F ir s t - C la s s U n iv e r s it y T u t o r s
The
T wo-‐Period
C onsumption
M odel
We
want
to
create
a
model
that
captures
this
concept
of
transitory
and
permanent
income,
and
which
can
therefore
distinguish
between
temporary
and
permanent
shocks
to
our
economy.
Introducing
the
Two-‐Period
Model
(It
has
two
periods)
The
first
period
represents
today,
the
current
time
period.
The
second
period
represents
tomorrow,
the
future
time
period.
Transitory
income
effects
will
only
effect
the
first
time
period,
whereas
permanent
income
effects
will
effect
both
current
and
future
consumption.
Below
is
an
indifference
curve
for
a
consumer.
Notice
that
they
have
smooth
preferences
over
current
and
future
consumption.
c2
U
c1
Glossary:
c1
current
consumption
c2
future
consumption
U
utility
Indifference
Curve
shows
all
the
bundles
of
c1
and
c2
that
give
the
consumer
the
same
level
of
utility.
Higher
indifference
curves
represent
higher
utility/
being
better
off.
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1
F ir s t - C la s s U n iv e r s it y T u t o r s
The
Lifetime
Budget
Constraint
Intertemporal
is
a
cool
word
meaning
“over
time.”
Intertemporal
decisions
involve
economic
trade-‐offs
across
time
periods,
choosing
whether
to
save
up
today
to
spend
more
tomorrow,
or
else
borrow
against
tomorrow’s
money
and
have
a
party
today.
Anything
we
don’t
spend
today
we
save
for
tomorrow.
If
we
spend
more
than
we
have
today,
then
we
must
be
borrowing.
We
shall
call
borrowing
“negative
saving”
because
this
means
we
only
have
to
use
one
symbol.
The
real
interest
rate,
r,
is
the
rate
at
which
consumers
can
lend
or
borrow.
c2
The
Endowment
point,
le neither
consuming
or
nd
(1+r)we
e r
saving
bo
E
rr
ow
y2–
t2
er
y1
–
t1
we
c1
Glossary
c1
current
consumption
c2
future
consumption
s
savings
(only
occurs
in
the
current
period)
y1
current
income
y2
future
income
t1
current
tax
t2
future
tax
y
–
t
disposable
(after-‐tax)
income.
The
money
that
the
consumer
can
actually
spend
after
paying
off
their
tax
to
the
government
E
Endowment
of
income
r
the
real
interest
rate
at
which
consumers
can
lend
or
borrow
(1
+
r)
the
total
amount
you
will
have
after
lending
or
borrowing
at
r
Above
we
can
see
the
lifetime
budget
constraint,
representing
all
the
possible
combinations
of
c1
and
c2
they
can
afford.
Consumers
are
Endowed
with
current
and
future
income.
They
can
always
consume
their
endowment
point,
and
therefore
their
after-‐tax
incomes,
y
–
t,
in
each
period.
However,
if
they
want
to
consume
more
than
this
in
the
current
period
then
they
must
borrow
against
their
future
income.
If
they
want
to
spend
more
tomorrow
then
they
can
save
(and
lend
to
others).
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2
F ir s t - C la s s U n iv e r s it y T u t o r s
Quick
Maths:
Imagine
that
a
consumer
is
endowed
with
£1000
worth
of
income
in
each
period
(y1
=
y2
=
£1000)
and
that
taxes
are
£100
(t1
=
t2
=
£100)
in
each
period.
The
rate
at
which
people
can
borrow
and
save
is
10%
(r
=
0.1).
Therefore,
after
tax
income
is
y-‐t
=
£900
in
each
period,
and
our
consumer
could
just
consume
this.
But
what
if
they
have
preferences
for
consuming
more
today
than
tomorrow
(i.e.
they
are
impatient)?
Let’s
say
that
they
want
to
consumer
£1000
today.
Well
then
they
could
borrow
£100
from
their
future
income,
but
they’ll
have
to
pay
it
back
at
the
interest
rate
of
(1+r).
Therefore,
next
period,
they
have
to
pay
back
the
£100
plus
10%
interest,
£10.
meaning
that
next
year,
they
only
have
£900
-‐
£110
to
spend,
or
£790.
c2
r
=
10%
(1+r)we
Gave
up
£110
E
£900
of
future
£790
consumption
U*
£900
we
c1
£1000
To
get
£100
of
current
consumption
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3
F ir s t - C la s s U n iv e r s it y T u t o r s
Deriving
the
Lifetime
Budget
Constraint:
The
Model:
The
consumer
lives
for
two
periods,
and
then
dies.
