Chapter 8: Private Sector Demand: Consumption and Investment
2. Consumption
Consumption tomorrow
Consumption tomorrow
Consumption tomorrow
Consumption today Consumption today Consumption today
(a) Normal case (b) Zero substitution (c) Constant substitution
(a) Consumption tomorrow can be substituted smoothly for consumption today, but at a
rate which decreases as today’s consumption increases.
(b) The consumer can be made better off only by increasing consumption today and
tomorrow in fixed proportions.
(c) Consumption today and consumption tomorrow are always substituted at the same
rate.
Each indifference curve corresponds to a given level of utility. A particular indifference curve
represents combinations of consumption today and consumption tomorrow that leaves a
person equally happy, or indifferent. The slope corresponds to someone’s willingness to
swap consumption tomorrow for consumption today.
Marginal rate of intertemporal substitution = the technical term for this willingness to trade
goods tomorrow for goods today.
Consumption smoothing = in good times, consumers accumulate assets or repay their debts.
When income is expected to increase over a lifetime, consumption smoothing implies
borrowing when young and paying back when older.
income
borrowing saving consumption
time
To maintain a constant flow of consumption, individuals should spend each year an amount
corresponding to their permanent income. Permanent income is that income which, if
constant, would deliver the same present value of income as the actual expected income
path.
Permanent income YP would be defined as: YP + YP(1+r) = Ω = Y1 + Y2/(1+r)
2. Consumption
Consumption tomorrow
Consumption tomorrow
Consumption tomorrow
Consumption today Consumption today Consumption today
(a) Normal case (b) Zero substitution (c) Constant substitution
(a) Consumption tomorrow can be substituted smoothly for consumption today, but at a
rate which decreases as today’s consumption increases.
(b) The consumer can be made better off only by increasing consumption today and
tomorrow in fixed proportions.
(c) Consumption today and consumption tomorrow are always substituted at the same
rate.
Each indifference curve corresponds to a given level of utility. A particular indifference curve
represents combinations of consumption today and consumption tomorrow that leaves a
person equally happy, or indifferent. The slope corresponds to someone’s willingness to
swap consumption tomorrow for consumption today.
Marginal rate of intertemporal substitution = the technical term for this willingness to trade
goods tomorrow for goods today.
Consumption smoothing = in good times, consumers accumulate assets or repay their debts.
When income is expected to increase over a lifetime, consumption smoothing implies
borrowing when young and paying back when older.
income
borrowing saving consumption
time
To maintain a constant flow of consumption, individuals should spend each year an amount
corresponding to their permanent income. Permanent income is that income which, if
constant, would deliver the same present value of income as the actual expected income
path.
Permanent income YP would be defined as: YP + YP(1+r) = Ω = Y1 + Y2/(1+r)
