Intermediate Macroeconomics, Sciences Po, 2014

Zsófia Bárány

Answer Key to Problem Set 8

1. Kuznets Consumption puzzle: Kuznets documented two facts in the con-

sumption data: (i) across households at a point in time, the average
propensity to consume is falling with income; and (ii) within a coun-
try over time, the average propensity to consume is stable. Explain why
these facts are a puzzle for the Keynesian consumption function. How
can the life-cycle theory of consumption resolve the puzzle?

Answer:

The average propensity to consume is AP C = C/Y . The Keynesian con-

sumption function states that consumption depends on current income:
C = a + bY . Taken together, the two facts potentially pose a puzzle be-
cause fact (i) implies that a > 0 while fact (ii) implies that a = 0.

The life-cycle theory could resolve this puzzle because the life-cycle con-
sumption function implies that consumption is a function of wealth (whereas
wealth does not appear at all in the Keynesian consumption function).
Across households, income varies more than wealth, so high-income
households should have a lower APC than low-income households.
But, over time, aggregate wealth and income grow together, which means
that the APC is stable.

2. Household optimality conditions: Suppose that an agent has only current

income y1 and is expecting to live just one additional period in which
she retires and earns no income. Her preferences are given by

U (c1 , c2 ) = u(c1 ) + β u(c2 )

There are no taxes and the interest rate is r.

(a) Derive the inter-temporal budget constraint.

Answer:

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 The inter-temporal budget constraint can be derived by combining
the two period budget constraints

y 1 = c1 + s 1

(1 + r) s1 = c2
to obtain
c2
y 1 = c1 +
1+r
The left-hand side is the present discounted value of income (we
have income only in one period) and the right-hand side is the present
discounted value of consumption. The slope of this constraint in a
c1 − c2 space will be the negative of (1 + r).

(b) Derive a condition that describes the optimal choice of c1 and c2 .

Hint: do not solve for c1 and c2 , show only the first-order condition
that relates these two variables to each other.

Answer:

We will maximize the utility function subject to the inter-temporal

budget constraint. One way to do so is to substitute the budget
constraint into the objective function to eliminate c2 so that we only
need to maximize with respect to c1 .

max u(c1 ) + β u [(1 + r) (y1 − c1 )]

Using the chain rule, the first-order condition for c1 is

u0 (c1 ) − β u0 [(1 + r) (y1 − c1 )] (1 + r) = 0

Note that the expression in the squared bracket is simply c2 , so we

can rewrite it as:
u0 (c1 ) = β (1 + r) u0 (c2 )
(c) To understand the optimality condition from part (b) it is useful to
argue in terms of the marginal rate of substitution between c1 and
c2 . The MRS is a measure of consumer’s internal valuation of c1
in terms of c2 : it can be defined as the amount of c2 that the con-
sumer is willing to give up for an additional unit of c1 and stay at
the same level of utility. Graphically it is captured by the slope of
an indifference curve coming through the point (c1 , c2 ): M RSc1 ,c2 =
M Uc1 /M Uc2 . Use this definition to find the MRS for the utility func-
tion in this question and interpret the condition you derived in part

2
 (b).

Answer:

Substituting M Uc1 = u0 (c1 ) and M Uc2 = β u0 (c2 ) in the definition of

the MRS, we have
u0 (c1 )
M RS =
β u0 (c2 )
We can rearrange the condition from part (b) to get that the M RS
must be equal to 1 + r, which is the slope (in absolute value) of
the inter-temporal budget constraint. In other words, it’s the rate at
which the market allows consumers to exchange c1 for c2 . If these
two rates differed (and the agent consumed both goods), she would
be better off trading one good for another until her internal relative
valuation of the goods (M RS) is consistent with the relative market
exchange value (1 + r).

3. Credit market imperfections: A consumer receives income y in the current

period, income y 0 in the future period, and pays taxes of t and t0 in the
current and future periods, respectively. The consumer can borrow or
lend at the real interest rate r.