So
there
is
no
point
saving
in
the
second
period
of
time.
In
the
first
period
the
consumer
can
either
consume
or
save
their
disposable
(after-‐tax)
income:
(𝑦! − 𝑡! ) = 𝑐! + 𝑠!
Rearranging,
savings
are
whatever
we
don’t
consumer:
our
current
disposable
income
minus
our
current
consumption.
=>
𝑠! = (𝑦! − 𝑡! ) − 𝑐!
Moving
to
the
second
period,
the
consumer
can
consume
any
disposable
income
they
receive
in
that
period,
and
also
their
savings
from
the
first
period
with
interest:
𝑐! = (𝑦! − 𝑡! ) + 1 + 𝑟 𝑠!
And
finally,
we
want
this
in
present
value,
so
we
divide
by
(1+r)
and
group
like
terms
(put
the
consumptions
on
one
side
and
the
incomes
on
another.
!! (!! ! !! )
=>
𝑐! + = (𝑦! − 𝑡! ) +
!!! !!!
This
equation
tells
us
that
the
present
value
of
our
consumption
in
both
periods
must
equal
the
present
value
of
our
disposable
income.
We
often
use
the
abbreviation
we,
meaning
wealth,
to
represent
the
right
hand
side
of
our
equation.
Glossary
c1
current
consumption
c2
future
consumption
s
savings
(only
occurs
in
the
current
period)
y1
current
income
y2
future
income
t1
current
tax
t2
future
tax
y
–
t
disposable
(after-‐tax)
income.
The
money
that
the
consumer
can
actually
spend
after
paying
off
their
tax
to
the
government
(1
+
r)s1
is
the
amount
of
savings
we
have
after
accumulating
one
year
of
interest
𝐜𝟐
is
the
present
value
of
future
consumption
𝟏!𝐫
𝐲𝟐 ! 𝐭 𝟐
𝟏!𝐫
is
the
present
value
of
future
disposable
income
Important
Note:
s1
can
be
negative
if
the
consumer
chooses
to
borrow
money.
Bottom
Line:
Savings
are
the
link
between
current
and
future
consumption
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4
F ir s t - C la s s U n iv e r s it y T u t o r s
The
Slope
of
the
Lifetime
Budget
Constraint
Above,
the
consumer
has
here
borrowed
against
their
future
income
to
satisfy
their
preference
for
current
consumption.
We
know
that
they
can
borrow
and
lend
at
(1+r),
meaning
that
they
have
to
pay
back
all
their
borrowing
plus
the
interest,
r.
How
do
we
work
out
a
gradient?
𝑟𝑖𝑠𝑒 −£110
= = − 1.1 = −(1 + 𝑟)
𝑟𝑢𝑛 + £100
The
gradient
is
the
rate
at
which
consumers
can
substitute
future
consumption
for
current
consumption,
and
this
is
the
interest
rate.
The
intercepts
of
the
Lifetime
Budget
Constraint
Above
we
see
that
we
is
the
intercept
of
the
current
consumption
axis.
we
stands
for
lifetime
wealth
and
so
the
most
that
we
can
afford
to
consume
in
the
current
period
is
everything
we
have,
leaving
nothing
left
to
consume
tomorrow.
Mathematically,
this
is
the
same
as
setting
c2
equal
to
0.
And
the
future
consumption
axis?
Well
this
is
the
most
that
we
can
afford
to
consume
tomorrow,
by
setting
c1
equal
to
zero.
This
is
saving
all
our
wealth
for
the
future
and
so
we
can
consume
our
future
disposable
income
(y2
–
t2)
plus
the
future
value
of
all
our
current
period
endowment,
having
saved
all
of
it,
which
is
(y1
–
t1)
times
(1
+
r).
Glossary
we
lifetime
wealth,
the
present
value
of
all
our
income,
both
current
and
future
disposable
income.
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5
F ir s t - C la s s U n iv e r s it y T u t o r s
Let’s
look
at
some
effects
1) écurrent
disposable
income
c2
(1+r)we2
(1+r)we1
E1
y2–
t2
E2
y1
–
t1
(y1
–
t1
)
we1
we2
c1
Firstly,
the
consumer
is
wealthier
because
they
have
more
disposable
income
in
the
current
period,
and
so
this
shifts
our
lifetime
budget
constraint
outwards.
Secondly,
we
can
see
that
the
consumer
has
not
consumed
the
entire
increase
in
their
wealth
in
the
first
period.
