EC223chapter10 - 1 Chapter 10: Learning Objectives Model of...

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2 Chapter 10: Learning Objectives Model of Intertemporal Savings Behaviour Applications: interest rate, income changes,  liquidity constraint Keynesian, Lifecycle and Permanent Income Hypotheses Ricardian Equivalence
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3 The household sector Households provide a major portion of the savings flow into the  economy.  Savings rate Savings rate : the proportion of disposable income devoted to saving rather  than to consumption.  Disposable income Disposable income : After tax income. Since the flow of savings provides the raw material necessary for the  existence of financial intermediaries, it is important to understand some  of the key elements of a theory of savings behavior.  Since savings represent a household’s residual income, a theory of  savings is also a theory of consumption.  Residual income Residual income : what is left after paying taxes and consumption spending.   Savings is nothing more than consumption postponed and conversely,  borrowing represents savings postponed. 
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4 Intertemporal Savings Behaviour Assumptions: 1. Individual earns a level of real income, denoted y,  in each of two periods.  2. The flow of income over the individual’s life time is  known with certainty.  3. This person or household has no wealth (from  inheritance or from previous savings) and does not  wish to leave anything to the next generation at the  end of the second period.  4. The interest rate does not change.   
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5 Intertemporal Savings Behaviour If the real interest rate is   , a 1$ investment will, after 1 year, yield: An individual can make one of three choices: 1. To keep each period’s consumption spending even with income.  2. To save at least part of the income in period 1 and then consume it in  period 2 (along with the period 2 income). 3. To consume more than the income in period 1, financing the extra  consumption by borrowing. The loan must be repaid from period 2  income.   ρ ( 29 ( 29 ( 29 [ ] e - R 1 1 1 1 equation, Fisher Using later. year one $1 on earned interest the represents 1 where 1 1 π + = + +
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6 Intertemporal Savings Behaviour Which course will the individual choose? It will be the one that provides  utility maximization -that is the one that  provides the greatest satisfaction, which economists interpret as the most  consumption.  1 , 1 : periods 2 over the income the of and spending n consumptio of lue present va The t. period for level income real the measure let and t period in spending n consumptio real represent Let 2 1 2 1 t ρ + + + + y y c c y c t
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7 Intertemporal Savings Behaviour: Basic Ingredients of the Model y 1 c 1 y 2 c 2 ρ y = real income c = real consumption ρ = real interest rate
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This note was uploaded on 10/11/2011 for the course EC 223 taught by Professor Mesta during the Winter '11 term at Wilfred Laurier University .

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EC223chapter10 - 1 Chapter 10: Learning Objectives Model of...

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