III_consumption_expectation_ho - ECON110B III. Expectations...

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48 ECON110B III. Expectations and Consumption Household decision: how much of their income to consume today and how much to save for the future To show how consumption decisions depend not only on a person’s current income but also on his or her expected future income and on financial wealth To look at the movements in consumption over time 1. Consumption behavior The theory of consumption was developed by Milton Friedman in the 1950s, who called it the permanent income theory of consumption , and by Franco Modigliani, who called it the life cycle theory of consumption How much to consume and how much to save? To explore how expectations affect the consumption decision 1) The very foresighted consumer a. The consumption decision of a very foresighted consumer i) The value of his nonhuman wealth , or the sum of financial wealth and housing wealth 49 ii) Human wealth : The present value of expected after- tax labor income over his working life iii) The value of his human wealth and nonhuman wealth together gives an estimate of his total wealth - Reasonable assumption: one would decide to spend a proportion of one’s total wealth such as to maintain roughly the same level of consumption each year throughout his life b. C t = C(total wealth t ) - Total wealth t : the sum of nonhuman wealth (financial plus housing wealth) and human wealth at time t (the expected present value of current and future after-tax labor income) c. Example - Three more years of college student, 19 years old, - Assumption: nonhuman wealth is equal to zero. - Starting annual salary: $40,000 (base-year dollar) and increase by an average of 3% a year in real terms, 25% of income tax, 39 years to retire,
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50 - ) ( e t e Lt T Y V : Present value of your labor income = the value of real expected after-tax labor income, discounted using real interest rates = human wealth - Y e Lt : real labor income in year t - T e t : real tax in year t - Under assumption that the real interest rate equals zero - ] ) 03 . 1 ( ) 03 . 1 ( ) 03 . 1 ( 1 )[ 75 . 0 )( 40000 ($ ) ( 38 2 + + + + = e t e Lt T Y V - 000 , 166 , 2 $ ) ( = e t e Lt T Y V - To expect to live about 16 years after you retire Expected remaining life today is 58 years - To consume the same amount every year (consumption smoothing) $2,166,000/58 = $37,344 a year - Given that your income until you get your first job is equal to zero You will have to borrow $37,344 a year for the next three years, and begin to save when you get your first job 2) More realistic description a. Other situations against to above example
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This note was uploaded on 09/18/2008 for the course ECON 100B taught by Professor Rauch during the Winter '07 term at UCSD.

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III_consumption_expectation_ho - ECON110B III. Expectations...

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