ECOM-G313: Macroeconomics 2

Part 2: Extensions of the Two-Period Model of Consumption

and Infinite Time Horizon

Timm Prein

Autumn 2023

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2023 1 / 31

Learning Objectives of this Lecture

After this lecture, you should be able to

extend the 2-period model of consumption (i.e. with borrowing

constraints),

describe the competitive equilibrium of an endowment economy,

extend the 2-period consumption model to the infinite time horizon,

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2023 2 / 31

The Two-Period Model of Consumption - Extensions

Examples:

Borrowing constraints
Wealth
Taxes
Housing investments
Uncertainty

We will for now only discuss the first two extensions.

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Extension: Borrowing Constraints

So far: household may borrow freely at interest rate rt .

Now: household is borrowing-constrained, i.e. cannot borrow:

st ≥ 0.
Let (ct? , ct+1
? , s ? ) denote the optimal consumption choice in the
t
absense of the borrowing constraint. Two cases emerge:
1 If the optimal unconstrained choice satisfies st? ≥ 0, st? is still the
optimal choice.
2 If the optimal unconstrained choice satisfies st? < 0 (he would like to
borrow), then the best choice will be

ct = wt , ct+1 = wt+1 , st = 0.

Preferred larger ct cannot be achieved due to the lack of the borrowing

option. → Welfare loss.
Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2023 4 / 31
Extension: Borrowing Constraints

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Extension: Borrowing Constraints

Fiscal policy becomes powerful:

1 Consider wt+1 ↑ but no consumption smoothing, because borrowing
against the future income is not possible. → No change in ct ,
one-to-one increase in ct+1 .
2 The case of wt ↑ (plus assumption that borrowing constraint still
binds) results one-to-one increase in ct .

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Extension: Wealth

Assume that the household

is born with wealth ht−1 (e.g. inherited wealth),

takes as given the price of wealth / asset today (period t), qt ,

may invest more today and accumulate wealth into ht .

The period t flow budget constraint is denoted by

ct + st + qt ht = wt + qt ht−1 .

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Extension: Wealth

Assume that the household

is born with wealth ht−1 (e.g. inherited wealth),

takes as given the price of wealth / asset today (period t), qt ,

may invest more today and accumulate wealth into ht .

The period t flow budget constraint is denoted by

ct + st + qt ht = wt + qt ht−1 .

Task: What is the period t + 1 budget constraint?

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Extension: Wealth

With terminal condition ht+1 = st+1 = 0 this reduces to

ct+1 = wt+1 + (1 + rt )st + qt+1 ht

Solve above for st and plug in to obtain the intertemporal budget

constraint
ct+1 wt+1 qt+1 ht
ct + + qt ht = wt + + qt ht−1 +
1 + rt 1 + rt 1 + rt

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Extension: Wealth

Terms:
ct + ct+1 /(1 + rt ) the present discounted value of the stream of
consumption
qt ht the present discounted value expenditure on the asset ht
wt + wt+1 /(1 + rt ) the present discounted value of the income stream
qt ht−1 existing value of (‘’inherited”) assets. It sells the asset ht−1 with
price qt and buys it back with the same price!
qt+1 ht
1+rt present discounted value of the asset in period t + 1.

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2023 9 / 31

Equilibrium in an Endowment Economy

Model Setup

L households, each denoted by index j

L is large → household j is price taker
Two-period model with exogenous income wt (j) and wt+1 (j).
Savings rate is common to each household.
Logarithmic preferences

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2023 10 / 31

Equilibrium in an Endowment Economy
Household j chooses ct (j) and ct+1 (j) by solving

max U(j) = log[ct (j)] + β log[ct+1 (j)]

ct (j),ct+1 (j)

subject to flow budget constraints

ct (j) + s(j) = wt (j)

ct+1 (j) = wt+1 (j) + (1 + r )s(j).

Since r is the same for each household, the optimality conditions are
identical to each household j:
ct+1 (j)
= β(1 + r )
ct (j)
⇒ the consumption growth rate is the same for each household but not
necessarily the level of consumption.
Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2023 11 / 31
Equilibrium in an Endowment Economy

Resulting consumption functions:

1 wt+1 (j)
 
ct (j) = wt (j) +
1+β 1+r
β wt+1 (j)
 
ct+1 (j) = (1 + r ) wt (j) + .
1+β 1+r

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Endowment Economy - Competitive Equilibrium
Even if the real rate r is given for each household (L is large!), in the
aggregate (macro!) level it is endogenous and determined as a
consequence of equilibrium.
Competitive equilibrium
Competitive equilibrium is a set of prices and quantities for which all
agents are behaving optimally and all markets simultaneously clear.

The price is r , the market is the financial market (i.e. for

loans/bonds).
Demand and supply in the financial market must be equal
→ Aggregate level saving must be zero
L
X
s(j) = 0.
j=1

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Endowment Economy - Competitive Equilibrium

Aggregate the first period budget constraint over all households

L
X L
X L
X
ct (j) + s(j) = wt (j)
j=1 j=1 j=1

PL PL
Denote ct = j=1 ct (j) and ct+1 = j=1 ct+1 (j).

