 𝐵
𝑤𝑒1 (1 + 𝑟1 )

𝑦′ − 𝑡 ′ 𝐴

𝑤𝑒2 𝑤𝑒1
𝑦−𝑡
Visualization– How an Increase in the
Real Interest Rate Affects a Borrower
𝑤𝑒2 (1 + 𝑟2 )

𝑤𝑒1 (1 + 𝑟1 )

𝑦′ − 𝑡 ′
𝐸

𝑤𝑒2 𝑤𝑒1
𝑦−𝑡
Visualization– How an Increase in the Real
Interest Rate Affects a Borrower?
𝑤𝑒2 (1 + 𝑟2 ) Only consider
Substitution Effects
----
Future consumption is
relatively cheaper
𝑤𝑒1 (1 + 𝑟1 ) 𝐷

𝑦′ − 𝑡 ′
𝐸

𝑤𝑒2 𝑤𝑒1
𝑦−𝑡
Visualization– How an Increase in the Real
Interest Rate Affects a Borrower?
𝑤𝑒2 (1 + 𝑟2 )

Combines both
Income &
Substitution Effects
𝑤𝑒1 (1 + 𝑟1 )

𝑦′ − 𝑡 ′
𝐸

𝐵
𝐴

𝑤𝑒2 𝑤𝑒1
𝑦−𝑡
Summary –
Increase in the Market Real Interest Rate
• The effect of interest rates changes based on whether
the household is a borrower or lender

Effect on Lender Effect on Borrower

• Lender receives higher • Borrowers pay more on
return on investment debt, decreasing money
for consumption
• They spend that money
on more consumption • They spend less on
tomorrow (c’) and a little consumption today (c) and
more today (c) little more tomorrow (c’)
Permanent
Income
Hypothesis
Permanent Income Hypothesis
• The interest change tilted the budget constraint
• An increase in income will shift the budget constraint
outward, and we consider the effect on consumption
• We distinguish between a “temporary” increase in a
single period (current or future) versus a “permanent”
increase in both periods

• Our goal is to understand how the optimal choice of

(c, c’) will change in both cases
Permanent Income Hypothesis
• A household will tend to save most of a temporary
increase in income in the current period
• A household will consume most of the permanent
increase in income.
• The difference between the effects of temporary and
permanent changes in income is a central prediction of
Milton Friedman’s Permanent Income Hypothesis
How a Temporary Change of
Income Affects the Budget
• The baseline budget constraint was

𝑐′ 𝑦′ − 𝑡′
𝑐+ =𝑦−𝑡+
1+𝑟 1+𝑟
• The budget constraint for a temporary increase in current period

𝑐′ 𝑦 ′ − 𝑡′
𝑐+ = 𝑦2 − 𝑡2 +
1+𝑟 1+𝑟

𝑦 − 𝑡 < 𝑦2 − 𝑡2

• For example, you receive $150 instead of $100 dollars today

Visualization– Affect of an Increase in
Current Period Income on the Budget

𝑤𝑒2 (1 + 𝑟)
Newly Affordable
Combinations of (c,c’)
𝑤𝑒(1 + 𝑟)

𝐸1 𝐸2
𝑦′ − 𝑡′

𝑦−𝑡 𝑦2 − 𝑡2 𝑤𝑒 𝑤𝑒2
Visualization– Affect of an Increase in
Current Period Income for a Lender

𝑤𝑒2 (1 + 𝑟)

𝑤𝑒(1 + 𝑟)

𝐴 𝐸2
𝑦′ − 𝑡′
𝐸1

𝑦−𝑡 𝑦2 − 𝑡2 𝑤𝑒 𝑤𝑒2
Visualization– Affect of an Increase in Current
Period Income for a Borrower (#1)

𝑤𝑒2 (1 + 𝑟)

𝑤𝑒1 (1 + 𝑟)

