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ProblemSet5 Consumption

The document outlines a problem set focused on consumption within the context of economic growth and business cycles. It covers topics such as intertemporal budget constraints, the Euler equation, the intertemporal elasticity of substitution, and Ricardian equivalence, providing mathematical derivations and optimal consumption conditions for different consumer types. Additionally, it explores the implications of credit constraints and government financing on aggregate consumption.

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3 views2 pages

ProblemSet5 Consumption

The document outlines a problem set focused on consumption within the context of economic growth and business cycles. It covers topics such as intertemporal budget constraints, the Euler equation, the intertemporal elasticity of substitution, and Ricardian equivalence, providing mathematical derivations and optimal consumption conditions for different consumer types. Additionally, it explores the implications of credit constraints and government financing on aggregate consumption.

Uploaded by

10621077
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Economic Growth and Business Cycles

Problem Set 5: Consumption


Johannes Van Vlodrop

1. Two-period consumption–savings
A representative household lives for two periods and maximizes

U (C1 , C2 ) = u(C1 ) + β u(C2 ), u′ > 0, u′′ < 0, β ∈ (0, 1].

Income (Y1 , Y2 ) is exogenous. The gross interest rate is R ≡ 1 + r, r > 0.

(a) Derive the intertemporal budget constraint.

(b) State the Euler equation and interpret it.

C 1−σ −1
Consider the case of CRRA (constant relative risk aversion) utility u(C) = 1−σ
, σ > 0.

(c) Derive u′ (C) and express C2 in terms of C1 . (Hint: Use the Euler equation.)

(d) Solve for C1∗ and C2∗ in closed form.

(e) How does r affect C1∗ when σ > 1 versus σ < 1?

2. IES and marginal propensity to consume


Y2
Keep CRRA utility and denote PV = W1 + Y1 + R
, with initial wealth W1 .

(a) Define the intertemporal elasticity of substitution (IES).

(b) Express C1∗ as a function of PV, β, σ, R.

(c) Compute the marginal propensity to consume (MPC) out of W1 (net wealth). What
does the MPC represent?

(d) How does MPCW1 vary with R when σ > 1?

1
3. Ricardian equivalence and credit constraints
Consider two types of consumers: a fraction µ ∈ [0, 1] is credit constrained (hand-to-
mouth), the remaining 1 − µ are unconstrained. Preferences are

U (C1 , C2 ) = u(C1 ) + βu(C2 ), u′ > 0, u′′ < 0, β ∈ (0, 1].

Endowments (Y1 , Y2 ), lump-sum taxes (T1 , T2 ), and initial wealth V1 are given. Gross
interest rate R = 1 + r, r > 0.
For the constrained type, the desired (unconstrained) choice would entail borrowing in
period 1 (S ⋆ < 0), but borrowing is not allowed. Therefore the borrowing constraint
S ≥ 0 binds: S = 0.

(a) Write the period budget constraints for both types and the intertemporal budget.

(b) State the optimality conditions (FOCs/KKT) and show what binding implies for
marginal utilities.

(c) Assume β(1 + r) = 1. Derive optimal consumption for both consumer types.

(d) Derive aggregate consumption (period 1 and period 2).

(e) Show that the aggregate MPC out of current disposable income is

∂C1agg 1+r
= µ + (1 − µ) .
∂ [V1 + Y1 − T1 ] 2+r

Compare to the MPC in an economy without credit-constrained consumers and


explain the difference.

(f) Derive the effect of switching from tax to debt finance on aggregate private consump-
tion in period 1. That is, consider a one-unit tax cut in period 1 that is temporarily
financed by issuing government debt, with government spending unchanged and all
debt repaid by the end of period 2. What is the effect on optimal period-1 con-
sumption when there are no credit-constrained consumers? Explain whether there
is a difference compared to the case with constrained consumers.

(g) Consider a temporary one-unit tax cut in period 1 that is financed by cutting gov-
ernment consumption in period 1 so that the intertemporal government budget con-
straint holds (no change in T2 ). Derive the effect on aggregate private consumption
in period 1 and compare it to the case with no credit-constrained consumers.

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