Chapter 8

A Two-Period Model: The Consumption-Savings Decision and Credit Markets

Teaching Goals
This chapter introduces the concept of intertemporal choice. Intertemporal choice concerns the distribution of consumption and production of goods over more than one time period. This chapter focuses on intertemporal consumption choice. Without a credit market, each individual must exactly consume his or her current disposable income in each and every period of time. However, many consumers would prefer to consume more or less than their current disposable income in each period. Credit markets allow some consumers to be better off by redistributing consumption over time. Each consumer may also choose not to participate in the credit market, and these consumers can be no worse off for the existence of a credit market. The existence of credit markets must therefore allow a Pareto improvement. An important first step for students is that they fully understand the meaning of the intertemporal budget constraint. The first key point is that, for given amounts of income, consumption in the present can only be changed if there is a corresponding change in future consumption. At an intuitive level, this point is well understood by students taking out loans for college expenses. However, students are naturally focused on making decisions on current consumption and often lose sight of the fact that current choices effectively preclude alternative future choices. One natural example of choice over time is consumers responses to lottery winnings. Does the choice of a lump-sum payoff as opposed to a series of annual payments affect current consumption? Does it affect current savings? How would students respond to improved prospects for future employment income? Students should also understand that there is more to a change in the interest rate than an incentive (substitution) effect acting on the returns to saving. Students should ponder the question of who wins and who loses from changes in interest rates. Can everyone win? Can everyone lose? The final, and often most challenging issue is Ricardian equivalence. One difficulty is that students find it difficult to conceive of tax changes that do not, at least implicitly, involve changes in current or future government spending. Discussions in the popular press often link tax increases as signaling prospective increases in the size of government, and tax cuts as promoting future spending discipline. While these are valid political possibilities to ponder, they are not the kinds of experiments that cast any light on the validity and relevance of Ricardian equivalence. Possibly the best intuitive case for Ricardian equivalence is the example of a change in the tax withholding tables with no change in the tax tables. The case of the withholding adjustment in 1992, which is discussed in the text, is an excellent introduction to this topic.

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Ricardian equivalence also has important implications for issues of public policy related to social security. Ricardian equivalence implies that fully funded Social Security is, at best, ineffective, and, at worst, welfare-reducing. Fully funded Social Security substitutes public saving for private saving. If the level of public saving required to finance the program is less than the optimal amount of private saving, then Social Security makes no difference to economic outcomes. If Social Security increases national saving, then it forces individuals to misallocate consumption over their lifetimes. Pay-as-you-go Social Security is always good for the first generation that receives benefits. Later generations can also benefit, but only if the population growth rate exceeds the real rate of interest. The current Social Security crisis exists because projected population growth is too low, leaving the next generation with a potentially onerous burden of supporting a vast cohort of retirees.

Classroom Discussion Topics

Ask the students what they think about cultural and religious admonitions against borrowing. Should everyone neither a borrower nor a lender be? What about usury prohibitions on charging any interest to borrowers? There are often tales of woe in the popular press about taking on too much consumer debt. In the modern economy, no one is forced to borrow or lend. Ask the students if they believe that there would be any benefits of outlawing credit. Ask them if they benefit personally from credit markets. Try to get them to separate the moral arguments and the economic arguments. Also, related to their own experience: student loans programs allow them to borrow against future income, despite having very little (physical or financial) collateral to show. Ask the students for their personal perspectives on the costs and benefits of government-sponsored Social Security. Todays students often believe that, while they are going to pay a large amount of Social Security taxes over their lifetimes, they will receive little or nothing in the way of benefits. Emphasize that the current system of pay-as-you-go Social Security may make them either better off or worse off. On the one hand, they face the difficult challenge of paying high taxes to support a larger-than-normal-sized cohort of retirees. However, their own prospects may depend on how many children they collectively raise and also on future immigration policies. What about fairness issues? Without Social Security, what would society do about those individuals who do no saving for their own retirement? In order for there to be the correct incentives for private savings, society would have to credibly commit itself to letting such individuals live out their final days in abject poverty. Finally, the fiscal policy of recent administrations give ample opportunities for discussion on the impact of various initiatives. Some are discussed in the books features, but one may also mention the drive of the Clinton administration to reduce the debt and recent attempts by the second Bush administration to make their tax cuts permanent.

