ECON 208 - Week 7

C = Consumption                       Y = Disposable income

C = Constant - interscept           c = MPC - slope

As income rises, the APC falls (consumers save more of their incomes). APC is the slope of a line drawn from the origin to a point on the consumption function. 

The consumption function predicted that C would grow more slowly than Y over time. Was not true. As incomes grew, APC did not fall and C grew just as fast. 

Simon Kuznets discovered that C/Y was very stable in the long term. 

• Assumes consumer is forward thinking and chooses consumption for the present and future to maximize lifetime satisfaction.
• Choices are subject to an intemporal budget constraint - a measure of the total resources available for present and future consumption. 
• Consumers live during two periods - 1) the present - 2) the future
• S = Y1 - C1 - in the first period, saving equals income minus consumption
• C2 = (1+r)S + Y2 - in the second period, consumption equals the accumulated saving (including interest earned) plus the second period income. No third period so no savings. 

The slope of the budget line equals -(1+r). 

Consumer Preferences are represented by indifference curves.

An indifference curve shows all the combinations of C1 and C2 that make the consumer equally happy.

Higher indifference curve represents higher levels of utility

The slope is the marginal rate of substitution(MRS)- the amount of C2 the consumer would be willing to substitute for one unit of C1

• The highest indifference curve that the consumer can obtain without violating the budget constraint is the one on a tangent.
• Point O is optimum - best combination of consumption in the two periods
• At point O the slope of the indifference curve equals the slope of the budget constraint.
• At point O MRS=(1+r)

• An increase in either Y1 or Y2
• Shifts the budget line outwards
• = C1 and C2 both increase (provided they're both normal goods) regardless of whether the increase occurs in period 1 or 2.

Fisher says current consumption depends only on the PV lifetime income

• Consumer is intially saving
• The increase in r rotates the budget constraint around (Y1, Y2) - now altering the amount of consumption in each period. 
• Consumer moves from A to B. 
• Income effect- when the consumer is saving, the rise is r makes him better off. Consumer spreads this improvement over both periods = moves to a higher indifference curve.
• Substitution effect - r increases changing the relative price of consumption in the two periods. C2 becomes less expensive relative to C1. The opportunity cost of current consumption increases. Reducing C1 and increasing C2. 
• The impact on C1 depends on the relative size of both effects. 

• Fischer's theory: the timing of income is less important because people can borrow and lend across periods.
• Borrowing is consuming some of your future income today.
• Borrowing is not always possible. Consumers face "borrowing constraints". If consumers cant borrow then consumption may behave in the Keynesian theory even though they are forward thinkers.
• When the borrowing constraint is not binding then the consumer's optimal C1 is less than Y1
• When the borrowing contraint is binding then optimal choice is B. But consumers cannot borrow so the best they can do is E.