Consumption

Question 1

Set up permanent income hypothesis

Answer 1

Question 2

Natural borrowing limit

Answer 2

Consumption is non-negative

Question 3

Permanent income definition

Answer 3

Constant flow of income whose present value equals the present value of all current and future income and assets

Question 4

Implications of permanent income hypothesis

Answer 4

• Current income is a function of the permanent income
• Current income only matters through its effect on permanent income
• Households want to smooth consumption over time
• Individuals decide current consumption by looking at the discounted present value of all their future income
• Changes in current income have only a minor effect in current consumption
• Changes in current income have a full impact on savings
• Profile of the income process is irrelevant to determine the consumption level but it does determine the profile fo savings

Question 5

Government’s budget constraint

Answer 5

Question 6

Equilibrium definition under ricardian equivalence

Answer 6

Question 7

Ricardian equivalence

Answer 7

Question 8

Violations of the ricardian equivalence to hold

Answer 8

• Finite lifetimes
• Capital market imperfections
• Income uncertainty
• Distortionary taxation
• Different interest rates