Intermediate Macroeconomics

Lecture 10 - Consumption 2

Zsófia L. Bárány

Sciences Po

2014 April
Last week

I Keynesian consumption function – Kuznets puzzle

I permanent income hypothesis
I life-cycle theory of consumption
I two-period model
the effect of an increase in income, in interest rate
I borrowing constraints
I the pull of instant gratification
This week

1. Ricardian equivalence
2. credit market imperfections
3. social security programs
The Ricardian equivalence

I the Ricardian Equivalence theorem states that a change in the

timing of taxes by the government has no effect on
consumption
example: reduce taxes today – less government revenue, but
the same spending
⇒ have to increase taxes in the future
I key message is that a tax cut is not a free lunch
I this is true under certain conditions
Introduce the government in the two-period model
I the government’s current period budget constraint is

G =T +B

G gov spending, T taxes collected, B bonds issued

(borrowing)
I the government’s future period budget constraint is

G 0 + (1 + r )B = T 0

the gov has to repay its borrowing in this period: (1 + r )B

I the government’s present-value budget constraint is:

G0 (1 + r )B T0
G+ + =T + B+
1+r 1+r 1+r
Introduce the government in the two-period model

I the government’s current period budget constraint is

G =T +B

G gov spending, T taxes collected, B bonds issued

(borrowing)
I the government’s future period budget constraint is

G 0 + (1 + r )B = T 0

the gov has to repay its borrowing in this period: (1 + r )B

I the government’s present-value budget constraint is:

G0 T0
G+ =T +
1+r 1+r
Competitive equilibrium

three conditions have to be satisfied in a competitive equilibrium:

1. consumers choose current and future consumption optimally
given their BC
2. the gov present-value BC holds
3. credit market equilibrium:
total private saving is equal to the quantity of government
bonds issued in the current period

Sp = B
I remember that before the credit market clearing: S = I
where S = S p + S g , and I is investment
here there is no capital, or capital accumulation ⇒ I = 0
⇒ S p = −S g = B
I the gov and consumers interact in the credit market:
they borrow and lend – effectively trade current for future
consumption goods
1
relative price: 1+r
I but the total amount of goods in each period is fixed: Y
I credit market clearing through Walras’ law implies that the
income-expenditure identity holds:

Y =C +G
Assume that there are N identical consumers: T = Nt
Plugging this into the government’s present value budget
constraint:
G0 t0
 
G+ =N t +
1+r 1+r
We can use this in the consumer’s present value lifetime wealth:

y0 t0 y0 G0
   
1
w =y+ − t+ =y+ − G+
1+r 1+r 1+r N 1+r
Assume that there are N identical consumers: T = Nt
Plugging this into the government’s present value budget
constraint:
G0 t0
 
G+ =N t +
1+r 1+r
We can use this in the consumer’s present value lifetime wealth:

y0 t0 y0 G0
   
1
w =y+ − t+ =y+ − G+
1+r 1+r 1+r N 1+r

remember: all that matters for the consumer in choosing c and

c 0 is wealth, w , and the interest rate, r

in particular the timing of his income does not matter

⇒ the timing of government spending, or the timing of the taxes
that finance it does not matter, as long as its present value is
the same
The effect of a cut in current taxes for a borrower
I lower current
taxes, t ↓
current net
income higher
I higher future
taxes, t 0 ↑
future net income
lower
I E1 ⇒ E2
I BUT the
consumer’s wealth
does not change,
just the
endowment point
⇒ the BC does
  not change
Credit market clearing
S P (r ) is the total saving by all consumers, private supply of credit
upward sloping here: assume that substitution effect is stronger
than the income effect across all consumers

I t ↓, t 0 ↑
current net income ↑, future net
income ↓
I for a given interest rate each
consumer’s saving increases by
exactly his tax cut
I S1P (r ) shifts to the right by
B2 − B1 to S2P (r )
I credit demand shifts: B1 to B2
 
I ⇒ the equilibrium interest rate
is unchanged
Does the Ricardian equivalence always hold?

NO – What assumptions are needed?

1. tax burden equally shared among consumers
if not: the change could be unequally shared as well ⇒ gov
can redistribute wealth
2. lump-sum taxes
if the consumer has a labor supply choice and taxes are lower
might change the labor supply thus overall output in a given
period
if taxes are distortionary, they change the incentives to work
Does the Ricardian equivalence always hold?

