Comparative Statics

EC2102 Lecture 3; Week 3; January 26, 27, 2016
Comparative Statics: Increase in Income (4/5)

Now suppose that both periods incomes rise given an interest rate: !y1 =
!y2 > 0.
It is as if your income has increased permanently, so call it a permanent change
in income
From the lectures, we know that consumption choices are made out of lifetime wealth. So in deciding how to change consumption choices when income
changes, either temporary or permanent, we basically have to ask how much
wealth changes in response to these changes
Comparative Statics: Increase in Income (5/5)

See Figure 7
Message: consumption depends on lifetime wealth, but changes in temporary
income yield smaller changes in lifetime wealth, which aects consumption by
less than permanent changes in income (which yield larger changes in lifetime
wealth).
Comparative Statics: Increase in
(1/5)
Question: How does consumption change in both periods when r increases?

Answer: Depends on whether you are a borrower or lender
Two eects:
1. Substitution eect
2. Income eect
shift of U curve
shift of U curve
Substitution eect:
- Consuming today is more expensive relative to consuming tomorrow, because
the opportunity cost of consuming today has increased (one unit of savings
yields a higher return when r is higher); price of consuming today relative to
tomorrow is (1 + r)

-
1
1+r
"
(2/5)
is the price of consumption goods tomorrow in terms of current con-
sumption goods. Increase in r means that

consume tomorrow.
1
1+r
"
is lower, i.e., cheaper to
) consume less today and more tomorrow, or c"1 #; s"1 " and c"2 "
Substitution eect is the same for both borrowers and lenders

BUT income eect works in opposite directions depending on whether you are
a borrower or lender
Income eect:
If borrower, feel poorer as pay back more interest on loan; c"1 #, s"1 " and c"2 #
If lender, feel richer because get more interest on loan; c"1 ", s"1 # and c"2 "

Summarizing results for a lender:
c"1 s"1 c"2
substitution eect # " "
income eect
" # "
and for a borrower,
c"1 s"1
substitution eect # "
income eect
# "
c"2
"
#
(3/5)
(4/5)
Eect of an interest rate increase on LBC? (gure 8)

- recall that LBCs slope is % (1 + r)
- intercepts of LBC? When c2 = 0, c1 = ! (PV of lifetime earnings),
- and when c1 = 0, c2 = ! (1 + r) (future value of lifetime earnings)
Let r be the old interest rate, re be the new interest rate, re > r
- new LBCs slope if % (1 + re) < % (1 + r) (new LBC is steeper)
y
! & y1 + 2 (LBC )
1+r
y
! 0 & y1 + 2 < !; and
1 + re
! (1 + r ) = y1 (1 + r ) + y2
! 0(1 + re) = y1 (1 + re) + y2 > ! (1 + r )
(5/5)
See gure 9
( For aggregate consumption function we will assume that the substitution

eect dominates the income eect so that current consumption decreases
with rises in the interest rate
backed by Macro data (savings increase with r increases)
Denition of Competitive Equilibrium (1/4)

A competitive equilibrium for the economy considered here with N individuals
n
oN
i"
i"
i"
c1 ; c 2 ; s 1
,
i=1
is an allocation
giving the amount consumed and saved in
each period by each individual i, and an interest rate r"; such that:
!
"
i" i"
( for each individual i, taking the interest rate r" as given, ci"
1 ; c2 ; s1 is
the solution to his lifetime utility maximization problem;
( the credit market clears at the interest rate r", i.e., total borrowing = total
savings, or
S1P (r") = 0;
(9)
where S1P (r) is the aggregate amount of (private) savings at time t when
the interest rate is r:

Why competitive?
Because all prices (real interest rate) taken as given when agents are optimizing,
implying that each agent considers that his actions have no impact on the
market interest rate. Hence, this notion of competitive equilibrium only makes
sense when the population of agents in the economy is large.
Interpretation of equation (9): the real interest rate will adjust to clear the
credit market.
There is an alternative way to express this market clearing condition in equation
(9). Denote Yt as aggregate output, and Ct as aggregate consumption.
10

Since
StP (r ")
Yt % Ct = 0
=) Yt = Ct; t 2 f1; 2g
(10)
then (10) is an alternative way of expressing the credit market clearing condition
This alternative way is: that goods market clears.
Walras Law tells us that in our economy, if credit market clears, goods market
clears; and goods market clears, credit market clears. That is why we only need
to write the condition that one of the two markets here clears.
11

