Williamson_3e_IM_08 - Chapter 8 A Two-Period Model The...

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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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68 Williamson • Macroeconomics, Third Edition Ricardian equivalence also has important implications for issues of public policy related to social security.
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This note was uploaded on 03/03/2010 for the course ECON 1001 taught by Professor Donaldberry during the Spring '09 term at UCL.

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Williamson_3e_IM_08 - Chapter 8 A Two-Period Model The...

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