𝐸2
𝑦1′ − 𝑡1 ′
𝐸1

𝐴 𝐵

𝑦1 − 𝑡1 𝑦2 − 𝑡2 𝑤𝑒1 𝑤𝑒2
Visualization– Affect of an Increase in Current
Period Income for a Borrower (#2)

𝑤𝑒2 (1 + 𝑟)

𝑤𝑒1 (1 + 𝑟)

𝐶
𝐸2
𝑦1′ − 𝑡1 ′
𝐸1

𝑦1 − 𝑡1 𝑦2 − 𝑡2 𝑤𝑒1 𝑤𝑒2
Summary –
Increase in Temporary Income
• The effect of a temporary increase in income

Effect on Lender Effect on Borrower

• Lender consumers more • Borrowers consume more
today and tomorrow today and tomorrow
• They were already • BUT – they might actually
lending, so more income have enough income to
means more lending stop borrowing and
become lenders
End of Class 2

STOP
Permanent Income Hypothesis
• When income increased in the second period as a result
of the interest rate change, lenders wanted to consume
more in both periods but borrowers consumed less
❑ That was a result of “temporary” change in income
❑ This will stay the same for all temporary changes

• We will then consider how the choice of (c, c’) will

change when income rises in both periods
❑ This is called a “permanent” change in income
Summary –
Increase in Temporary Income
• The effect of a temporary increase in income

Effect on Lender Effect on Borrower

• Lender consumers more • Borrowers consume more
today and tomorrow today and tomorrow
• They were already • BUT – they might actually
lending, so more income have enough income to
means more lending stop borrowing and
become lenders
How a Permanent Change of
Income Affects the Budget
• The baseline budget constraint was
𝑐′
𝑐+ = 𝑤𝑒
1+𝑟

• The budget constraint for a permanent increase

𝑐′
𝑐+ = 𝑤𝑒
1+𝑟

𝑤𝑒 < 𝑤𝑒2
Visualization– How a Permanent
Change of Income Affects the Budget
𝑤𝑒2 (1 + 𝑟)

Newly Affordable
𝑤𝑒1 (1 + 𝑟) Combinations of (c,c’)

𝐸2
𝑦2′ − 𝑡2′
𝐸1
𝑦1′ − 𝑡1 ′

𝑤𝑒1 𝑤𝑒2
𝑦1 − 𝑡1 𝑦2 − 𝑡2
Visualization– Affect of Permanent
Income Growth for a Lender
𝑤𝑒2 (1 + 𝑟)

𝑤𝑒1 (1 + 𝑟)

𝑦2′ − 𝑡2′ 𝐵
𝐸2
𝐴
𝑦1′ − 𝑡1 ′
𝐸1

𝑤𝑒1 𝑤𝑒2
𝑦1 − 𝑡1 𝑦2 − 𝑡2 𝑤𝑒𝑡𝑒𝑚𝑝
The Euler Equation
• Households will choose an optimal ratio of
consumption between the current and future periods
• We call the optimal relationship between consumption
today and consumption tomorrow the Euler Equation

Log utility: 𝑐′ = 𝛽(1 + 𝑟)𝑐

1>𝛽>0

• The parameter 𝛽 is called the discount rate

Visualization –
The Euler Equation with Log Utility
𝐶 ′ = 𝛽1 1 + 𝑟 𝐶
𝑤𝑒(1 + 𝑟)

𝐴1
𝛽1 1 + 𝑟
𝑤𝑒
1 + 𝛽1

𝐶 ′ = 𝛽2 1 + 𝑟 𝐶
𝐴2

𝛽2 < 𝛽1

𝑤𝑒 𝑤𝑒
1 + 𝛽1
Example –
Solving Household Problem
Assign men t
• Suppose a household had log preferences,
lifetime income of $120k, a discount factor of
0.9, and the interest rate is 15%.
1. Solve for consumption today and tomorrow

STOP
Example –
Solving Household Problem
•Assign men
Suppose t
a household had log preferences,
lifetime income of $120k, a discount factor of
0.9, and the interest rate is 15%.
• Plug those details into the Euler Equation
𝑐′ = 𝛽 1 + r c

