BorrowingConstraints

Sofarwehaveassumedthatconsumerscanborrowandlendatthe
same interestrate.However,notallconsumersaregodcreditrisks.
Consumerswithlittleornowealthmayfindthattheycannot get
loans.
Iftheconsumerhasno wealthandcannot borrow,he/shecannot
spendmorethanhe/sheearns.Aconstraintonborrowingcan
,indicatingconsumptiontodaymust
thereforebewrittenas:
beless thanorequal toincometoday.Thisadditionalconstrainton
theconsumeriscalledaborrowing constraint (oraliquidity
constraint).

BorrowingConstraints
Toseetheimplicationforconsumptionchoices,letsfirstlookatthe
effectofaborrowingconstraintontheconsumersintertemporal
budgetline.
Intertemporalbudgetlinewithaborrowingconstraint
Supposethatwithoutaborrowingconstraint,theintertemporal
budgetlineisastraightlinewithaslopeof 1
.Witha
borrowingconstraint,theconsumercannot spendmore thanhis/her
currentincome.Thatis, cannot riseabove .Atpoint ,where

,theintertemporalbudgetlinebecomesvertical.

Figure 3B.6:ABorrowingConstraint

BorrowingConstraints
Q:Howwillaborrowingconstraintchangetheconsumers
consumptionchoices?
A:Weconsidertwocases.
Case1:Borrowingconstraintisnotbinding
Sincetheconsumersoptimallevelofconsumptionisless than ,
he/shehasno needtoborrow.Asaresult,he/shewillnot be
constrainedbyhis/herinabilitytoborrow,andwecansaythatthe
constraintisnot binding.

Figure 3B.7:OptimizationwithaBorrowingConstraint

BorrowingConstraints
Case2:Borrowingconstraintisbinding
Theconsumerwouldliketoborrowandchoosepoint .Butbecause
borrowingisnot allowed,thebestavailablechoiceispoint .When
theborrowingisbinding,firstperiodconsumptionequalsfirstperiod
and
.Theslopeoftheindifference
income,so
,sothat
.
curveatpoint issteeper than 1

Figure 3B.8:OptimizationwithaBorrowingConstraint

Example (3B.2):ContinuationofExample (3B.1)

Thecurvelabeled
representsJennifersinitialintertemporal
budgetconstraintorline.SupposethatJennifersincomeinperiod1
risesto12.78,while remainsequalto12.
a)WritedownJennifersnewintertemporal budgetlineorconstraint.
Graphthisnewintertemporal budgetconstraintandlabelit
(Ans.)
.

.
.

.
.

Example (3B.2):ContinuationofExample (3B.1)

b)Findthenewoptimalconsumptionof and ,locatethispointonthe
graphinpart(a),andlabelitpoint .Findherutilityatthenewoptimum.
(Ans.)
SetMRS equaltotheslopeofthebudgetline:

.
.
By(1)and(2),
15.59 and
10.39 and

10.39 15.59 162.

Consumptionduringeachperiodhasincreased.Thechangesin
consumptionbetweenpoint andpoint aretheresultofthe income
effect.

Example (3B.2):ContinuationofExample (3B.1)

c)Finally,supposethatJennifersincomeineachperiodreturnstoits
formerlevelof12andthattherealinterestraterisesto100percent,or
1.0.WritedownJennifersnewintertemporal budgetlineorconstraint.
Graphthisnewintertemporal budgetconstraintandlabelit
.
(Ans.)

d)Findtheoptimalconsumptionof and ,locatethispointonthe

graphinpart(a),andlabelitpoint .Findherutilityattheoptimum.
(Ans.)
SetMRS equaltotheslopeofthebudgetline:

Example (3B.2):ContinuationofExample (3B.1)

18 and
9 and

9 18 162.
By(1)and(2),
Thechangeinconsumptionfrompoint topoint reflectsthe
substitutioneffect.Jenniferrespondstothischangeintherelative
priceofconsumptioninthetwoperiodsbydecreasing and
increasing .Sincethesubstitutioneffectoutweighstheincome
effect inthiscase, obviouslyfallswhile increases.

FrancoModiglianiandtheLifeCycleHypothesis
Inaseriesofpaperswritteninthe1950s,FrancoModigliani(thenat
CarnegieMellon,lateratMIT)andhiscollaboratorsAlbertAndoand
RichardBrumberg extendedFishersintertemporalchoicemodelof
consumerbehaviortomanyperiods,developingthelifecycle
hypothesis.
Goals:Solvetheconsumptionpuzzle thatis,toexplain
theapparentlyconflictingpiecesofevidencethatcametolightwhen
Keynessconsumptionfunctionwasconfrontedwiththedata.

FrancoModiglianiandtheLifeCycleHypothesis
Modiglianiemphasizedthatformostpeople,incomechanges
systematicallyoveralifetime,mostnotablywhenincomedeclinesat
retirement.Asthetheorysuggested,peopletendtosmooth
consumptionovertheirlifecycle bymovingtheirincomefromthose
timesinlifewhenincomeishigh tothosetimeswhenitislow.
Thisinterpretationofconsumerbehaviorformedthebasisfor
thelifecyclehypothesis.

LifeCycleConsumptionFunction
Consideraconsumerwhostartsearninganincomeattime
0,
thestartingageofadulthood(say,age20),andworksuntilhe/she
retires yearslater(say,45=age65 age20).Theconsumerexpects
tolivefor additionalyearsafterhe/shebecomesanadult
(say,60=age80 age20).
Q:Whatlevelofconsumptionwilltheconsumerchooseifhe/she
wantstomaintainasmoothlevelofconsumptionoveralifetime?