Note that credit and goods markets are intricately linked. If goods demanded
in goods market exceeds goods supplied, then it must be because too few
individuals want to save relative to the number who want to borrow. Conversely,
if goods supplied exceeds goods demanded in the goods market, then there are
relatively too few borrowers. It is clear that when demand equals supply in
both markets, then both markets clear. But we know from Walrass Law that
if there are M markets in the economy and if (M % 1) markets clear, than the
last market must clear. Which is why we can focus on credit market clearing.
At the market clearing interest rate r"; StP (r") = 0; credit market clears, and
goods market must also be clearing.
12
Competitive Equilibrium: An example (1/2)

Assume all individuals are identical (with the same preference and same income
process).
Then all agents will choose to save the same amount in each period.
It must be that S1P (r") = 0 in equilibrium because no one saves and borrows and just consumes whatever income they have in each period, and in the
aggregate, S1P (r") = 0:
i" = y i"
In other words, each individual i will choose to save si"
=
0,
and
c
1
1
1
i"
i"
and c2 = y2
Since everyone is identical, we can just talk about a representative consumer
13
Competitive Equilibrium: An example (2/2)

n
oN
i" i"
"
A competitive equilibrium here is an allocation ci"
1 ; c2 ; s1 i=1 and price, r ,
such that
c"1
y1; s"1
( the representative consumer chooses

=
imize lifetime utility, taking as given real interest
= 0; c"2
rate r"
"
= y2 to max-
( the credit market clears at r". That is, S1P (r ") = 0, i.e., no aggregate
savings or dissavings.
WARNING: denition of competitive equilibrium diers according to the economy being described. Do NOT memorize; UNDERSTAND what exactly it is
that makes the economy be in equilibrium!
14
Introducing Govt. into our Two-Period Model (1/5)

Now we introduce a Government (notice the variables are in caps)
- Expenditures: G1 and G2
- Levy lump-sum taxes: T1 and T2
Can issue bonds at the end of rst period: B1; so rst period budget constraint
is
G1 = T1 + B1:
- If G1 > T1, then the government is running a decit, and it must issue bonds
to nance it, and hence, B1 > 0. That is, the government is in debt.
- but if G1 < T1, then the government is running a surplus, and the government
can lend out this surplus by buying bonds issued by individuals, so B1 < 0:
15

In the second period, governments budget constraint is
G2 = T2 % (1 + r )B1
What is assumed here is that govt does not default.

Like an individual, we can write the governments lifetime budget constraint:
G2
T2
G1 +
= T1 +
,
(14)
1+r
1+r
and like an individual, the government also has to nance its expenditures based
on how much lifetime "earnings" it has.
Homework:
Verify that the governments budget constraint holds by manipulating its rst and second period budget constraints.
16

If we think of this economy as having N people, with each person paying the
same amount of taxes t1 in period 1 and t2 in period 2, then T1 = N t1;
T2 = N t2;
G2
T2
N t2
G1 +
= T1 +
= N t1 +
.
1+r
1+r
1+r
For consumers, since each of them pays taxes of t1 and t2 in periods 1 and 2
respectively, there is now a distinction between income y and disposable income
ytd = yt % tt
An individuals budget constraints:
- rst period: c1 + s1 = y1 % t1 = y1d
- second period: c2 % (1 + r) s1 = y2 % t2 = y2d;
17

where disposable income in each period t as income net of taxes:
ytd = yt % tt
The new LBC for the consumers is

y2d
c2
(y2 % t2)
d
c1 +
= (y1 % t1) +
= y1 +
,
1+r
1+r
1+r
which can be rewritten as
*
+
c2
y2
t2
c1 +
=
y1 +
%
t1 +
= ! % 8,
1+r
1+r }
|
{z1 + r}
|
{z
P V of lifetime income
P V of taxes
t2
where 8 = t1 + 1+r
is the present value of taxes consumer pays.
18

So if we dene disposable wealth as
!d = ! % 8 ;
then the individuals LBC is

c1 +
c2
= !d
1+r
(15)
From (15), it is clear that an individuals consumption decisions are based on

wealth, but now we have to be more careful: it is based on disposable wealth
since the individual could be paying taxes
Note that PV of taxes aect consumers decision.
19
Competitive Equilibrium (1/2)

Given that the government
in this two-period
*
+ economy with N individuals is
spending and taxing
oN
i
i
G1; G2; t1; t2
i=1
such that the governments LBC
holds, a competitive equilibrium is an allocation

interest rate r", such that
( each individual i chooses
rate r"; and
i" i"
ci"
1 ; c2 ; s1
"
*n
oN +
i" i"
ci"
1 ; c2 ; s1 i=1 , and an
optimally, given the real interest
( the credit market clears at r"; that is,
S1P (r ") = B1:
(16)
20
Competitive Equilibrium (2/2)

g
Why equation (16)? Because S1 = %B1, and S1 = S1P + S1 ,

where S1 : aggregate savings
g
So if S1 (r") = S1P (r") + S1 (r") = 0 ) S1P (r") = B1