→ 𝑐′ = 0.9 1 + 0.15 c

→ 𝑐′ = 1.035c
Example –
Solving Household Problem
•Assign men
Plug that t rate and income into the
interest
household’s budget constraint
1.035c
𝑐+ = 120
1 + 0.15
• Then, substitute out c’ using the Euler equation
1.035c
𝑐+ = 120
1.15
1.035
→ c (1 + ) = 120
1.15
Example –
Solving Household Problem
•Assign men
Simplify andt solve for c’
1.035
c (1 + ) = 120
1.15
c(1.9) = 120
c = 63.15
• Plug back into the Euler equation to solve c’

𝑐′ = 1.035(63.15)
𝑐′ = 65.36
Government
Government Budget Constraints
• The government’s current-period budget constraint:

𝐺 = 𝑇 + 𝐵

• The government’s future-period budget constraint:

𝐺 ′ + 𝐵(1 + 𝑟) = 𝑇 ′
Government Budget Constraint
• The government’s present-value budget constraint:

• For given amount of spending, taxes must adjust to

guarantee this holds
Equilibrium
The Economy
• Our economy consists of
1. N-many households that choose consumption in the
current and future period (c, c’) and saving (s)
2. A government that chooses spending and benefits
(G,B)
3. An interest rate, r

• All of these pieces have to fit together

Aggregate Consumption & Saving
• If there are N representative households, then
Aggregate Consumption C and Aggregate Savings S p
are defined as
𝐶 = cN

S p = sN
Credit Market Equilibrium Condition
• Total private savings is equal to the quantity of government
bonds issued in the current period.

Sp = B

• Credit market equilibrium implies that the income-expenditure

identity holds. By definition,
Sp = B

𝑌 − 𝐶 − T = G −T

𝑌 =C+ G
Equilibrium Equations
• The equilibrium equations are given by

1. Household Euler Equation

𝐶′ 𝑌 ′ −𝑇 ′
2. 𝐶 + 1+𝑟
=𝑌−𝑇+
1+𝑟

𝐺′ 𝑇′
3. 𝐺 + 1+𝑟
=𝑇+
1+𝑟

4. 𝑌 = 𝐶 + 𝐺
End of Class 3

STOP
Equilibrium of a Saving Economy
• Our economy consists of
1. N-many households that choose consumption in the
current and future period (c, c’) and saving (s)
2. A government that chooses spending and benefits
(G,B)
3. An interest rate, r

• In equilibrium, these pieces all fit together

Equilibrium Equations
• The equilibrium equations are given by

1. Household Euler Equation

𝐶′ 𝑌 ′ −𝑇 ′
2. 𝐶 + 1+𝑟
=𝑌−𝑇+
1+𝑟

𝐺′ 𝑇′
3. 𝐺 + 1+𝑟
=𝑇+
1+𝑟

4. 𝑌 = 𝐶 + 𝐺
Putting Idea into Practice
Solve for aggregate
Assign men t consumption in both periods (C, C’),
the interest rate r, and taxes T’ using the following info
• Suppose households have combined incomes of 200
and 250 in the current and future periods, respectively
• Households Euler Equation is C′ = 0.95 1 + 𝑟 𝐶.
• Government expenditures are 50 and 60 in the current
and future periods.

STOP
Ex – Solve an Equilibrium
• Filling in the details from the previous slide, the
equilibrium equations are given by

1. 𝐶 ′ = 0.95 1 + 𝑟 𝐶

𝐶′ 250−𝑇 ′
2. 𝐶 + 1+𝑟
= 200 +
1+𝑟

60 𝑇′
3. 50 +
1+𝑟
=
1+𝑟

4. 200 = 𝐶 + 50
Ex – Solve an Equilibrium
• First, we see from equation (4) that 𝐶 = 20 − 5 = 15
• Then, we solve substitute future taxes (3) into the
consumers budget equation (2) to solve 𝐶 ′
𝐶′ 250 𝑇′
150 + = 200 + −
1+𝑟 1+𝑟 1+𝑟

