Name: Bismah Ayesha (10394221)
Assignment Title: Two Period Consumption Model
Tutor Name: Lavinia Rognone
Date Submitted: 9th July 2018
In this academic assignment I will be talking about the two period consumption model. This model represents the current consumption behaviour and how it affects the second period (the future).
This is with the idea that an individual maximising their level of utility from todays consumption which is written as, Co and from future consumption, Cf creates the equation;
max U = f (Co, Cf) = U(Co) + ΣLU(Ct)(1+ρ)-t. The higher the rates of time preference simply that the individual hasn’t received full satisfaction from future consumption compared to their current consumption spending. In this diagram you will see how there are equal levels of satisfaction from different types of consumption both present and future in net savers and net borrowers. If the budget line has a slope it means that the current consumption equals current income and so therefore future consumption and income must in addition to be equal.
Inter-temporal Decisions. This is how variables can change over time and this is represented in the two period model. The first period and the second period. Consumption savings are a key trade off between present and future consumptions. The consumer can do two things either save or borrow or just spend income as it comes. If the consumer saves, then it gives up consumption for today saving it for the future where as if the consumer borrows then they can consume more today and then later repay what they owe for example their debt. Budget Constraint in the Current Period. The budget constraint says that consumption added with savings must equal disposable income in the present period. So if the customer saves more than 0 then they are saving and if they are over the 0 mark then the consumer is dissaving. Riskless bonds are bonds that pay the consumption tomorrow in change for a unit of consumption today.
Consumer preferences in regard to consumption in the two periods are represented by indifference curves. This shows the mixture of the first and second period consumption that can make the individual happy. The slope on the second period consumption must increase in order for them to be equally happy and meet their standards. If the first period consumption is reduced, then it means that on the second period there is a requirement of extra compensation. The slope at any any point on the indifference curve shows us how second period consumption is needed by the consumer. This slope is the marginal rate of substitution between first and second period consumption. The marginal rate of substitution all depends on consumption levels in the two periods. If the first period consumption is high, then this automatically means that the second period is low and therefore the marginal rate of substitution is low. This also counts vice versa. In both terms the consumer can be equally happy but can also show the preferences of indifferences.
Optimisation. This is where the consumer gets their highest level of satisfaction as they have chosen the the point on the budget constraint that is on the highest indifference curve. After discussing the consumer’s preferences and what they wouldn’t like to do there can then be a decision made on how much to consume in each period of time. The first period and second period. This is most likely to be on the highest possible indifference curve. However, the individual must be below the budget line as it is necessary due to the measures of the resources available to them. The highest they can do without changing and affecting the budget constraint.
How changes income affect consumption. Within the two period consumption model we look at the effects of changes on interest rates and the expected income that the individual’s hope to receive in
the future. As well as the patterns of consumption and on borrowing/saving activity. Changes in income can affect consumption. The changes can vary from either first or second period and this causes the budget to become constraint outwards. For example, an individual could have an unexpected increase in their income like an inheritance which would make the individual effectively change their consumption pattern over both periods, present and future. This however could also create and increase in their consumption expenditure. These have direct impact on the individuals’ economic activity as it shows the changes and differences in consumption behaviour. Taxes can also have an impact on change as it depends on what the individual sees their taxes and how he reacts to it as for example, if the individual sees the taxes as permanent and aren’t going to change anytime soon then they will alter their consumption plans, this causes an outward shift on the budget constraint. However, if the individual realises that the tax cuts lead to future deficits and could cause them to be in debt then they will use it so save for the future and not allow them to be in a loss.
Temporary change in income has a small impact on the bigger, permanent income therefore in turn has a small impact on consumption. Because permanent change in income has a bigger impact it creates a larger impact on consumption. In the two period consumption model is shows that if consumption increases if income increases in both the first period and the second period than if it only increases in one period making the impact of savings very small and doesn’t affect consumption a lot.
Measuring Smoothly. This model predicts that consumers would prefer to spread the increase of income by consuming over several different periods over time. This is as consumption is less unpredictable and we can see the changes that may occur before they do. Consumption is in fact less volatile than income which shows the consistency of consumption smoothing. There is an excess sensitivity of consumption this is due to imperfections in the credit market. This theory or the two period consumption model assumes that consumers can freely borrow to smooth consumption but this isn’t the case and therefore this isn’t a good assumption. Secondly the market price will fall if all the consumers demand smooth consumption at the same time. If all customers want to borrow or save, then the interest rates of products will change therefore changing what the consumers would want in the first place.
In conclusion the two period consumption model reflects how people can save/borrow now and that will increase/decrease their consumption in the future. Todays behaviour affects what affects the second period. Also how income can have an impact on consumption either increasing or decreasing the interest rates that will change consumer demand in regards to whether they save or borrow. This inconsistency causes the two period consumption model to lack reliability. However this theory does support the use of riskless bonds and how they are an effective way to deal with consumption.
References
* Douglas, A Ruby (2005). The Two Period Consumption Model
* Part VI More on the Microeconomics Behind Macroeconomics, 17, pg. 502-506
* Hlouskova, Jaroslava, Fotin, Ines, Tsigaris, Panagoitis. (2016) The consumption–investment decision of a prospect theory household: A two-period model. E Article; https://ac-els-cdn-com.manchester.idm.oclc.org/S0304406817300460/1-s2.0-S0304406817300460-main.pdf?_tid=78848653-b4bd-4184-8c29-7fe8a8137685&acdnat=1531104542_a154b81bbe4812b589080466ecb7d028 * http://www.economics.soton.ac.uk/staff/alicesch/Teaching/200910/Econ2004/ch6a_slides_hand.pdf – The University of Southampton (2010) A two-period model: the consumption-savings decision pg. 1-16
* University of Madrid (2012). Consumption and Savings Decisions: A Two-Period setting, pg. 3 * George-Marios Angeletos, Journal of economic perspectives, vol. 15, no. 3, summer 2001(pp. 47-68) – Angeletos, George-Marios, David Laibson, Andrea Repetto, Jeremy Tobacman, and Stephen Weinberg.2001. "The Hyperbolic Consumption Model: Calibration, Simulation, and Empirical Evaluation." Journal of Economic Perspectives, 15 (3): 47-6