But this also implies that goods market clears. The goods market clears if
Yt = Ct + Gt; t 2 f1; 2g
Note: To see this for t = 1, since S1P = Y1 % C1 % T1; and B1 = G1 % T1;

so saying that S1P = B1 is equivalent to saying that Y1 = C1 + G1.
21
Question:
Can we apply what we have learnt so far to the real
world? Is it actually useful?
What we have learnt so far sounds very theoretical.
Some of you may be thinking that we have a lot of symbols all over the
slides, so you may be thinking: So what? Im never going to see all this stu,
much less use it, in the real world.
But all this theory is very useful. What is the message you have learnt so far?
Current issues: global recession of last few years and current recovery;
current global stock market volatility
Another: tax cuts, especially before elections
22
The Ricardian Equivalence Theorem (1/5)

Theorem 1 For a given level of government expenditures for the rst and
second periods, the exact timing of taxes has no impact on the real economy,
i.e., the consumption choices of the individuals and the real interest rate do not
change when the timing of taxes changes.
Intuition: if govt is going to spend G1 and G2; so long as the govts own
LBC, (14) ; holds, it doesnt matter when the govt levies taxes; the individuals
lifetime disposable wealth is unaected, and since each individual consumes and
saves out of lifetime disposable wealth, his consumption choices are unchanged.
Also, real interest rate is unaected. That is, all real variables are unchanged
Message: A tax cut is not a free lunch!
23

Suppose initially the government balances its budget in each period: Gt = Tt;
so that tt = Tt=N = Gt=N
Suppose now the govt still wants to spend (G1; G2) ; but decides to implement
a tax cut in the rst period so that Tb1 < G1 :
- hence, tb1 < t1;
- and govt therefore runs a decit in the rst period since (G1 % Tb1) > 0
- hence, govt must be issuing bonds to nance decit B1 > 0:
Then second period taxes must increase in order to pay back debt issued in
rst period, that is, Tb2 = G2 + B1 (1 + r) ; so each individual now pays

Tb2
G2 + B1 (1 + r)
G2 B1 (1 + r)
=
=
+
N
N
N !
N "
G1 % Tb1
B1
= t2 + (1 + r)
= t2 + (1 + r)
N
N
!
!
"
G1 Tb1
= t2 + (1 + r)
%
= t2 + (1 + r) t1 % tb1 ;
N
N
tb2 =
and the PV of taxes paid by each individual is:
b
t
8b = tb1 + 2
1+r
!
"
b
!
"
t2 + (1 + r) t1 % t1
t
2
= tb1 +
= tb1 +
+ t1 % tb1
1+r
1+r
t2
= t1 +
= 8!
1+r
24
25

So PV of taxes unchanged! But this means that disposable wealth unchanged!
So each individuals maximization problem unchanged!
So consumption choices unchanged!
What is going on here? Govt cuts taxes in rst period, but individuals know
they have to pay for this shortfall in
! taxes "in the second period, so they save
the entire amount of the tax cut t1 % tb1 by buying bonds from govt. (If
they were dissaving, they will dissave
less.)
In the second period, the govt will
!
"
increase taxes to the tune of t1 % tb1 (1 + r) ; so individuals will use what
they have saved, plus interest, to pay o this increase in taxes.
Since PV of taxes unchanged, LBC unchanged, so consumers do not modify
i"
their optimal consumption choices, and hence ci"
1 ; and c2 not aected by the
change of timing of taxes for every individual
26

But si"
1 changes because each consumer saves more now to pay more taxes
later.
- (see gure 10)
Intuition as to why r" is unchanged:
- private savings increase today since each individual saves more,
- but govt is borrowing more; in fact, the exact increase in govt dissavings
equals increase in private savings,
- hence, credit market is still clearing at original interest rate of r"
(See Figure 9.17, but in our example, B1 = 0)
27
When does the Ricardian Equivalence fail?

Ricardian Equivalence result relies on several assumptions. And when some of
these assumptions are relaxed, it can fail; however, it can also be robust to
modications of the assumptions.
Four instances under which the Ricardian Equivalence fails
1. Intragenerational Transfers
2. Intergenerational Transfers
3. Distortionary Taxes
4. Credit Market Imperfections
- credit constraints

Comparative Statics

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EC2102 Lecture 3; Week 3; January 26, 27, 2016