Outline
I. The Two-period Model A. Consumer Behavior 1. Consumers Lifetime Budget Constraint a. Lifetime Wealth b. Endowment Point and the Slope of the Budget Line 2. Consumers Preferences a. More Is Preferred to Less b. Consumers Value Diversity c. Current and Future Consumption Are Normal Goods 3. Consumers Optimization: MRSc,c ' = 1 + r.

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4.

5.

6.

7.

An Increase in Current Income a. Effects on Current and Future Consumption b. Effects on Savings 1. Lenders 2. Borrowers c. Excess Variability of Consumption 1. Credit Market Imperfections 2. Changes in Interest Rates An Increase in Future Income a. Effects on Current and Future Consumption b. Effects on Savings 1. Lenders 2. Borrowers c. Permanent Income Hypothesis An Increase in the Real Interest Rate a. Income Effects b. Substitution Effects 1. Lenders 2. Borrowers The Demand for Consumption Goods

B. Government Behavior 1. Debt Issue 2. The Governments Present-value Budget Constraint C. Competitive Equilibrium 1. Consumers Optimally Choose Consumption and Savings 2. Government Budget Constraint Is Satisfied 3. Credit Market Clears II. Ricardian Equivalence A. Statement of the Theorem B. Proof of the Theorem C. The Burden of the Government Debt 1. The Distribution of Taxes across Different Individuals 2 The Distribution of Taxes across Different Generations 3. Distorting Taxes 4. Credit-market Imperfections D. Social Security Systems 1. Pay-as-you-go 2. Fully Funded E. Consumption Choice with Credit Market Imperfections 1. Different Borrowing and Lending Rates 2. Credit-constrained Consumers 3. Government Policy

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Textbook Question Solutions

Questions for Review
1. Consumers save so that they can smooth their consumption over time. 2. Consumers save by issuing bonds. 3. The consumer chooses how to spread her consumption over time. To make this decision, the consumer needs to know the real interest rate, and the present value of her lifetime wealth. 4. The relative price of future consumption is 5. Current period: s = y c t Future period: c' = y' t' + (1 + r )s Substituting for s from the first equation into the second equation shows that the present value of lifetime consumption is equal to the present value of lifetime income minus the present value of lifetime taxes. 6. The slope of the budget line is (1 + r ). 7. The horizontal intercept is we. The vertical intercept is we(1 + r ). 8. To consume the endowment point, the consumer consumes y t in the first period, and consumes y' t' in the second period. The consumer neither lends nor borrows. 9. More is preferred to less, the consumer likes diversity, and both current and future consumption are normal goods. 10. The preference for a smooth consumption stream implies a declining marginal rate of substitution, and so indifference curves are bowed toward the origin. 11. The consumer wishes to spread an increase in current income over the consumers lifetime. Firstperiod consumption, second-period consumption, and saving all increase. 12. The excess variability of consumption is explained by credit market imperfections, and that movements in the equilibrium real interest rate prevent all consumers from simultaneously trying to smooth consumption. Aggregate consumption is constrained by aggregate income, and therefore aggregate consumption must rise during booms and fall during recessions, even though consumers would prefer smoother consumption. 13. An increase in future income increases both current and future consumption. This pattern is achieved by reducing savings. 14. A permanent increase in income produces a larger increase in current consumption, because it is unnecessary to smooth the increase over time.
1 , where r is the real interest rate. (1 + r )

