M3 - Neoclassical Model + Equations

Question 1

the neoclassical model has three main actors

Answer 1

the household
the firm
the government

• The household chooses consumption, labor supply, and money holdings.
• The firm chooses labor demand and investment.
• Then the model adds production, goods-market clearing, money demand, and the Fisher relationship.

households decide how much to work, consume, save, and hold as money
firms decide how much to hire and invest
output is produced
all markets have to fit together in equilibrium

Question 2

Consumption function

What deos it mean?

Answer 2

Question 3

Exogenous variables in the Neoclassical Model

Answer 3

inputs to the model

Question 4

Endogenous variables in the neoclasincal model

Answer 4

In a model, equations are what determine the endogenous variables.
So what matters is:
how many unknown endogenous variables you are solving for
how many independent equations you have to solve them
You want those numbers to match.

8 endogenous variables = 8 equations for 8 unknowns

Question 5

An equilibrium is the …

Answer 5

combination of outcomes where everyone is doing the best they can, firms and households are behaving optimally, and all markets are consistent with one another.

Question 6

competitive equilibrium is the point where

Answer 6

• households choose consumption and labor optimally
• firms choose labor and investment optimally
• production is determined
• goods market clears
• money market clears
• interest rates are consistent in nominal and real terms

Question 7

What does Ricardian Equivalence mean here?

Answer 7

Question 8

Why does Ricardian Equivalence let us ignore taxes and debt in the model?

Answer 8

Question 9

What does “the household behaves as though the government balances its budget each period” really mean?

Answer 9

Question 10

What does it mean that the household wants to smooth consumption over time?

Answer 10

• if I have more income today, I consume more today
• if I expect more income tomorrow, I also consume more today, because I feel richer overall
• if the real interest rate is high, saving is more attractive, so I consume less today

Question 11

What does the 1st partial derivative of the consumption function mean?

Answer 11

MPC

How does desired consumption today change when current disposable income changes, holding future disposable income and the real interest rate fixed?

Question 12

Why is the 1st partial derivative of consumption between 1 and 0?

Answer 12

If you have more income today, you usually want to consume more today.

• That is why the derivative is positive.
  Why not bigger than 1?

Because households usually do not spend all of an extra dollar of income. They consume part of it and save part of it. That is why this derivative is usually between 0 and 1. This is the marginal propensity to consume (MPC).

Question 13

How do we derive the first partial derivative of the consumption function?

Answer 13

Question 14

What does this mean?

of the consumption function

Answer 14

If expected future disposable income goes up a little, while current disposable income and the real interest rate stay the same, current desired consumption goes up.

If you expect to be richer tomorrow, you feel more comfortable consuming more today.
Why? Because households want to smooth consumption across time. If future income is high relative to current income, households may borrow and consume more today.

So this derivative is also positive.

Question 15

Why is the second derivative also between 0 and 1?

Answer 15

households want to smooth consumption across time

if future income is high relative to current income, households may borrow and consume more today

if you expect 1 more unit of income tomorrow, you probably will not increase today’s consumption by more than 1. If you did, you would borrow too much and have trouble repaying it tomorrow.

This is why the derivative should also be between 0 and 1.

Question 16

How do we get the 2nd partial derivative of consumption?

Answer 16

Question 17

What does the 3rd partial derivative of consumption mea?

Answer 17

If the real interest rate goes up a little, while current and future disposable income stay the same, current desired consumption goes down.

A higher real interest rate makes saving more attractive

Therfore this derivative is negative

Question 18

For the consumption equation, the underlying first-order-condition idea is:

Answer 18

the household is choosing how much to consume today versus how much to save today and consume tomorrow.

choose consumption today and tomorrow optimally, balancing the benefit of consuming now against the benefit of saving and consuming more later.

That is why the consumption function depends on current income, future income, and the real interest rate. The derivatives are just the signs of how optimal consumption responds when each of those changes.