3. perfect credit markets

if there are credit market imperfections, then
credit-constrained consumers might benefit from a current tax
cut
4. any debt issued by the gov is paid off during the lifetime of
the people who were alive when the debt was issued, i.e. who
enjoyed the tax cut
if not, there might be inter-generational tax cuts, i.e. those
some benefit from lower taxes, have higher wealth, others
suffer the higher taxes, and have lower wealth
Credit market imperfections

1. credit market imperfections and consumption

2. asymmetric information and the financial crisis
would-be borrowers know more about their characteristics
than do lenders
classic adverse selection: ”the market for lemons” by Akerlof
in 1970
3. limited commitment and the financial crisis
borrowers may choose to default – lender can overcome
limited commitment with collateral
Credit market imperfections and consumption

Type 1: interest rate spread

for the consumers the lending and borrowing interest rates are not
the same

rl < rb

for the government they are the same and equal to the lending
interest rate: rl

⇒ the Ricardian equivalence does not hold

Lifetime budget constraints

I for a lender
c < y ⇒ s > 0 ⇒ second period income y 0 + (1 + rl )s

c0 y0 t0
 
s(1 + rl )
c+s+ = y+ + − t+
1 + rl 1 + rl 1 + rl 1 + rl

I for a borrower
c > y ⇒ s < 0, b = −s ⇒ second period income
y 0 − (1 + rb )b
Lifetime budget constraints

I for a lender
c < y ⇒ s > 0 ⇒ second period income y 0 + (1 + rl )s

c0 y0 t0
 
c+ =y+ − t+
1 + rl 1 + rl 1 + rl

I for a borrower
c > y ⇒ s < 0, b = −s ⇒ second period income
y 0 − (1 + rb )b
Lifetime budget constraints

I for a lender
c < y ⇒ s > 0 ⇒ second period income y 0 + (1 + rl )s

c0 y0 t0
 
c+ =y+ − t+
1 + rl 1 + rl 1 + rl

I for a borrower
c > y ⇒ s < 0, b = −s ⇒ second period income
y 0 − (1 + rb )b

c0 y0 t0
 
b(1 + rb )
c+ = y +b+ − − t+
1 + rb 1 + rb 1 + rb 1 + rb
Lifetime budget constraints

I for a lender
c < y ⇒ s > 0 ⇒ second period income y 0 + (1 + rl )s

c0 y0 t0
 
c+ =y+ − t+
1 + rl 1 + rl 1 + rl

I for a borrower
c > y ⇒ s < 0, b = −s ⇒ second period income
y 0 − (1 + rb )b

c0 y0 t0
 
c+ =y+ − t+
1 + rb 1 + rb 1 + rb
Different borrowing and lending rates

I AEB would be the

BC if r = rl (= r1 ) for
borrower and lender
I DEF would be the
BC if r = rb (= r2 ) for
borrower and lender
I if r = rl for s > 0
⇒ AE
if r = rb for s < 0
⇒ EF
the BC becomes AEF
 

how does this compare to the borrowing constrained consumer’s

BC?
The effect of a tax cut

I a change in the timing of taxes:

G0 T10 T20 ∆T 0
G+ = T1 + = T2 + ⇒ ∆T = −
1 + rl 1 + rl 1 + rl 1 + rl
I for the consumer this implies

∆T ∆T 0 ∆t 0
∆t = =− =−
N N(1 + rl ) 1 + rl
0
(1 + rl )∆t = −∆t

I a current tax cut and future tax decrease moves his

endowment along the AEB line, since the government’s
borrowing and lending rate is rl
I ⇒ the consumer’s BC CHANGES
The effect of a tax cut
assume that the consumer initially consumes his endowment point

I the consumer is credit

constrained: he’d prefer
c > y , but borrowing is
too expensive
I the entire tax cut is
spent on current
consumption: ∆c = ∆t,
∆s = 0
I very diff from no credit
market imperf: the
consumer saves the
entire tax cut to pay the
higher future taxes:
∆c = 0, ∆s = ∆t
 
Asymmetric information

I lending carried out through banks

I deposit rate at banks is rl , loan rate is rb (these are
endogenous)
I fraction a of borrowers never defaults
fraction 1 − a always defaults
bank cannot distinguish the good borrowers from the bad ones
I bad borrowers mimic good borrowers
I ⇒ each borrows L
I the bank’s profit on a loan of amount L is:

π = aL(1 + rb ) − L(1 + rl )

I in equilibrium profits must be zero (why?)