𝐶′ 250 60
150 + = 200 + − 50 −
1+𝑟 1+𝑟 1+𝑟

𝐶′ 190
150 + = 150 +
1+𝑟 1+𝑟

𝐶 ′ = 190
Ex – Solve an Equilibrium
• We use the Euler Equation (1) last to solve r
𝐶 ′ = 0.95 1 + 𝑟 𝐶

19 = 0.95 1 + 𝑟 15

19
𝑟= − 1 = 0. 33
0.95 ∗ 15

• The interest rate implies that future taxes T’ are

𝑇 ′ = 5 ∗ 1. 33 + 6 = 12. 66
Comparative
Statics
What if? Analysis
Government Taxes and Spending

• What if the government collected taxes tomorrow and

not today?
• Suppose that the Government wants to postpone taxes
because it wants to stimulate the economy
• It will have to pay for spending eventually, but for now,
what happens to interest rates and consumption?
Ricardian Equivalence (1 of 3)
• David Ricardo, a famous British economist who made
a fortune based on his insights, asked this question way
back in the late 1700/early 1800’s
• Ricardian Equivalence Theorem
The timing of government taxes does not influence
real economic outcomes
Ricardian Equivalence (2 of 3)
• The Household’s lifetime tax burden is equal to the Household’s
share of the present value of gov. spending
• Timing of taxation does not matter for the Household.
• Key equation:
Ricardian Equivalence (3 of 3)
• Then, substitute in the Household’s budget constraint – taxes do
not matter in equilibrium for the Household’s lifetime wealth,
just the present value of government spending.
Figure 9.16 Ricardian Equivalence with a
Cut in Current Taxes for a Borrower
Ricardian Equivalence and Credit
Market Equilibrium
Why Might Ricardian Equivalence Fail
in Practice?
1. Redistributional effects of taxes: tax changes affect
the wealth of different Households differently.
2. Intergenerational redistribution: debt issued by the
government today is paid off by future generations.
3. Taxes are not lump sum; they cause distortions.
4. Credit market frictions
End of Class 4

STOP
Putting Idea into Practice
Assign men t
1. Homework: Use the Ricardian Equivalency
handout to see whether the timing of taxes change
economic outcomes

STOP
 Ricardian Equivalency Example
Solve for aggregate consumption in both periods (C, C’), the
interest rate r, and current taxes T using the following info
• Suppose households have combined incomes of 200 and
250 in the current and future periods, respectively

• Households Euler Equation is C′ = 0.95 1 + 𝑟 𝐶.

• Government expenditures are 50 (G) and 60 (G’) in the

current and future periods.
Ex – Ricardian Equivalency
• The equilibrium equations are given by
1. 𝐶 ′ = 0.95 1 + 𝑟 𝐶
𝐶′ 25
2. 𝐶 + 1+𝑟
= 20 − 𝑇 +
1+𝑟
6
3. 5 +
1+𝑟
=𝑇

4. 20 = 𝐶 + 5
Ex – Ricardian Equivalency
• First, we see from equation (4) that 𝐶 = 20 − 5 = 15
• Then, we solve substitute current taxes (3) into the
consumers budget equation (2)
𝐶′ 25
15 + = 20 − 𝑇 +
1+𝑟 1+𝑟
𝐶′ 6 25
15 + = 20 − 5 − +
1+𝑟 1+𝑟 1+𝑟
𝐶′ 19
15 + = 15 +
1+𝑟 1+𝑟

𝐶 ′ = 19
Ex – Ricardian Equivalency
• We use the unused Euler Equation last
𝐶 ′ = 0.95 1 + 𝑟 𝐶

19 = 0.95 1 + 𝑟 15

19
𝑟= − 1 = 0. 33
0.95 ∗ 15

• That implies that current taxes T are

6
𝑇 =5+ = 9.5
1. 33