Chapter 4

Applications/Variations

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4.1 Consumption Smoothing

4.1.1 The Intertemporal Budget

• For any given sequence of interest rates {Rt }∞ ∞

t=0 , pick an arbitrary q0 > 0 and define {qt }t=1 , by

q0
qt = .
(1 + R1 )...(1 + Rt )

qt represents the price of period−t consumption relative to period−0 consumption.

• The budget in period t is given by

ct + at+1 ≤ (1 + Rt )at + yt

where at denotes assets and yt denotes labor income.

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• Multiplying the period-t budget by qt , adding up over all t, and using the fact that qt (1 + Rt ) = qt−1 ,
we have
T
� T
�
qt ct + qT aT +1 ≤ q0 (1 + R0 )a0 + qt yt
t=0 t=1

• Assuming either that the agent dies at finite time without leaving any bequests, in which case
aT +1 = 0, or that the time is infinite, in which case we impose qT aT +1 → 0 as T → ∞, we conclude
that the intertemporal budget constraint is given by

T
� T
�
qt ct ≤ q0 (1 + R0 )a0 + qt yt ,
t=0 t=1

whether T < ∞ (finite horizon) or T = ∞ (infinite horizon).

• The interpretation is simple: The present value of the consumption the agent enjoys from period 0
and on can not exceed the value of initial assets in period 0 plus the present value of the labor income
received from period 0 and on.

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• We can rewrite the intertemporal budget as

T
�
qt ct ≤ q0 x0
t=0

where

�∞
qt
x0 ≡ (1 + R0 )a0 + h0 and h0 ≡ yt .
t=0
q0

• (1 + R0 )a0 is the household’s financial wealth as of period 0.

• h0 is the present value of labor income as of period 0; we often call h0 the household’s human wealth
as of period 0.

• The sum x0 ≡ (1 + R0 )a0 + h0 represents the household’s effective wealth.

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• Note that the sequence of per-period budgets and the intertemporal budget constraint are equivalent.
We can thus rewrite the household’s consumption problem as follows

T
�
max β t U (ct )
t=0
T
�
s.t. qt ct ≤ q0 x0
t=0

• The above is like a “static” consumption problem: interpret ct as different consumption goods and
qt as the price of these goods. This observation relates to the context of Arrow-Debreu markets that
we discuss later.

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4.1.2 Consumption Smoothing

• The Lagrangian for the household’s problem is

T
� T
�
� �
L= β t U (ct ) + λ q0 x0 − qt ct
t=0 t=0

where λ is the shadow cost of resources for the consumer (that is, the Lagrange multiplier for the
intertemporal budget constraint).

• The FOCs give

U � (c0 ) = λq0

for period 0 and similarly

β t U � (ct ) = λqt

for any period t.

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• Suppose the interest rate equals the discount rate in all t: Rt = ρ ≡ 1/β − 1 and hence

qt = β t q0

The FOCs then reduce to

U � (ct ) = λq0 ∀t

It follows that consumption is constant over time: there exists a c such that ct = c for all t.

• But how is the value of c determined? From the intertemporal budget, using qt = β t q0 and ct = c,
we infer
T
� 1
q 0 x0 = qt c t = q0 c
t=0
1−β

and therefore the household consumes a constant fraction 1 − β of his initial effective wealth in every
period:
c = (1 − β)x0 = (1 − β) [(1 + R0 )a0 + h0 ]

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4.2 Arrow-Debreu Markets

• We now introduce uncertainty. Each period t nature draws a random variable st , which has (for
simplicity) finite support S. Let st = {s0 , s1 , ..., st } denote the entire history of these realization up
to (and including) period t.

• At time 0, we open a complete set of Arrow-Debreu markets: agents can trade commodities contingent
on all possible realizations of future uncertainty. If there are T period and S possible states per period,
this means that we open 1 + S + S 2 + S 3 + ... + S T markets.

• Let q(st ) be the period-0 price of a unit of the consumption good in period t and event st , and w(st )
the corresponding wage rate in terms of period-t, event-st consumption goods. q(st )w(st ) is then the
period-t, event-st wage rate in terms of period-0 consumption goods.

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• We can then write household’s consumption problem as follows

�� � �
max β t π(st )U cj (st ), z j (st )
t st
��
s.t. [q(st ) · cj (st ) + q(st )w(st ) · z j (st )] ≤ q0 · x̄j0
t st

where

x̄j0 ≡ (1 + R0 )a0 + h̄j0 ,

∞
� q(st )
h̄j0 ≡ [w(st ) · z̄ − T j (st )].
t=0
q0

(1 + R0 )aj0 is the household’s financial wealth as of period 0; z̄ is the endowment of time (normalize it
to 1, if you like); T j (st ) is a lump-sum tax obligation, which may depend on the identity of household
but not on its choices. h̄j0 is the present value of the entire time endowment as of period 0 net of
taxes. (caution: this h is different than the one previous defined.)