LifeCycleConsumptionFunction
Assumption:Forsimplicity,theinterestrateiszero,sothatallfuture
incomeandconsumptionstreamshavethesame present
(discounted)valueascurrent incomeorconsumption.
Untiltimeperiod ,theconsumerearnsayearlysalaryof ,but
whenhe/sheretiresattime ,his/hersalaryfallstozero.
Atanygivenpointintime ,theconsumerslifetimeresourcesare
and(ii)
,
madeupoftwocomponents:(i)wealth
timesthesalary.
thenumberofyearshe/shelefttowork
.
Theconsumerstotallifetimeresourcesattime is:

LifeCycleConsumptionFunction
Sincetheconsumerwantstosmoothhis/herconsumptionandenjoy
thesame consumptionthroughouttherestofhis/herlife,he/shewill
dividehis/herlifetimeresourcesby
,thenumberofyears
he/shelefttolive,todetermineeachyearsconsumption:

3 .5 :

Wecanrewritethisconsumptionfunctionbyseparatingoutthe
wealthandincometermsasfollows:

3 .6 :

where

and

LifeCycleConsumptionFunction
Theparameter isthemarginalpropensitytoconsumeroutof
wealth andtheparameter isthemarginalpropensitytoconsume
outofincome.
Conclusion:Changesinconsumptionaredrivenbychangesinincome
andwealth.

Figure 3B.6:TheLifeCycleConsumptionFunction

Noticethat theinterceptoftheconsumptionfunction
fixed value,butinsteaddependsonthelevelofwealth.

isnot a

Example (3B.3):ConsumptionFunction
SupposeCarmenisprettyyoung,say25yearsold,sothat
5,and
alsosupposethatshewillretireat65andhasalifeexpectancyof80.
a)WritedownCarmensconsumptionfunction.
(Ans.)

and

.
.
WhenCarmenisyoung,shewillhaveaMPCof2centsoutofevery
dollarofwealthand73centsoutofeverydollarofincome.

Example (3B.3):ConsumptionFunction
b)WritedownCarmensconsumptionfunctionwhensheis60years
old.
(Ans.)

,
,

.
.
CarmennowhasaMPCof5centsoutofeverydollarofwealthand
25centsoutofeverydollarofincome.

Example (3B.3):ConsumptionFunction
c)DrawaconclusionfromCarmenslifecycleconsumptionfunction.
(Ans.)
Asconsumersgetolder,theMPCoutofwealthrises,whiletheMPC
outofincomefalls.
Intuitivelyspeaking,asconsumersgetolder,theyhavefeweryearsto
liveandsowillconsumeahigher fractionoftheirwealtheachyear,
whiletheirannualincomewillcontinueforfeweryears,sothe
increaseintheirlifetimeresourceswillbelower relativetotheir
annualincomeandtheywillspendless ofit.

SavingandWealthOvertheLifeCycle
Accordingtothelifecycleconsumptionfunction,theaverage
propensitytoconsume(APC)is:

3 .7 :

Becausewealthdoesnotvaryproportionatelywithincome from
persontopersonorfromyeartoyear,weshouldfindthathigh
incomecorrespondstoalow APCwhenlookingatdataacross
individualsorovershort periodsoftime.Butoverlong periodsof
time,wealthandincomegrowtogether,resultinginaconstant ratio
andthusaconstant APC.

SavingandWealthOvertheLifeCycle
Considerhowconsumptionfunctionchangesovertime.Keynes
positedthattheAPCfalls asincomerises.ButKeynessconjecture
holdsonlyintheshort runwhenwealthisconstant.Inthelong run,
aswealthrises,theconsumptionfunctionshiftsupward.Thisupward
shiftpreventstheAPCfromfalling asincomeincreases.
Inthisway,Modiglianiresolvedtheconsumptionpuzzleposedby
KeynessconjectureandbySimonKuznetssdata.

Figure 3B.7:HowChangesinWealthShifttheConsumption
Function

SavingandWealthOvertheLifeCycle
Thelifecyclehypothesishelpsseehowsavingandwealthevolveover
peopleslifetimes.
Forsimplicity,weassumethattherearenocapitalgainsorlosseson
theconsumerswealth,sothatthechangeinwealthforanyyearis
equaltotheamounthe/shehassaved:
.
Sincetheconsumerwantstosmoothconsumption,he/shewillwant
his/herconsumptiontobethesame everyperiodat :
3 .8
.

Example (3B.5):Continuation ofExample(3B.3)

IfCarmenhasasalaryof$50,000,howmuchwillsheconsumeevery
year?
(Ans.)

everyyear.
Nowletslookatwhathappenstosavingandwealthovertime.
Forthefirst45yearsofherworkinglife,
.
.
.
$
$ ,
.Everyyearhersaving
(wealth)isincreasingby$12,500untilsheretiresatageof65.

Figure3B.8:ConsumptionandSavingovertheLifeCycle

Figure 3B.9:WealthovertheLifeCycle

SavingandWealthOvertheLifeCycle
Wealthincreaseslinearly withaslopeof .
$ ,
.
Atretirement,Carmenstotalwealthhasaccumulatedto
$ ,
$
,
.Afterretirement,shehasnegative saving
equaltoherconsumption of .
or$37,500.Attheendofher
lifeshehasexhausted allofhersavings.
Thelifecyclehypothesisimpliesthataspeoplegrowolderbefore
retirement,theirwealthgrows;afterretirement,theirwealth
declines.Thisresultexplainsanimportantfactfoundinthedata:
older peopletendtohavehigher holdingsofassets(stocks,bonds,
andhousing)thandoyounger people.