INTERTEMPORAL MACRO 'Macroeconomics' Carlin & Soskice 2006 ...

INTERTEMPORAL MACRO ‘Macroeconomics’ Carlin & Soskice 2006 CHAPTER 7 • Consumption o Introducing intertemporal smoothing in consumption behaviour  Consumer expenditure makes up about one half of total final expenditure on goods and services in the economy  Keynesian consumption function: • • Constant autonomous consumption, means we expect 2 things: o Aggregate consumption is volatile because any change in current income is reflected in a change in consumption in the Keynesian consumption function o Should be no difference between effect on consumption of transitory changes in personal income and permanent changes. • These predictions seem too extreme. Why? o Consumer preferences o Ability of people to look ahead and form a view about their future income prospects o Ability of people to borrow • Alternative views take the above into account e.g. PIH/LCH o ‘suggested that consumption was a function not of measured income as in the Keynesian consumption function but of average or expected income or of the value of lifetime resources.’ o ‘the law student will have a much clearer idea of his earnings over the years ahead and the law student is more likely to be able to borrow to sustain higher current consumption.’ • PIH and LCH o Both emphasise firstly the use of saving and dissaving to smooth consumption and secondly the unresponsiveness of consumption to income changes that were perceived to be transitory. o LCH model begins from insight that income will follow a reasonably predictable pattern over most people’s lives – borrow when they’re young, save when middle aged for retirement. o PIH model – what counts for level of consumption is not the income we earn at any one moment, but, rather the average income we expect to be earning in any time period.  i.e. it is the average expected income that truly determines the resources we have available for consumption – average income is permanent income  e.g. recession – if income falls PIH would predict no change in consumption unless people’s expectations of ongoing future income have fallen as well o LCH produces qualitatively similar results to the PIH o With standard Keynesian consumption function, a deficit funded increase in G has a bigger effect on output than does the same increase in spending financed by higher T  PIH suggests this might not occur  If government sells bonds to finance G, bonds will have to be paid pack in the future (increase taxes) -> permanent income falls where taxes decreased today or in the future – Ricardian equivalence • If Ricardian equivalence holds, then the remedy for a recession that government should cut taxes will

not work – private savings will rise to exactly match the fall in government savings  Ricardian equivalence in IS: • o Consumer preferences, income and interest rates  Assume households live for two periods only and enter and leave the world with no wealth  FIGURE 7.1 (a)

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IC’s convex to origin – reflects the preference for smooth consumption over the lifetime i.e. equally happy at C and D on U 1 (high consumption in one period and low in another), but at E the utility is higher on U 2 • Labour income in each period is y 1 and y 2 and consumption in each period is c1 and c2, real IR is r. • If wealth is zero at start and finish, value today of lifetime consumption must = value today of lifetime income • Intertemporal budget constraint: o o Present value of lifetime consumption = present value of lifetime income FIGURE 7.1 (c) see above • • •

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Slope of budget constraint is –(1+r) Maximises utility at F FIGURE 7.2 (a) shows implication of a rise in income in the first period only. o Outward shift of budget constraint, IR not changed so budget constraint moves parallel. o If change in income is in the second period but not the first, but is known about in the first period, same effects. PIH – timing does not matter. FIGURE 7.2 (b)