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4.2.1 The Consumption Problem with CEIS

• Suppose for a moment that preferences are separable between consumption and leisure and are
homothetic with respect to consumption:

c1−1/θ
U (c, z) = u(c) + v(z) u(c) =
1 − 1/θ

• Letting µ be the Lagrange multiplier for the intertemporal budget constraint, the FOCs imply

� �
β t π(st )u� cj (st ) = µq(st )

for all t ≥ 0. Evaluating this at t = 0, we infer µ = u� (cj0 ). It follows that the price of a consumable
in period t relative to period 0 equals the marginal rate of intertemporal substitution between 0 and
t: � �−1/θ
q(st ) β t π(st )u� (cj (st )) cj (st )
= = β t π(st ) .
q0 u� (cj0 ) cj0

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� �−θ
θ q(st )
• Solving the latter for cj (st ) gives cj (st ) = cj0 [β t π(st )] q0
. It follows that the present value of
consumption is given by

�� ∞
� � �θ
t j t
q(s )c (s ) = q0−θ cj0 β t π(st ) q(st )1−θ
t st t=0

Substituting into the resource constraint, and solving for c0 , we conclude

cj0 = m0 · x0j

where m0 represents the MPC out of effective wealth as of period 0 and is given by

m0 ≡ �∞ .
t t θ t 1−θ
t=0 [β π(s )] [q(s )/q0 ]

• A similar result applies for all t ≥ 0. We conclude

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Proposition 19 Suppose preferences are separable between consumption and leisure and homothetic in
consumption (CEIS). Then, the optimal consumption is linear in contemporaneous effective wealth:

cjt = mt · xjt

where

xjt ≡ (1 + Rt )atj + hjt ,

∞
� qt
hjt ≡ [wτ lτj − Tτj ],
τ =t
qt
1
mt ≡ �∞ .
τ =t β θ(τ −t) (qτ /qt )1−θ

mt is a decreasing (increasing) function of qτ for any τ ≥ t if and only θ > 1 (θ < 1). That is, the marginal
propensity to save out of effective wealth is increasing (decreasing) in future interest rates if and only if the
elasticity of intertemporal substitution is higher (lower) than unit. Moreover, for given prices, the optimal
consumption path is independent of the timining of either labor income or taxes.

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• Obviously, a similar result holds with uncertainty, as long as there are complete Arrow-Debreu
markets.

• Note that any expected change in income has no effect on consumption as long as it does not affect
the present value of labor income. Also, if there is an innovation (unexpected change) in income,
consumption will increase today and for ever by an amount proportional to the innovation in the
annuity value of labor income.

• To see this more clearly, suppose that the interest rate is constant and equal to the discount rate:
Rt = 1/β−1 for all t. Then, cjt = cj0 for all t and the consumer chooses a totally flat consumption path,
no matter what is the time variation in labor income. And any unexpected change in consumption
leads to a parallel shift in the path of consumption by an amount equal to the annuity value of the
change in labor income. This is the manifestation of intertemporal consumption smoothing.

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4.2.2 Incomplete Markets and Self-Insurance

• The above analysis has assumed no uncertainty, or that markets are complete. Extending the model
to introduce idiosyncratic uncertainty in labor income would imply an Euler condition of the form

u� (cjt ) = β(1 + R)Et u� (cjt+1 )

Note that, because of the convexity of u� , as long as V art [cjt+1 ] > 0, we have Et u� (cjt+1 ) > u� (Et cjt+1 )
and therefore
Et cjt+1
> [β(1 + R)]θ
cjt
This extra kick in consumption growth reflects the precautionary motive for savings. It remains
true that transitory innovations in income result to persistent changes in consumption (because of
consumption smoothing). At the same time, consumers find it optimal to accumulate a buffer stock,
as a vehicle for self-insurance.

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4.3 Aggregation and the Representative Consumer

• Consider a deterministic economy populated by many heterogeneous households. Households differ in

their initial asset positions and (perhaps) their streams of labor income, but not in their preferences.
They all have CEIS preferences, with identical θ.

• Following the analysis of the previous section, consumption for individual j is given by

cjt = mt · xtj .

Note that individuals share the same MPC out of effective wealth because they have identical θ.

• Adding up across households, we infer that aggregate consumption is given by

ct = mt · xt

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where

xt ≡ (1 + Rt )at + ht ,
∞
� qτ
ht ≡ [wτ lτ − Tτ ],
τ =t
qt
1
mt ≡ �∞ .
τ =t β θ(τ −t) (q τ /qt )
1−θ

• Next, recall that individual consumption growth satisfies

� �−1/θ
qt β t u� (cjt ) cjt
= j = βt ,
q0 �
u (c0 ) cj0

for every j. But if all agents share the same consumption growth rate, this should be the aggregate
one. Therefore, equilibrium prices and aggregate consumption growth satisfy

� �−1/θ
qt ct
= βt
q0 c0

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Equivalently,

qt β t u� (ct )

= � .
q0 u (c0 )

• Consider now an economy that has a single consumer, who is endowed with wealth xt and has
preferences
c1−1/θ
U (c) =
1 − 1/θ

The Euler condition for this consumer will be

qt β t u� (ct )
= � .
q0 u (c0 )

Moreover, this consumer will find it optimal to choose consumption

ct = mt · xt .

But these are exactly the aggregative conditions we found in the economy with many agents.