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15. The market value of stocks is a proxy for the expected present value of lifetime wealth. An increase in stock prices is therefore likely to cause an increase in consumption. In the data, stock prices and aggregate consumption are positively correlated. 16. An increase in the real interest rate includes both a substitution effect and an income effect. In response to an increase in the interest rate, the substitution effect leads to lower first-period consumption, higher second-period consumption, and increased saving. The direction of the income effect depends on whether the consumer is initially a borrower or a lender. For borrowers, the income effect reduces both current and future consumption, and increases saving (less borrowing). For lenders, the income effect increases both current and future consumption and reduces saving. 17. The government finances a deficit by issuing bonds. 18. Holding current and future government spending fixed, a change in the timing of taxation has no effect on the equilibrium interest rate, and no effect on any consumers choice of current and future consumption. 19. First, changes in taxes are not shared equally by all consumers. Second, debt issued to finance current deficits may not be repaid during the lives of all current consumers. Third, taxes are not lump sum. Fourth, in practice there are credit market imperfections. 20. Pay-as-you-go Social Security always improves the welfare of the first generation to receive benefits. Later generations only see a welfare improvement if the population growth rate exceeds the real rate of interest. 21. Fully funded Social Security has no effects as long as taxes collected are less than the optimal amount of saving. If taxes and benefits are larger, then individuals consume less when working and more when retired relative to what they would prefer. 22. Government deficits may allow credit-constrained consumers to achieve their desired consumption plans.

Problems
1. Given information:
y = 100 y' = 120 t = 20 t' = 10 r = 0.1

(a) To calculate wealth, we compute:

w = yt + 110 y' t' = 80 + = 180 1+ r 1.1

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(b) In the perfect complements case, the indifference curves are like I1 and I2 in the figure below.

(c) The consumers optimal consumption bundle is at point A. Point A simultaneously solves:
c = c' , and c+ c' = c + 0.91c' = 180 1+ r

Upon solving, we find that c = c ' = 94.2 . Savings is therefore given by:
s = y t c = 80 94.2 = 14.2

The consumer is a borrower. In the figure above, the endowment point is E1 and the consumer chooses A. (d) First-period income rises from 100 to 140. We now recompute w = 220. Solving as in part (c), we find that c = c' = 115.2, and s = 4.8. In the figure above, the endowment point is E2 and the consumer chooses B. (e) In part (c), the consumer is a borrower. In part (d), first-period income increases and savings has consequently increased enough that the consumer is now a lender. 2. In this problem, there is a simultaneous increase in both future income and the real interest rate. The increase in future income is a positive income effect for both borrowers and lenders. The increase in the real interest rate includes a pure substitution effect and a pure income effect. The substitution effect induces the consumer to consume less in the current period and more in the second period. The direction of the pure income effect part of the real interest rate change depends on whether the consumer is a borrower or a lender. Lenders are better off with a higher real interest rate and borrowers are worse off with a higher real interest rate.

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The top figure below shows the case of a borrower. The consumer starts out with endowment E1 and picks point A on indifference curve I. The diagram shows the case in which the positive income effect of the increase in y is exactly canceled out by the negative income effect of the increase in r. In this particular case, c falls and c' increases. Since current income is fixed, the consumer must increase saving. For the borrower, this amounts to a reduction in borrowing. The consumer therefore picks point B, which is also on indifference curve I, but which is parallel to a budget line that passes through E2. The bottom figure below shows the case of a lender. The consumer starts out with endowment E3. The consumer chooses point D that is a tangency of indifference curve I1 with the budget line that passes through point E3. The disturbance shifts the budget line out to the line that passes through E4, the new endowment point. The substitution effect moves the consumer from point D to point G on I1. The pure substitution effect induces a reduction in c and an increase in c' . The net income effect is then represented by a parallel shift in the line through G to the new budget line. In this case, the two income effects move in the same direction. Therefore both c and c' increase from point G to point F. Second-period consumption unambiguously increases. First-period consumption (and therefore savings) may either rise or fall. The bottom figure below shows the case in which c increases. If c increases, s must fall.

