Econ 3010

Topics in Macroeconomics
Semester 1, 2006
Marked Problem Set 2
Consumption-Savings Decision and
Permanent Income Hypothesis

Please hand in your solutions before 4pm on Monday, November 17th.

All problem sets must be handed in to the designated box in building 58, 3rd floor,
close to the support office. The problems herein will be discussed in tutorials in
week 7. No late submissions can therefore be accepted.

SOLUTIONS

Question 1: Consumption and savings in two periods (35 points)

Consider the following two-period economy. A two-period lived agent wants to max-
imize the value of utility defined over consumption in two periods, c1 and c2 , respec-
tively. Utility is represented by u(c1 ) + u(c2), with < 1 and u(c) = ln c. The
(exogenous) endowments of income in each period are y1 and y2 respectively. The
agent can freely borrow and lend in financial markets in the first period at the interest
rate r.

(a) Write the intertemporal budget constraint of the consumer. Solve the con-
sumers problem and find an expression for the level of savings as a function of
incomes and the interest rate.

Answer: Intertemporal budget constraint:

c2 y2
c1 + = y1 +
1+r 1+r
To solve the consumers problem, reduce it to an unconstrained problem in c1
only. Take first derivatives and set to zero.
max u(c1 ) + u ((1 + r)(y1 c1 ) + y2 )
c1

To get the Euler equation given by

u (c1 ) = (1 + r)u (c2 )
c2
c1 =
(1 + r)
with c2 = (1 + r)(y1 c1 ) + y2
 Savings, a2 = y1 c1 are given by
y1 y2 /(1 + r)
a2 =
1+

(b) Suppose income in both periods is the same, y1 = y2 . Under what conditions
on the interest rate, r, and the rate of time preference, = 1

, is the consumer
going to borrow; under what condition is he/she going to lend? Explain.

Answer:
If r > , the consumer lends because he/she is more patient than the market.
If r < , the consumer borrows because he/she is less patient than the market.

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(c) Suppose = 1+r . Under what conditions on income in period 1, y1 , and income
in period 2, y2 , is the consumer going to borrow; under what condition is he/she
going to lend? Explain.

Answer:
In this case, the consumer wants to equalize consumption in the two periods.
Hence, he will borrow if y1 < y2 and lend if y1 > y2 .

Question 2: Consumption and savings in the two-period model (30 points)

Consider the following two-period economy. A two-period lived agent wants to max-
imize the value of utility defined over consumption in two periods, c1 and c2 , respec-
tively. Utility is represented by u(c1 ) + u(c2), with < 1 and u(c) = ln c. The
(exogenous) endowments of income in each period are y1 and y2 respectively. The
agent can freely borrow and lend in financial markets in the first period at the interest
rate r. Assume there is a government that taxes interest income in period 2 at rate
.
(a.) Write the intertemporal budget constraint of the consumer. Solve the con-
sumers problem and find an expression for the level of savings as a function of
income (y1 , y2 ) and taxes .
Answer:
c2 y2
c1 + = y1 +
1 + r(1 ) 1 + r(1 )

To solve the consumers problem, reduce it to an unconstrained problem in c1

only. Take first derivatives and set to zero.
max u(c1 ) + u ((1 + r(1 ))(y1 c1 ) + y2 )
c1

2
 To get the Euler equation given by

u (c1 ) = (1 + r(1 ))u (c2 )

c2
c1 =
(1 + r(1 ))
with c2 = (1 + r(1 ))(y1 c1 ) + y2
Thus ((1 + r(1 )))c1 = (1 + r(1 ))(y1 c1 ) + y2
(1 + )(1 + r(1 ))c1 = (1 + r(1 ))y1 + y2
(1 + r(1 ))y1 + y2
c1 =
(1 + )(1 + r(1 ))
Savings, a2 = y1 c1 are given by
y1 y2
a2 =
1 + (1 + )(1 + r(1 ))

(b.) Explain the effect on saving of a rise in , on (1) initial lenders and (2) initial
borrowers.
Answer: This question was poorly set up. I will therefore be lenient in marking.
Holding the interest rate fixed:
For lenders, an increase in decreases the effective interest rate and hence
decreases the relative price of consumption in period 1 relative to consumption
in period 2. In general, the substitution effect tends to decrease savings. The
decrease in lenders wealth, however, tends to increase savings. Due to the
special assumption of log preferences, savings always decrease in this case.
For borrowers, in principle, nothing changes: they still have to pay all the
interest to lenders, who will then be taxed. hence, there would be no effect on
borrowers.
General equilibrium effects, adjustments in r:
Above we have held the interest rate constant. Another effect, not addressed
yet, is that the tax above decreases the supply of loans (for a given interest
rate, people are willing to lend less because the effective interest rate is lower).
This tends to increase the interest rate and decrease the amount of lending (and
borrowing) in general equilibrium.

Question 3: Permanent income hypothesis (35 points)

Consider the following intertemporal choice problem. An agent wants to maximize

the value of utility defined on consumption, ct , over periods t = 1, ..., T :
PT t
t=1 (1/(1 + )) u(ct ),

3
with > 0 and u(c) = ln c. The (exogenous) endowments of income in each period
are denoted as yt . The agent can freely borrow and lend in financial markets at the
one-period interest rate r, but debt at the end of period T cannot be positive.

(a) Derive the Euler equation (you may use the case T = 2).
Answer: The problem of optimal intertemporal choice under certainty can be
solved by setting up the following maximization programme:
For T = 2, given yt , yt+1 and r, the consumer solves
1
max u(ct ) + u(ct+1 )
ct ,ct+1 1+
1 1
s.t. ct + ct+1 = yt + yt+1
1+r 1+r
This problem can be solved by directly substituting the intertemporal budget
constraint for
ct+1 = (yt ct )(1 + r) + yt+1
into the utility function which actually reduces the maximisation problem to a
non-constrained maximisation with respect to the single variable ct .
1
max u(ct ) + u((yt ct )(1 + r) + yt+1 )
ct 1+
Computing the first derivative of this expression and equating it to 0 leads to
the Euler equation
1+r
u (ct ) = u (ct+1 )
1+
Now use the explicit form of the utility function and you are done. Since
u (c) = 1/c, the Euler equation becomes
1 1+r 1
= or
ct 1 + ct+1
ct+1 1+r
=
ct 1+

(b) Assume r = = 0. Derive an expression for consumption as a function of

current and future income.

Answer: In this case, the Euler equation becomes

ct+1
= 1 or
ct
ct+1 = ct = c

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 We will use the Euler equation in the budget constraint for the general case.
T  T 
X 1 t1 X 1 t1
ct =a1 + yt
t=1
1+r t=1
1+r
T
X T
X
ct =a1 + yt
t=1 t=1
T
X
T c =a1 + yt
t=1

Thus in every period (assuming zero initial assets), we have

PT
t=1 yt
ct = = y
T
where y is average income.

(c) Explain why this model is consistent with the life-cycle/permanent-income hy-
pothesis.

Answer: The permanent income hypothesis postulates that

Transitory changes in disposable income have a minor impact on current

consumption (consumption is smoother than income)
Permanent changes in disposable income have a large effect on consumption

This holds in this model since temporary changes in income change average
income, y, only slightly. Therefore they change consumption only slightly. Per-
manent changes in income change average income by the same amount and
therefore change consumption by that amount in every subsequent period.