Focus on economic growth and business cycle issues when
the economy trades with the rest of the world and is financially open. Also introduce students to modern macroeconomics which has microeconomic foundations by presenting the intertemporal model.
Introduction
Objective :
– This 3rd chapter focuses on intertemporal decision.
– Objective : Understand the saving (S henceforth) behavior in
order to explore the causes of current account (CA henceforth)
deficit (CA = S − I)).
– A CA < 0 can be caused by changes in savings or investment or
both.
– If CA < 0 is the result of I behavior, then the open economy
version of the Solow model is well suited to rationalize CA < 0.
– If CA < 0 caused by changes in savings, then the Solow model
is helpless since the saving rate is fixed → s does not react to
changes in future income or interest rates which considerably
limits the predictive power of the model when it comes to
take the model to the data.
– If we want to explain increasing CA < 0 in the EA between
1993 and 2007, we need to understand the saving behavior.
– Savings decision is an intertemporal choice as this is
fundamentally a decision involving a trade-off between
, current and future consumption. If we can understand how
consumers arbitrage between future and present consumption,
then we can bring out the determinants of savings.
– It is important to understand well the basic
consumption/saving problem since it is at the core of modern
dynamic macroeconomics.
To understand the trade-off between current and
future C, we consider a simple endowment economy
(i.e., without capital) where agents live two periods.
– There are 3 basic and fundamental concepts related
to intertemporal choices : real interest rate (r), the
intertemporal marginal rate of substitution (I-MRS),
the rate of time preference (RTP) :
– The real interest rate (r) determines the return on
savings consisting of financial assets. It measures
the price of current consumption in terms of future
consumption you have to pay on the market. It can
be observed by agents.
– I-MRS (i.e., MRS of current consumption for future
consumption) = subjective price of current
consumption in terms of future consumption.
,– I-MRS varies with consumption ; if we want to
compare preference for present consumption
between individuals or countries, we need to set the
same consumption time profile for all individuals ⇒
subjective rate of time preference (RTP), ⇒
MRS along a constant consumption path.
– RTP allows us to compare the subjective taste for
present consumption between individuals or
countries. RTP will determine whether the agent will
be a borrower or a lender (along a constant income
path) ⇒ tell us if savings is negative or positive.
Savings depends on the ratio of future to present
income :
– In an intertemporal model, consumption decisions
are based on future and current income.
– In face of high future income relative current
income, the agent will smooth consumption instead
of having a low consumption today and a high
consumption in the future.
, – Consumption smoothing is the result of the taste
for diversity which means that the agent dislikes
large differences in consumption.
– The agent agent has a taste for diversity because
consuming only in the present or in the future is
very costly in utility terms : you prefer present and
future consumption to be close (not equal but close
enough to each other).
– Forward-looking agents along with convex
preferences (caused by decreasing marginal utility)
which reflect the fact that agents have a taste for
variety ⇒ Consumption smoothing.
– In the intertemporal model, savings helps to
neutralize the effects of large changes in income
across time on the time path of consumption.
Savings and the interest rate :
– A rise in r encourages agents to save less by making
a lender richer (income effect : IE) while it also
induces agents to save more by increasing the
relative price of present consumption (substitution
effect : SE). While with logarithmic utilities, IE and
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