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3. This problem involves a firms offer to provide an interest-free advance on the consumers income. If the consumer takes the advance, then his lifetime wealth is given by:
we = y + y' 1 + x 1 1+ r 1+ r

Therefore, provided that r > 0, the consumer should take the advance, as any increase in his lifetime wealth makes him better off.

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4. Temporary and Permanent Tax Increases. (a) The increase in first-period taxes induces a parallel leftward shift in the budget line. The original budget line passes through the initial endowment, E1. The new budget line passes through E2. The consumer reduces both current and future consumption. In the figure below the consumers optimum point moves from point A to point B. First-period consumption falls by less than the increase in taxes and so savings falls.

(b) Next consider a permanent increase in taxes. A permanent tax increase adds a second tax increase to the first tax increase, the current-period tax increase. The increase in second-period taxes induces a parallel downward shift in the budget line. The new budget line passes through E2 in the figure above. The second part of the tax increase also reduces both first-period and secondperiod consumption. The consumer moves from point B to point D. Because the second tax increase reduces first-period consumption holding first-period disposable income fixed, savings must rise. Since the permanent tax increase is the sum of the two individual tax increases, the permanent tax increase reduces both first-period and second-period consumption, but on net, savings may either rise, fall, or remain unchanged.

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5. A tax on interest income. (a) Initially, AB in the first figure below depicts the consumers budget constraint. The introduction of the tax results in a kink in the budget constraint, since the interest rate at which the consumer can lend, r (1 t ), is now smaller than the interest rate at which the consumer borrows, r. The kink occurs at the endowment, E.

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(b) The first figure above shows the case of a consumer who was a borrower before the imposition of the tax. This consumer is unaffected by the introduction of the tax. The second figure above shows the case of a consumer who was a lender before the imposition of the tax. Initially the consumer chooses point G, and then chooses point H after the imposition of the tax. There is a substitution effect that results in an increase in first-period consumption and a reduction in second-period consumption, and moves the consumer from point G to point J. Savings also fall from point G to point J. The income effect is the movement from point D to point B, and the income effect reduces both first-period and second-period consumption, and increases savings. On net, consumption must fall in period 2, but in period 1, consumption may rise or fall. The figures above show the case in which first-period consumption increases, which is a case where the substitution effect dominates. 6. The consumer faces a borrowing constraint that places a ceiling on the level of current consumption. The consumer may consume more than the current endowment, y t, but less than the amount of the lifetime endowment, we. The consumers budget line is as in the first figure below. The budget line becomes vertical at c = x. An example of such a budget line is depicted in the two panels of the figure as ABD. As one possibility, the constraint is nonbinding as in the figure below. The consumer chooses point H. A change in the level of x has no effect on such a consumer. Alternatively, the consumer depicted in the second figure below originally chooses the corner solution, point B. The consumer achieves the level of utility corresponding to indifference curve, I1. An increase in x produces the new budget line, ACJ. This consumer now chooses point G. She increases current consumption and decreases both current saving and future consumption. This consumer is able to improve her level of utility to that corresponding to indifference curve, I2.

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7. This problem contrasts two alternative forms of credit market imperfections. As one possibility, consumers may either borrow or lend at the same real interest rate, but face a maximum amount of borrowing. The alternative possibility allows unlimited borrowing, but the interest rate paid on borrowing exceeds the interest rate earned from lending. Clearly, consumers who choose to be lenders are unaffected by such constraints. We therefore only need to be concerned about the behavior of borrowers. In the two figures below, the point B represents the endowment point. The first type of constraint imposes a maximum amount of borrowing. This constraint is depicted as budget line ABCJ in the figures. The second type of constraint imposes a higher interest rate on borrowing. This constraint is depicted as budget line ABD in the figures. The first figure below depicts the case of a consumer who prefers to pay the higher interest rate on borrowing. This consumer picks point G, a point that is preferred to any of the points along ACJ. The second figure below depicts the case of a consumer who prefers the maximum borrowing constraint. This consumer picks point C (or alternatively a point along segment BC). Clearly the second consumer prefers point C to any of the points along BD.