PL
With the market clearing condition j=1 s(j) = 0, we can derive the
aggregate resource constraint as

ct = wt .

Note: as there is no production, resources cannot be transferred

between periods t to t + 1!

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Endowment Economy - Equ. with Identical Households

Assume that
1 preferences are identical, and
2 households face the same income stream wt (j) and wt+1 (j).

Normalize the number of households L = 1, i.e. households are

indexed in [0, 1].
Then
wt (j) = wt and wt+1 (j) = wt+1 , for all j.

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Endowment Economy - Equ. with Identical Households
Consumption functions are the same for each household.
Market clearing implies s = 0 → no household will borrow or lend
Aggregate resource constraint:
ct = wt (and ct+1 = wt+1 ).
→ Two unknows ct and ct+1 and two equations (consumption
function and aggregate resource constraint).
→ The real interest rate must follow from
wt+1
= β(1 + r )
wt
i.e.
1 wt+1
1+r =
β wt
Then, the real interest rate is a function of the (gross) growth rate of the
economy.
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Infinite Time Horizon

So far: planning horizon of only two periods: ‘’today” and

‘’tomorrow”.

Next: allow for infinite horizon:

Households are ‘’dynasties” who live forever
Decision-making takes into account future generations.
Households value today’s consumption more than future consumption.
Time preference rate ρ; Discount rate β ≡ 1/(1 + ρ).
Instantaneous utility is given by

Ut = U(ct )

with the usual concavity assumptions: Ut0 > 0 and Ut00 ≤ 0.

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Infinite Time Horizon - Consumption Decision

The representative household seeks to maximize the present value of utility

∞
X
max Vt = β s U(ct+s ) (1)
{ct+s ,at+1+s }∞
s=0 s=0

subject to the flow budget constraints

at+1+s + ct+s = wt+s + (1 + rt+s )at+s , s = 0, 1, 2, . . . (2)

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Infinite Time Horizon - Consumption Decision

Note that 0 < β < 1. Interest rate rt and income wt are exogenous.

at net stock of financial assets at the beginning of the period t.

The level has been decided on in the previous period!
If at > 0 households are net lenders, if at < 0 households are
net borrowers.
Since at+1 denotes the assets held at the beginning of the
period t + 1, it corresponds the savings st in the two-period
model.
rt is the interest rate on financial assets at from period t − 1 to
period t and is paid at the beginning of the period.

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Infinite Time Horizon - Budget Constraint

Beginning of period t: stock of financial assets at is given.

In period t, households must choose the entire future path of

consumption and savings:
{ct , at+1 } of the period t
.
{c , a } of the period t + 1 ..
t+1 t+2

Due to the linking of consumption and financial assets this is

equivalent for choosing the entire path of consumption
{ct , ct+1 , ct+2 , . . . }.

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Infinite Time Horizon - Optimality Conditions

Using the Lagrangean:

∞
X
L= {β s U(ct+s ) + λt+s [wt+s + (1 + rt+s )at+s − ct+s − at+s+1 ]} .
s=0

We have period-per-period (=flow) budget constraints

→ Separate Lagrange multiplier for each period!

The FOCs:
∂L
= β s U 0 (ct+s ) − λt+s = 0 s = 0, 1, 2, . . .
∂ct+s
∂L
= −λt+s + λt+s+1 (1 + rt+s+1 ) = 0 s = 0, 1, 2, . . ..
∂at+s+1

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Infinite Time Horizon - Optimality Conditions

Solve λt+s and λt+1+s from the first set of FOCs and substitute them to
the second set of FOCs to obtain the Euler equation:

βU 0 (ct+1+s )
(1 + rt+1+s ) = 1, s = 0, 1, 2, . . ..
U 0 (ct+s )

This applies to any t ∈ {−∞, . . . , 0, . . . , ∞} such that we also write it as

βU 0 (ct+1 )
(1 + rt+1 ) = 1, t = −∞, . . . , −1, 0, 1, 2, . . . , ∞.
U 0 (ct )

This is identical to the two-period model, but applies to all possible s!

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Infinite Time Horizon - Intertemporal Budget Constraint

Iterate the budget constraint to eliminate assets {at+1 , at+2 , . . . }. Write

for period t and t + 1:

at+1 + ct = wt + (1 + rt )at
at+2 + ct+1 = wt+1 + (1 + rt+1 )at+1 .

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Infinite Time Horizon - Intertemporal Budget Constraint

Iterate the budget constraint to eliminate assets {at+1 , at+2 , . . . }. Write

for period t and t + 1:

at+1 + ct = wt + (1 + rt )at
at+2 + ct+1 = wt+1 + (1 + rt+1 )at+1 .