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• That is, the two economies share exactly the same equilibrium prices and allocations. It is in this
sense that we can think of the single agent of the second economy as the “representative” agent of
the first multi-agent economy.

• Note that here we got a stronger result than just the existence of a representative agent. Not only
a representative agent existed, but he also had exactly the same preferences as each of the agents
of the economy. This was true only because agents had identical and homothetic preferences. With
other Gorman-type preferences, the preferences of the representative agent are “weighted average”
of the population preferences, with the weights depending on the wealth distribution.

• Finally, note that these aggregation results extend easily to the case of uncertainty as long as markets
are complete.

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4.4 Fiscal Policy

4.4.1 Ricardian Equilivalence

• The intertemporal budget for the representative household is given by

∞
�
qt ct ≤ q0 x0
t=0

where
�∞
qt
x0 = (1 + R0 )a0 + [wt lt − Tt ]
t=0

q 0

and a0 = k0 + b0 .

• On the other hand, the intertemporal budget constraint for the government is

∞
� ∞
�
qt gt + q0 (1 + R0 )b0 = qt Tt
t=0 t=0

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• Substituting the above into the formula for x0 , we infer

�∞ �∞
qt qt
x0 = (1 + R0 )k0 + w t lt − gt
t=0
q 0 t=0
q 0

That is, aggregate household wealth is independent of either the outstanding level of public debt or
the timing of taxes.

• We can thus rewrite the representative household’s intertemporal budget as

∞
� ∞
�
qt [ct + gt ] ≤ q0 (1 + R0 )k0 + qt w t l t
t=0 t=0

Since the representative agent’s budget constraint is independent of either b0 or {Tt }∞

t=0 , his con­

sumption and labor supply will also be independent. But then the resource constraint implies that
aggregate investment will be unaffected as well. Therefore, the aggregate path {ct , kt }∞
t=0 is indepen­

dent of either b0 or {Tt }∞

t=0 . All that matter is the stream of government spending, not the way this

is financed.

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• More generally, consider now arbitrary preferences and endogenous labor supply, but suppose that
the tax burden and public debt is uniformly distributed across households. Then, for every individual
j, effective wealth is independent of either the level of public debt or the timing of taxes:

�∞ �∞
qt qt
xj0 = (1 + R0 )k0j + j
wt lt − gt ,
t=0
q 0 t=0
q 0

Since the individual’s intertemporal budget is independent of either b0 or {Tt }∞

t=0 , her optimal plan

{cjt , ltj , ajt }∞ ∞

t=0 will also be independent of either b0 or {Tt }t=0 for any given price path. But if individual

behavior does not change for given prices, markets will continue to clear for the same prices. That
is, equilibrium prices are indeed also independent of either b0 or {Tt }∞
t=0 . We conclude

Proposition 20 Equilibrium prices and allocations are independent of either the intial level of public debt,
or the mixture of deficits and (lump-sum) taxes that the government uses to finance governement spending.

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• Remark: For Ricardian equivalence to hold, it is critical both that markets are complete (so that
agents can freely trade the riskless bond) and that horizons are infinite (so that the present value of
taxes the household expects to pay just equals the amount of public debt it holds). If either condition
fails, such as in OLG economies or economies with borrowing constraints, Ricardian equivalence will
also fail. Ricardian equivalence may also fail if there are

4.4.2 Tax Smoothing and Debt Management

topic covered in class

notes to be completed

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4.5 Asset Pricing and CCAPM

• Consider an asset that costs 1 unit in period t and delivers 1+r�t+1 in period t+1, where r�t+1 = r�(st+1 )
is possibly random. By arbitrage,

� � �

q(st ) = q(st+1 ) 1 + r�(st+1 )

st+1 |st

• Using

� �

µq(st ) = β t π(st )u� c(st )

we infer

� � �� � � �� � � � ��

u� c st = β Pr st+1 |st 1 + r�(st+1 ) u� c st+1

st+1 |st

or equivalently

u� (ct ) = βEt [(1 + r�t+1 ) u� (ct+1 )]

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• It follows that

u� (ct ) = β {Et [1 + r�t+1 ] Et [u� (ct+1 )] + Covt [1 + r�t+1 , u� (ct+1 )]}

u� (ct ) Covt [1 + r�t+1 , u� (ct+1 )]

= E t [1 + r
�t+1 ] +
βEt [u� (ct+1 )] Et [u� (ct+1 )]
� �
ct+1
≈ 1 + Et [r�t+1 ] − γCovt r�t+1 ,
ct

• For the riskless bond

u� (ct )
= 1 + rt∗+1
βEt [u� (ct+1 )]

• It follows that � �
ct+1
Et [r�t+1 ] − rt∗+1 = γCovt r�t+1 ,
ct

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• For the US data 1980-1979,

� �1/2
ct+1
V ar = 3.6%
ct
V ar [r�t+1 ]1/2 = 16.7%
� �
ct+1
Corr r�t+1 , = 40%
ct
� �
ct+1
Cov r�t+1 , = 0.24%
ct
∗
Et [r�t+1 ] − rt+1 = 6%

To match these data, one needs

γ = 25

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