Macroeconomics plus MyEconLab plus eBook 1-semester Student Access Kit (6th Edition)

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Econ 304 Sonoma State University Dr. Robert Eyler Fall 2007 Homework #2: Suggested Answers 1. Explain the consumption-saving tradeoff of the consumer by using the following methods: a. The microeconomic foundations analogous to the utility maximizing consumer; The microeconomic foundations of macroeconomics begin with the consumer’s problem of maximizing utility from consuming a bundle of goods and services, what we can think of as units of GDP. The consumer faces a budget constraint, where the sources of funds flow from both income earned from labor and income earned from wealth. Any income saved is considered an augmentation to wealth. An indifference curve exists that links the utility earned in one period from consumption to another for a total amount of utility over the household’s lifetime. When the marginal rate of substitution (MRS) between consumption today and consumption tomorrow is equal to the price ratio between today’s prices of GDP and tomorrow’s prices discounted back into today’s terms by (1 + R), the household maximizes utility. This is the same idea as a consumer choosing between food and shelter in microeconomics, as an example. 0 b. The macroeconomic ideas of intertemporal consumption. The macroeconomic idea concerning intertemporal consumption is that the choice between consuming today and consuming tomorrow involve three macroeconomic statistics. First is the interest rate. As the interest rate changes, so does the incentives for the household to save; the interest rate rising, holding all else constant, leads to a “tilting” of consumption to later time periods, as the household has a larger incentive to save. Income is another matter. As income rises, and that income change is permanent, the consumer has an incentive to consume more in both periods, because the consumer has an incentive to both consume and save more given the increase in income. The permanency of that change is key, as the household may elect to consume all of a one- time change income because that income shock is unlikely to return and does not affect lifetime income or the financial strategy of the household over its lifetime. Finally, the consumer also faces an intertemporal elasticity of substitution that links consumption today to consumption tomorrow within the household’s utility function. Interest rates and income affect the consumer’s budget, while this intertemporal elasticity of substitution affects the utility function. The combination of those three statistics, and the microeconomic foundation of utility maximization lead the household to choose consumption over time based on the following problem:
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Max U(C t , C t+1 ) subject to C t + R) (1 C P 1 t 1 t + + + = , where represent the sum of lifetime income and the initial wealth of the household.
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