Problem 1: Consumption smoothing (50 marks)

EC1101 PROBLEM SET 6

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Economic Fluctuations

Problem 1: Consumption smoothing (50 marks)

Consider consumption smoothing households. Suppose that there are two types of households: type A are unconstrained, and type B are credit-constrained.

(a) Which households are more likely to be credit constrained and which households can smooth consumption perfectly? Give examples.

(10 marks)

(b) Consider the case with 2 periods: today (t = 0) and tomorrow (t = 1). Consumers value consumption in both periods according to the utility function U(c0, c1). The household receives income y0 in period 0 and y1 in period 1 and the interest rate is r. Use the intertemporal budget constraint and the indifference curves to show the optimal choice of a consumer. Suppose that both household types A and B have the same income in both periods and the same preferences. Show how the budget constraint differs between the two types of households. Which household type is likely to consume more in the first period?

(20 marks)

(c) Now consider a multi-period model. For each household type, use a figure with time on the horizontal axis and income and consumption on the vertical axis to explain what happens to consumption when income decreases unexpectedly at time t0 and then recovers to its original level at time t1. At time t0, it is known that the increase in income is temporary.

(20 marks)

Problem 2: Great Recession vs Great Lockdown (50 marks)

Use data from FRED to construct charts for the growth rates of real GDP, consump- tion and investment for the UK for 2000-2021. Use quarterly frequency and use percent- age changes from one year ago.

To learn how to use FRED to find macroeconomic data, follow these steps:

1. Visit the FRED website: https://fred.stlouisfed.org/

2. Use the search bar and type ‘ gross domestic product by expenditure United King- dom’.

( 1 )

3. Select the annual series for real (constant prices) total gross domestic product for the UK.

4. Click ‘Edit Graph’ and make sure that the Units are percentage change from year ago, so that you plot the growth rate. (You will have to repeat this for the other series/lines.)

5. To add consumption/investment to your plot go to ’Edit Graph’ again and click on the ‘Add Line’ button at the top of the window. Now you can search for other series. To be coherent search for ’ gross domestic product by expenditure United kingdom’ and select the private final consumption option. Do the same to select ’Gross domestic product by expenditure in constant prices : gross fixed capital formation for the United Kingdom’. (Notice that FED has series for all the compo- nents of GDP calculated by expenditure as we seen in class.)

6. Make sure that all series are in real terms (i.e. at constant prices), at quarterly frequencies and to show annual growth rates (in the Units as mentioned in 4).

7. Above the graph you can specify the time period – select January 2000 to the latest available month of 2021.

(a) Plot the percentage change in real GDP (use ’Gross domestic product by expenditure in constant prices: total gross domestic product for the United kingdom’), private consumption expenditures (use ’Gross domestic product by expenditure in constant prices: private final consumption for the United Kingdom’) and private investment expenditures (use ’Gross domestic product by expenditure in constant prices: gross fixed capital formation for the United kingdom’) over the period of 2000-2021.

(25 marks)

(b) Compare the effect of the Great Recession (2009) on consumption and investment to that of the Covid-19 pandemic. Is the drop in consumption and investment larger or smaller than the drop in output? What can explain the difference in the response of consumption and investment during these two recessions?

(25 marks)