Chapter 4 - Disclaimer: These notes were prepared based on...

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Unformatted text preview: Disclaimer: These notes were prepared based on lectures of Prof Sala-i-Martins 2008 Fall Course of Intermediate Macro-W3213. Contents of these notes might not match completely with the current teachings in class. An updated version would be available later in the semester. 4.1 Consumption Theory and Intertemporal Choice In Chapter 3 we studied static wealth and substitution effects. We saw when productivity increases consumption(C) increases but effect on leisure (l) is ambiguous because the substitution effects lead people to increase C and reduce leisure and the wealth effect leads to increase both. As a result the effect on labor (L) is also ambiguous. We now move over to a slightly more complicated world than considered in the Robinson Crusoe case. We add two new features: i) The Robinson Crusoe story neglects the ability that people have to save part of their income if they do not want to consume all the cookies produced during the year. We also ignored TIME effects (if we know that we will make more cookies next year we may want to borrow and spend more today). We need to introduce Credit Markets so that people can borrow and lend if the amount of consumption they desire is larger than the amount of income they get. Note we still do not have Money, so bonds here mean real or cookie bonds and all our discussion is in real terms. We will introduce Money in the next chapter. ii) The story also neglected the fact that people produce different goods and exchange them for one another. Since Robinson Crusoe was the only consumer as well as producer of the economy exchange was not possible. 4.2 Credit Market and Bonds If TODAY people want to consume less than they earn, they can put the extra cookie in the BANK (think of a cookie bank). We call this purchasing a BOND by the amount ? ? dollars. Purschasing a BOND means that we give the bank some cookie today. In exchange we get a piece of paper that says WE owe you ? ? plus interest to be paid TOMORROW in terms of cookies. When ? ? > 0, we say that we lend cookie to the bank and we own the bonds, which constitute positive wealth. When ? ? < 0, we say that we receive LOANS which needs to be paid back later with interest and is like negative wealth. 4.3 Dynamic Budget Constraints and Intertemporal Budget Constraints Imagine that we start the year with some bonds and some cookies in our pockets, we receive some income from selling our product, we spend by purchasing consumption goods, we purchase some bonds and we go to bed with some cookies in our pocket. OVERALL RESOURCES: ? + ? ? 1 + ? ? ? 1 = ? + ? ? 1 1 + ? 4.1 Where ? is the income we earn this period (t) and ?...
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Chapter 4 - Disclaimer: These notes were prepared based on...

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