(a) This consumer faces a constraint on how much she can borrow,
much like the credit limit typically placed on a credit card account.
0 −t0
That is, she cannot borrow more than x, where x < y1+r , with we
denoting lifetime wealth. Use diagrams to determine the effects on
the consumer’s current consumption, future consumption, and sav-
ings of an increase in x.

Answer:

The consumer faces a borrowing constraint that places a ceiling on

the level of current consumption. The consumer may consume more
than the current endowment, y − t, but less than the amount of
the lifetime endowment, we. The consumer’s budget line is shown
in the left panel of Figure 1. The budget line becomes vertical at
c = y − t + x, which is the maximum amount she can consume to-
day. As one possibility, the constraint is non-binding as in the left
panel of Figure 1. The consumer chooses point H. A change in the
level of x has no effect on such a consumer.

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 Alternatively, the consumer depicted in the right panel of Figure 1
originally chooses the corner solution, point B, and achieves a level
of utility corresponding to indifference curve, I1 . An increase in x
expands the budget constraint and the consumer now chooses point
G. The new equilibrium allocation consists of higher current con-
sumption and lower both current saving (higher debt) and future
consumption. This consumer is able to improve her level of util-
ity to that corresponding to indifference curve, I2 . Notice that this
also illustrates a well-known case of failing Ricardian Equivalence,
when a change in lump-sum taxes has real effects on consumption.

C′ C′

I1

H
I0

B B G
I2

C C

Figure
Figure1:1:The
The effect
effect ofof a relaxation
a relaxation in credit
in credit constraints
constraints

(b) constraint”).
Alternatively,Clearly, consumers who choose to be lenders are unaffected by
the consumer is given
such constraints. We therefore only need
an option
to be concerned
to borrow an unlim-
about the behaviour
∗ ∗
ofited amountThe
borrowers. at the
first interest r , where
type of constraint r > ar.maximum
imposes Use a diagram
amount ofto deter-
mine which
borrowing. This option the consumer
is the kinked chooses.
constraint from part (a). The second type of
constraint imposes a higher interest rate on borrowing.

Answer:
The choice of the best constraint depends on the consumer’s preference between
current and future consumption, i.e. the shape of the indifference curves. The
left
This panel of figure contrasts
problem 2 depicts thetwo casealternative
of a consumerforms
who prefers to paymarket
of credit the im-
higher interest rate on borrowing. This consumer picks point G, a point that
perfections. As one possibility, consumers may either
is preferred to any of the points along the kinked budget line. Her preferences
borrow or
lend
are suchatthat
theshesame real interest
puts higher rate, consumption.
value on current but face a maximum amount of
The arrow depicts
borrowing
the direction of(this is sometimes
increase of utility. referred to in the economics literature
as a ’hard credit constraint’). The alternative possibility allows un-
The secondborrowing,
limited panel depicts but
the case
the of a consumer
interest ratewhopaidprefers the maximumexceeds
on borrowing
borrowing constraint because here preferences are more evenly spread over
the interest
current and futurerate earned from
consumption. She maylending
pick point(which is known
C (for example). as a ’soft
Clearly
credit constraint’). Clearly, consumers who choose to be lenders
this type of consumer prefers point C to any of the point on the budget line are
unaffected
with byslopes.
two different such constraints. We therefore only need to be con-
cerned about the behavior of borrowers. The first type of constraint

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 imposes a maximum amount of borrowing. This is the kinked con-
straint from part (a). The second type of constraint imposes a higher
interest rate on borrowing.

The choice of the best constraint depends on the consumer’s prefer-

ence between current and future consumption, i.e. the shape of the
indifference curves. The left panel of Figure 2 depicts the case of a
consumer who prefers to pay the higher interest rate on borrowing.
This consumer picks point G, a point that is preferred to any of the
points along the kinked budget line. Her preferences are such that
she puts higher value on current consumption. The arrow depicts
the direction of increase of utility.

The second panel depicts the case of a consumer who prefers the
maximum borrowing constraint because here preferences are more
evenly spread over current and future consumption. She may pick
point C (for example). Clearly this type of consumer prefers point
C to any of the point on the budget line with two different slopes.

C′ C′

B
B
C

C C

Figure 2: Different types of credit rationing

Figure 2: Different types of credit rationing