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8. Given information:
y = 200 y' = 150 t = 40 t' = 50 r = 0.05

(a) If the consumer could borrow and lend at the real interest rate, r = 0.05, then the consumers lifetime budget constraint would be given by: c y' t' c+ = yt + . (1 + r ) (1 + r ) Plugging in the numbers from this problem, we obtain: c + 0.95c' = 255.2. In the figure below, the initial budget constraint is given by BE1D. The budget constraint has a kink at the initial endowment point E1 = (160,100), because the consumer cannot borrow, and therefore cannot consume more than 160 in the first period. Because the consumer has perfectcomplements preferences, the indifference curves are kinked at c = c'.

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(b) With perfect-complements preferences, the consumer picks point A in figure on the previous page. Plugging in c = c' into the budget constraint and solving, we find that c = c' = 130.7 and so s = y t c = 160 130.7 = 29.3. In this case, the fact that the consumer cannot borrow does not matter for the consumers choice, as the consumer decides to be a lender. (c) When t = 20 and t' = 71, the consumers lifetime wealth remains unchanged at 255.2. However, the budget constraint shifts to BE2F, figure on the previous page, with the new endowment point at E2 = (180,79). This change does not matter for the consumers choice, again because he or she chooses to be a lender. Consumption is still 130.7, but now savings is s = y t c = 180 130.7 = 49.3. (d) Now first-period income falls to 100. Wealth is now equal to w = 155.2. In the figure above, the budget constraint for the consumer is AE1D, so when the consumer chooses the point on his or her budget constraint that is on the highest indifference curve, any point on the line segment BE1 will do. Suppose that the consumer chooses the endowment point E1, where c = 60 and c' = 100. This implies that s = 0, and the consumer is credit-constrained in that he or she would like to borrow, but cannot. Now with the tax change, the budget constraint shifts to AE2G, with the endowment point E2 = (80,79). Thus the consumer can choose c = c' on the new budget constraint, and solving for consumption in each period using the budget constraint
c + 0.95c' = 155.2,

we get c = c' = 79.5, and s = 0.5. Here, notice that first-period consumption increased by almost the same amount as the tax cut, although lifetime wealth remains unchanged at 155.2. Effectively, the budget constraint for the consumer is relaxed. Therefore, for tax cuts that leave lifetime wealth unchanged, lenders will not change their current consumption, but creditconstrained borrowers will increase current consumption. 9. Given information:
y = 50 y' = 60 t = 10 t' = 20 r = 0.08

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(a) First consider the consumers budget constraint. All consumers receive identical amounts of income and pay identical amounts of taxes. Therefore, all consumers face:
c = yt + y' t' c' 60 20 c' = 50 10 + . 1.08 1.08

For the consumers who consume 60 in the second period:

c = 40 20 = 21.48 s = 40 21.48 = 18.52 1.08

For the consumers who consume 20 in the second period:

c = 40 + 20 = 58.52 s = 40 58.52 = 18.52. 1.08

(b) Aggregate first-period consumption is given by:

C = 500 21.48 + 500 58.52 = 40,000.