1 + rl
π = 0 ⇒ 1 + rb =
a
I as long as a < 1, rb > rl
I there is a default premium: rb − rl > 0
Link to the current financial crisis

I the fraction of good borrowers in the population decreases

⇒ the credit market imperfection becomes more severe
I a ↓ the default premium increases
⇒ even the good borrowers face higher loan rates
I ⇒ consumption falls for all borrowers
I this matches the observations from the current financial crisis
– increase in credit market uncertainty, reduction in lending,
decrease in consumption expenditures
Fraction of good borrowers decreases

I lower a
I ⇒ higher rb
I BC shifts in on the
borrowing part
I consumption for all
  borrowers falls
Interest rate spread in the data
measured by: the difference between the interest rates on
AAA-rated and BAA-rated corporate debt
I the spread hikes at
the end of recessions
as default rate ↑ then
I most recent recession:
spread ↑ at the
beginning
I cause of recession –
financial crisis:
the degree of
asymmetric
information increased
due to increasing
  uncertainty in credit
markets
Limited commitment

I any loan contract represents an inter-temporal exchange – the

borrower receives goods and services in the present in
exchange for a promise to repay in the future
I borrowers need incentives not to default on their debts – these
incentives typically provided by collateral requirements
I collateral is something that the lender can seize in case of
non-payment (default)
I examples: house is collateral for a mortgage loan or for
financing consumption, car is collateral for a car loan
Limited commitment

Introduce limited commitment into the two-period consumption

model
I H – quantity of housing owned by consumer
I p – price of housing
I assume that housing is illiquid – can’t be sold in the current
period
I BUT it is possible to borrow against housing wealth, with a
collateral constraint
⇒ loan repayment cannot exceed what the bank can get by
selling the house: pH
Limited commitment

I the lifetime BC of the consumer:

c0 y 0 − t 0 + pH
c+ =y −t +
1+r 1+r
I collateral constraint:

−s(1 + r ) ≤ pH

I using that s = y − t − c
pH
c ≤y −t +
1+r
A fall in house prices

I E endowment point
I the consumer can only
borrow up to the value of
the house
⇒ AEB and then BD
I a fall in the price of the
house implies
endowment point shifts
down
and borrowing limit is
  lower
⇒ FG and then GH
The evolution of house prices in the US

the average selling price of houses divided by the CPI

Percentage deviations from trend in consumption in the US

I house prices do
not fall during
the 2001
recession
I consumption
also does not
decline too
much
I ⇒ consumers
financed their
consumption by
borrowing
against the
value of their
  house
Social security programs – Pensions

I pension programs: government provided means for saving for

social security
→ helps people smooth consumption over their life cycle
I why is there a need for this? why can’t individuals do it
themselves on the credit markets?
I social security programs can be rationalized by a credit market
failure – the inability of the unborn to trade with those
currently alive
I there are two important types of social security programs
I pay-as-you-go: transfer between the young and the old
I fully funded: a government sponsored savings program where
the old receive the payoffs on the assets that were acquired
when they were young
Pay-as-you-go social security

I taxes on the working population pay for social security

transfers to those who have retired each period
I assume for simplicity that there are two generations are alive
at each date, young and old
I the young pay social security taxes t, the old receive social
security benefits b
I the population grows at rate n: N 0 = (1 + n)N, where each
period, there are N 0 young and N old alive
I for a balanced social security budget
total social security benefits must equal total taxes on the
young: Nb = N 0 t
b
I ⇒t= 1+n
The introduction of a pay-as-you-go social security
the effect on those who are old at the time of its introduction

I they receive benefits b

I endowment point shifts
up
E 1 → E2
I pure positive income
effect

 
The introduction of a pay-as-you-go social security
the effect on those who are born at or after the time of its
introduction
I pay tax t when young
receive benefits b when
old
I endowment point shifts
in and up
E 1 → E2
slope: −(1 + n)
I if n > r the BC shifts out
and the consumer is
better off
I income effect:
b
∆w = −t + 1+r =
b b
− 1+n + 1+r =
  −r +n
b (1+n)(1+r )
Pay-as-you-go social security
I pay-as-you-go is beneficial only if the population growth rate
exceeds the real interest rate
I interpretation: the population growth rate is the implied rate
of return for an individual from the social security system
⇒ social security is only worthwhile if the return exceeds what
could be obtained in private credit markets
I due to the baby boom in the 50 and 60s, currently (in the
US), the social security taxes paid by the working age
population can cover social security benefits to the old
but when the baby boom generation retires
- the social security tax (paid by future young) has to go up
- or the benefits have to be cut
I some European countries are already facing the problem of an
aging population and considering a transition to some form of
fully funded social security
Fully funded social security
essentially a mandated savings program where assets are acquired
by the young, with these assets sold in retirement

I E endowment point
I D optimal point without
the pension program
I mandated savings: y − c1
I → optimal point with
pension program: F
I consumer worse off due
to pension program

 
Fully funded social security

I the program only matters if it mandates a higher level of

saving than the consumer would choose otherwise
I in such a case the consumer is worse off than without the
pension program
I might be subject to a moral hazard problem
government insures a minimum return on retirement savings
⇒ fund managers might take high risk projects, as they only
get the upside
⇒ so what is the rationale for such a forced saving program?
I government’s inability to commit ⇒ people know that they
won’t be left to die when old and without any income
I pull of instant gratification
I there is no Pareto optimal transition from PAYG to
fully-funded, as someone has to pay to the current retirees.