Thread by @BachmannRudi

Lecture 6 - Intermediate Macro:

Reflecting on our findings from last lecture about a current income change, I mentioned that quantitative versions of our simple model often lead to too much consumption smoothing relative to the data.

That's why the literature has developed two strands of research: 1) Credit markets are in reality not as perfect as we have them in the simple baseline model (we will look at this case soon). 2) Households are not as sophisticated in using credit/financial markets to smooth their

consumption as we assume in the baseline model - that is the financial literacy literature (which we will not talk about in this class).

Anyway, you can learn here how economists work: start with a simple, very abstract model to learn about some basic mechanisms (like consumption smoothing) and then build up from failings of these simple models other fruitful areas of research.

Next, we studied changes in future income. Important lesson here: expectations about the future matter. The effects on consumption are very similar to those from a current income change. Only the implied saving/borrowing decision is different: future income increases make people

dissave or even borrow against those future income increases.

Then we combined both changes and looked at permanent income changes, that is, income changes both today and in the future. Their consumption effects are larger than temporary income changes. This is the Permanent Income Hypothesis (PIH) at work.

Formulated differently: under the assumptions of the model, only the total lifetime income matters for an agents' consumption decision, not WHEN this income arrives.

This is important because before Milton Friedman's insight Keynesian Orthodoxy held that consumption only depends on current income. Today we know through detailed empirical work that both extremes are too simple.

Then we moved on to study interest rate changes. Our old friends, the substitution and the income effects showed up. Intuitively, (small) interest rate changes lead to relative price changes between consumption tomorrow and today - interest rate increases making consumption

tomorrow relatively cheaper - and, depending on whether agents are lenders or borrowers at the outset make them richer (lenders for increases) or poorer (borrowers for increases).

The interaction of both effects can lead to complex total effects on today's consumption and tomorrow's consumption at the micro level.

We then stipulated that for our future macro models aggregate consumption depends negatively on the interest rate and aggregate saving positively (in a sense, the substitution effect dominates in the aggregate).

This positively-sloping aggregate saving curve from the private sector constitutes a supply of funds curve. What is the demand for funds? In our simple model it is government borrowing.

Therefore, we moved on to studying a rudimentary government with two flow budget constraints that you need to be able to combine into an intertemporal budget constraint.

We, finally, proved that S^p=B (credit market equilibrium) is equivalent to a form of goods market equilibrium: Y=C+G (income = expenditures).

Next lecture, we will talk about Ricardian equivalence, a theorem describing the interactions of the private sector and the government on the credit market under certain assumptions. And then we will study what happens when these assumptions are violated.