Instead,
they
have
smoothed
their
consumption
across
both
periods.
How
do
we
know
this?
Because
they
began
by
consuming
their
endowment,
neither
lending
nor
borrowing.
However,
after
their
budget
constraint
shifts
out,
they
are
now
to
the
left
of
their
new
endowment
point,
E2,
meaning
that
they
must
be
saving
some
of
their
increased
wealth
for
the
future
period,
because
they
have
smooth
preferences
to
increase
both
current
and
future
consumption.
We
can
see
on
the
graph
that
c1
has
increased
at
the
new
optimised
point,
and
also
that
c2
has
increased,
but
what
about
savings?
𝑠! = (𝑦! − 𝑡! ) − 𝑐!
éé é
We
can
see
that
the
increase
in
disposable
income
(y1
–
t1)
is
greater
than
the
increase
in
c1
meaning
that
savings
must
have
increased
overall.
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6
F ir s t - C la s s U n iv e r s it y T u t o r s
1) éfuture
disposable
income
c2
(1+r)we2
(1+r)we1
E2
(y2
–
t2)
E1
y2–
t2
y1
–
t1
we1
we2
c1
Firstly,
the
consumer
is
wealthier
because
they
have
more
disposable
income
in
the
future
period,
and
so
this
shifts
our
lifetime
budget
constraint
outwards.
Secondly,
we
can
see
that
the
consumer
has
not
consumed
the
entire
increase
in
their
wealth
in
the
second
period.
Instead,
they
have
smoothed
their
consumption
across
both
periods.
How
do
we
know
this?
Because
they
began
by
consuming
their
endowment,
neither
lending
nor
borrowing.
However,
after
their
budget
constraint
shifts
out,
they
are
now
to
the
right
of
their
new
endowment
point,
E2,
meaning
that
they
must
be
borrowing
some
of
their
increased
wealth
from
the
future
period,
because
they
have
smooth
preferences
to
increase
both
current
and
future
consumption.
We
can
see
on
the
graph
that
c1
has
increased
at
the
new
optimised
point,
and
also
that
c2
has
increased,
but
what
about
savings?
𝑠! = (𝑦! − 𝑡! ) − 𝑐!
=
é
We
can
see
that
there
is
no
change
in
current
period
disposable
income
(y1
–
t1)
but
there
has
been
an
increase
in
c1
meaning
that
savings
must
have
decreased
overall.
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7
F ir s t - C la s s U n iv e r s it y T u t o r s
Understanding
the
Solution
to
the
Kuznets
Consumption
Problem
Temporary
vs
Permanent
Changes
in
Income
Consumers
will
tend
to
save
most
of
a
temporary
increase
in
current
income
(see
above).
However,
if
the
increase
in
income
is
not
permanent,
meaning
that
it
occurs
in
both
periods,
then
there
will
be
a
must
larger
affect
on
lifetime
wealth,
and
a
larger
affect
on
current
consumption,
meaning
that
they
will
not
mean
to
change
their
savings:
c2
E3
(y2
–
t2)
E2
E1
y2–
t2
y1
–
t1
(y1
–
t1
)
c1
There
is
a
lot
going
on
in
the
above
graph.
The
Move
from
E1
to
E2
represents
an
temporary
increase
in
income.
As
discussed
above,
this
causes
savings
to
increase
to
smooth
the
consumption.
However,
E1
to
E3
represents
a
permanent
increase
in
income
because
disposable
income
as
increased
in
both
periods.
Now,
the
consumer
is
has
not
changed
their
consumption
patterns
and
is
staying
on
their
endowment
point
because
there
was
no
need
to
smooth
their
consumption,
they
could
simply
consume
more
in
both
periods
without
needing
to
save.
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8
F ir s t - C la s s U n iv e r s it y T u t o r s
Problem
Solved!
This
is
the
solution
to
the
Kuznets
Consumption
Puzzle.
We
see
that
a
temporary
or
transitory
increase
in
income
has
been
largely
saved,
meaning
that
APC
has
decreased
with
an
increase
in
transitory
income.
However,
when
there
was
a
permanent
increase
in
income,
consumption
increased
by
the
same
amount
in
both
periods,
with
no
change
to
savings,
meaning
that
the
APC
was
constant.
Household
Consumption,
C
Economy
Wide
Consumption
over
time
Individual
Households’
Consumption
at
a
particular
point
in
time
National
Income,
Y
Why
am
I
still
here?
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9