Total GDP for the first period is equal to 50,000. Therefore, G = 10,000. Since aggregate disposable income (40,000) is exactly equal to aggregate consumption, aggregate private savings is equal to zero. First-period government spending and first-period taxes are equal, so the government budget deficit is also zero. To satisfy the government budget constraint, secondperiod government spending must equal second-period taxes minus principle and interest on firstperiod government debt. The government has no debt to repay, and so second-period taxes and second-period government spending both equal 20,000. (c) Assuming that consumers do not change their spending plans, we modify the calculation from part (a) to obtain:
c = yt + y' t' c' 40 c' = 35 + 1.08 1.08

The consumers who save now consume 13.52 in the first period. The consumers who borrow now consume 53.52 in the first period. Disposable income and consumption fall by the same amount, so first-period private savings is unchanged. Since private savings is unchanged, the government continues to issue no debt, and so government spending must equal 15,000. 10. Social Security. (a) When the program is first instituted, the current old receive b in benefits and pay nothing. The effect on the current old is as in Figure 8.17 in the text. The current young receive b in benefits when they are old. This effect is also captured by the shift from BA to FD in the texts Figure 8.17. The current young also lend bN to the government in period T and receive (1 + r )bN in principal and interest when they are old. In per capita terms, these amounts are bN/(1 + n) N = b /(1 + n) and (1 + r )bN /(1 + n) N = (1 + r )b /(1 + n) respectively. However, this borrowing and lending are represented in Figure 8.17 as movements along the budget line. Unless there is a change in the real interest rate, there is no additional shift in the budget line. Therefore, both these generations unambiguously benefit from the program.

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(b) Once the program is running, it is identical to the pay-as-you-go system in the text. This program benefits a typical cohort as long as n > r , as is depicted in textbook Figure 8.18. A special circumstance applies to the cohort born in period T + 1. These individuals each receive a benefit per capita of b /(1 + r ) in present value terms. However, they pay taxes to support two generations worth of benefits. They pay taxes to retire the principal and interest on debt incurred in period T. The per capita share of principal and interest on their grandparents benefits is equal to (1 + r )b /(1 + n)2 . The per capita share of their parents benefits is equal to b /(1 + n). This generation can only benefit if:
1> (1 + r ) (1 + r )2 + (1 + n) (1 + n)2

This requirement is obviously more stringent than n > r. 11. (a) Consumers born in T are the first ones not to get benefits. The government finances the benefits of the last generation, bN, with bonds DT. Thus each consumer born in T buys DT/N bonds, or b/(1 + n) each. In T + 1, the government has to reimburse principal and interest, (1 + r)DT, thus each old consumer at that time obtains (1 + r)b/(1 + n). This means that for the intertemporal budget constraint in the figure below, the endowment point is shifted b/(1 + n) to the left and (1 + r)b/(1 + I) up. This is on the same budget constraint as before. However, this household is also losing the old-age benefits it was expecting, thus the new endowment point shifts an additional b down. However, this generation does not have to pay, when young, for the benefits of the previous generation, as they are covered by the debt. Thus, the endowment point shifts b/(1 + n) to the right. As r > n, the new endowment point is now to the right of the old budget constraint, see the figure below, and this household is better of. Essentially, it just the opposite of the situation that made it viable to institute a pay-as-you-go system when n > r. The exact same reasoning applies to all future generations.

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12. Government loan program. (a) There is no government spending in either period. In the first period, the government must collect lump-sum taxes so that T = L. In the second period, a lump-sum rebate is given so that T' = (1 + r*)L, where r* is the market rate of interest. (b) The present-value government budget is therefore:
T+ T' =0 (1 + r * )

(c) The consumers budget constraint is rewritten as follows.

s = y+ ct c ' = (1 + r )(s + y' t' )

where represents the size of the loan that the individual consumer takes from the loan program. Combining, we obtain:
c+ c' y' t' = y+ t (1 + r ) (1 + r ) (1 + r ) = y+ y' T' 1 T + (1 + r ) n (1 + r )

(d) The size, L, of the loan program, does not change the fact that the present value of tax collections * must equal zero. If a consumer originally chose c = c and c' = c' at r , the consumer will continue to choose c = c and c' = c'. Therefore, if r = r * was originally a competitive equilibrium, it will continue to be a competitive equilibrium.