Chapter3 - Sanjay K. Chugh 43 Spring 2008 Chapter 3 The...

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Unformatted text preview: Sanjay K. Chugh 43 Spring 2008 Chapter 3 The Consumption-Savings Model We just studied the consumption-leisure model as a one-shot model in which individuals had no regard for the future: they simply worked to earn income, all of which they then spent on consumption right away, putting away none of it for the future. Individuals do, of course, consider their future prospects when making economic decisions about the present. When an individual makes his optimal choice about consumption and leisure in the current period, he usually recognizes that he will make a similar consumption-leisure choice in the future. In effect, then, it seems there are multiple consumption-leisure choices an individual makes over the course of his lifetime. However, these choices are not independent of each other because consumers can save for the future (or borrow against future income, which is simply negative saving, also known as dissaving). That is, current choices affect future choices, and, conversely, expectations of future choices affect current choices. In this section, we will focus on the study of intertemporal (literally, across time) choices of individuals by ignoring leisure altogether. That is, we will revert to our assumption that an individual has no control over his income. But we will enrich our model of consumer theory by now supposing that each individual lives for two time periods the present period and the future period. We will designate the present period as period 1 and the future period as period 2. There is no period 3, and every individual knows there is no period 3. Think of this as meaning that the world (and hence the economy) ends with certainty after two periods. This stark division of all time into just two periods will serve to illustrate the basic principles of (macro)economic events unfolding as a sequence over time; after mastering the basics of dynamic macroeconomics by using the two-period model, we will eventually extend ourselves to consideration of an infinite-period model, which arguably may be more realistic because, after all, when does time end? But lets build up that slowly. In the two-period model, our stylized (that is, representative) individual will receive labor income (over which he has no control) in each of the two periods and have to make a choice about consumption in each of the two periods, and we will allow him to save or borrow in period 1. The notation we will use here, indeed the entire method of analysis, should remind you of our initial study of consumer theory. A Simple Intertemporal Utility Function As always, in order to study consumer choice, we need to first specify the individuals utility function. In our present intertemporal context, the two arguments to the utility function are consumption in period 1 and consumption in period 2, which we will denote...
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This document was uploaded on 11/01/2011 for the course ECON 325 at Maryland.

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Chapter3 - Sanjay K. Chugh 43 Spring 2008 Chapter 3 The...

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