Académique Documents
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Culture Documents
Fall 2016
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Microeconomics of Macro
I We now move from the long run (decades and longer) to the
medium run (several years) and short run (months up to
several years)
I In long run, we did not explicitly model most economic
decision-making just assumed rules (e.g. consume a
constant fraction of income)
I Building blocks of the remainder of the course are decision
rules of optimizing agents and a concept of equilibrium
I Will be studying optimal decision rules first
I Framework is dynamic but only two periods (t, the present,
and t + 1, the future)
I Consider representative agents: one household and one firm
I Unrealistic but useful abstraction and can be motivated in
world with heterogeneity through insurance markets
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Consumption
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Basics
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Budget Constraints
I Two flow budget constraints in each period:
Ct + St Yt
Ct +1 + St +1 St Yt +1 + rt St
Ct + 1 Yt +1
Ct + = Yt +
1 + rt 1 + rt
u (Ct ) = ln Ct
1
u 0 ( Ct ) = >0
Ct
u 00 (Ct ) = Ct2 < 0
U = u (Ct ) + u (Ct +1 )
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Household Problem
s.t.
Ct + 1 Yt +1
Ct + = Yt +
1 + rt 1 + rt
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Euler Equation
u 0 (Ct ) = (1 + rt )u 0 (Ct +1 )
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Indifference Curve
I Think of Ct and Ct +1 as different goods (different in time
dimension)
I Indifference curve: combinations of Ct and Ct +1 yielding fixed
overall level of lifetime utility
I Different indifference curve for each different level of lifetime
utility. Direction of increasing preference is northeast
I Slope of indifference curve at a point is the negative ratio of
marginal utilities:
u 0 (Ct )
slope =
u 0 (Ct +1 )
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Budget Line
slope = (1 + rt )
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Optimality Graphically
I Objective is to choose a consumption bundle on highest
possible indifference curve
I At this point, indifference curve and budget line are tangent
(which is same condition as Euler equation)
+1
(1 + ) + +1
2,+1 (2)
+1
3,+1
(3) = 2
0,+1
1,+1 = 1
(0)
(1) = 0
0, 3, 2, 1, +1
+
1 + 13 / 36
Consumption Function
Ct = C d (Yt , Yt +1 , rt )
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Increases in Yt and Yt +1
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Increase in rt
I A little trickier
I Causes budget line to become steeper, pivoting through
endowment point
I Competing income and substitution effects:
I Substitution effect: how would consumption bundle change
when rt increases and income is adjusted so that household
would locate on unchanged indifference curve?
I Income effect: how does change in rt allow household to locate
on a higher/lower indifference curve?
I Substitution effect always to reduce Ct , increase St
I Income effect depends on whether initially a borrower
(Ct > Yt , income effect to reduce Ct ) or saver (Ct < Yt ,
income effect to increase Ct )
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Borrower
+1
Hypothetical bundle
with new on same
indifference curve
+1
0,+1
1,+1
New bundle
1, 0,
0,
New bundle
+1
0, 0,
1,
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Algebraic Example with Log Utility
I Suppose u (Ct ) = ln Ct
I Euler equation is:
Ct +1 = (1 + rt )Ct
1
I MPC: 1+ . Go through other partials
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Permanent Income Hypothesis (PIH)
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Applications and Extensions
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Wealth
I Allow household to begin life with stock of wealth Ht 1 . Real
price of this asset in t is Qt
I Household can accumulate more of this asset or sell it
I Period t constraint:
Ct + St + Qt (Ht Ht 1 ) Yt
I Period t + 1 constraint:
Ct +1 + St +1 + Qt +1 (Ht +1 Ht ) Yt + (1 + rt )St
Ct = C d (Yt , Yt +1 , rt , Qt )
+ + +
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Alternative Simplifying Assumption
I Assume Ht 1 = 0, and assume that household must purchase
an exogenous amount of the asset, Ht (e.g. has to buy a
house)
I IBC:
Ct +1 Yt +1 Qt +1
Ct + = Yt + + Ht Qt
1 + rt 1 + rt 1 + rt
Ct = C d (Yt , Yt +1 , rt , Qt , Qt +1 )
+ + +
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Permanent vs. Transitory Changes in Income
I Go back to standard consumption function:
Ct = C d (Yt , Yt +1 , rt )
C d () C d () C d ()
dCt = dYt + dYt +1 + drt
Yt Yt +1 rt
dCt C d ()
I If just dYt 6= 0, then dY t
is equal to partial Yt
I But if changes in income are persistent (i.e. dYt > 0
d
dYt +1 > 0), then dYdCt
t
> CY()
t
I Implication: consumption reacts more to a change in income
the more persistent is that change in income
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Application: Tax Cuts
I Suppose household pays taxes, Tt and Tt +1 , to government
each period, so net income is Yt Tt and Yt +1 Tt +1 .
Consumption function is:
Ct = C d (Yt Tt , Yt +1 Tt +1 , rt )
(+1 )
[ (+1 )]
([+1 ])
(+1 )
+1
[+1 ]
+1 +1
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Increase in Uncertainty: Mean-Preserving Spread
I Raises E [u 0 (Ct +1 )]
(+1 )
uncertainty [ (+1 )]
(1,+1 )
(0,+1 )
[ (1,+1 )]
[ (0,+1 )]
([+1 ])
(0,+1 )
(1,+1 )
+1
1,+1
0,+1 [+1 ] 0,+1 1,+1
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Precautionary Saving
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Random Walk Hypothesis
I Suppose that (1 + r ) = 1
I Euler equation is then implies u 0 (Ct ) = E [u 0 (Ct +1 )]
I Suppose that u 000 () = 0 (so no precautionary saving). Then
this implies that E [Ct +1 ] = Ct
I In expectation, future consumption ought to equal current
consumption. This is the random walk hypothesis
I Doesnt mean that future consumption always equals current
consumption
I But it does imply future changes in consumption ought to not
be predictable, because in expectation future consumption
should equal current consumption
I Random walk model due to Hall (1978)
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Empirical Tests
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Borrowing Constraints
I Empirical failures can potentially be accounted for by
borrowing constraints
I Simplest form of a borrowing constraint: you cant. St 0.
Introduces kink into budget line
+1
(1 + ) + +1
+1
Infeasible if 0
+1
+
1 +
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Binding Borrowing Constraint
I If borrowing constraint binds you locate at the kink in the
budget line (i.e. Euler equation does not hold)
+1
0,+1 = 0,+1
0,,+1
0, = 0, 0,,
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Implications of a Binding Borrowing Constraint
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