Solve the period t budget constraint for at+1 and substitute it into the
period t + 1 budget constraint:

at+2 + ct+1 + (1 + rt+1 )ct = wt+1 + (1 + rt+1 )wt + (1 + rt+1 )(1 + rt )at

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Infinite Time Horizon - Intertemporal Budget Constraint

Iterate the budget constraint to eliminate assets {at+1 , at+2 , . . . }. Write

for period t and t + 1:

at+1 + ct = wt + (1 + rt )at
at+2 + ct+1 = wt+1 + (1 + rt+1 )at+1 .

Solve the period t budget constraint for at+1 and substitute it into the
period t + 1 budget constraint:

at+2 + ct+1 + (1 + rt+1 )ct = wt+1 + (1 + rt+1 )wt + (1 + rt+1 )(1 + rt )at

Division by 1 + rt+1 implies

at+2 ct+1 wt+1
+ + ct = + wt + (1 + rt )at
1 + rt+1 1 + rt+1 1 + rt+1

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Infinite Time Horizon - Intertemporal Budget Constraint
Further substitutions of at+2 , at+3 , . . . , at+T gives the more general form

T −1
at+T X ct+s
QT −1 + Qs =
k=1 (1 + rt+k ) s=0 k=1 (1 + rt+k )
T −1
X wt+s
Qs + (1 + rt )at , (3)
s=0 k=1 (1 + rt+k )

where
s−1
Y
(1 + rt+k ) ≡ (1 + rt+1 )(1 + rt+2 ) · · · (1 + rt+s−1 ).
k=1
For T → ∞, we obtain the infinite intertemporal budget constraint
∞ ∞
X ct+s X wt+s
Qs = Qs + (1 + rt )at . (4)
s=0 k=1 (1 + rt+k ) s=0 k=1 (1 + rt+k )

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Infinite Time Horizon - Intertemporal Budget Constraint
where it must hold that (corresponding the first term in (3)):

lim β T at+T U 0 (ct+T ) = 0. (5)

T →∞

Since by assumptions U 0 (c) > 0, the condition can be written as

lim β T at+T = 0.
T →∞

→ The very distant future discounted value of an asset must go to zero.

This is the ‘’no-Ponzi-game” condition; economically: households cannot

finance their consumption infinitely by borrowing.

Note that the β T comes from

1
β T = QT −1 .
s=1 (1 + rt+s )

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Infinite Time Horizon - Consumption Function

Let’s use the constant relative risk aversion (CRRA), ie the CES form as in
the two-period case.
ct+1 σ
 
= β(1 + rt+1 )
ct
Shift it one period forward
σ
ct+2

= β(1 + rt+2 )
ct+1

and solve ct+1 and substitute it to the first one to obtain

σ
ct+2

= β 2 (1 + rt+1 )(1 + rt+2 )
ct

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Infinite Time Horizon - Consumption Function

and more generally s period consumption Euler equation:

σ s
ct+s
 Y
= βs (1 + rt+k ),
ct k=1

which gives
" s
#1/σ
Y
s
ct+s = β (1 + rt+k ) ct .
k=1

Substitute this to the intertemporal budget constraint (4)

∞ Qs 1/σ ∞
X [β s k=1 (1 + rt+k )] ct X wt+s
Q s = W t ≡ Qs + (1 + rt )at .
s=0 k=1 (1 + rt+k ) s=0 k=1 (1 + rt+k )

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Infinite Time Horizon - Consumption Function

Assuming σ = 1 (logarithmic utility function), the above equation

simplifies to
∞ ∞
[ s (1 + rt+k )] ct
Q
wt+s
β s Qk=1
X X
s = W t ≡ Qs + (1 + rt )at .
s=0 k=1 (1 + rt+k ) s=0 k=1 (1 + rt+k )

The consumption function results as follows

ρ
ct = (1 − β)Wt = Wt
1+ρ

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Infinite Time Horizon - Features of the Consumption
Function

Only small fraction of the wealth is consumed: suppose ρ = 0.03 (3%

per annum), then ρ/(1 + ρ) = 0.029!

Temporary increase in income has a small effect on consumption.

Permanent increase (higher income in all future periods) has a larger

effect!

Expected rise in future income increases consumption already today.

If households are net borrowers (at < 0), increase in rt will cause a
decline in ct .

Savings is undertaken to offset (expected) future falls in income.

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Next Steps - Outlook

Consumption theory only determines ct (t = 0, 1, 2, . . . ).

Need to determine the demand for labor and supply of labor to study
(and to endogenize) wages.
→ Determine labor demand via the firms’ problem.
→ Determine labor supply via the augmented household’s problem.
⇒ Take all of the results to build a real business cycle model (RBC).

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2023 30 / 31

References

Garín, Julio, Robert Lester and Eric Sims (2021), Intermediate

macroeconomics, Chapter 9 (extensions of the two-period model), 10
(endowment economy), and 11 (infinite time horizon).
https://www3.nd.edu/~esims1/GLS_may_2021.pdf

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