Temporary and Permanent Income Shocks

I examine the effects on consumption of a temporary and a permanent exogenous shock to income. This is done in our two-period intertemporal choice model. Income shocks thus affect consumption in periods one and two.

A temporary shock to income means we change income in only period one, with period two income remaining the same. For a permanent shock to income, we change the level of income in both periods. These differing shocks to income thus have very different marginal propensities to consume with respect to income in period 1. We shift the budget constraint and examine graphically how consumption changes in each period.

To get up to speed, look at the playlist for previous videos, where I derive the intertemporal budget constraint for a two-period model of intertemporal choice. I shall derive this for more periods. Check out the playlist for intertemporal macroeconomics as a whole, linked at the end of this video.

We discuss the assumptions of the two-period model of intertemporal choice. This involves consumers living for 2 periods. They can consume, save or borrow in these time periods, allowing for consumption that differs from their income in that period. In order to defer income to other periods, they can buy or sell one-period bonds with interest r.

We can then mathematically write the budget constraint for each of these periods. With a bit of substitution and rearranging, this gives us the intertemporal budget constraint. This says that the present value of consumption is equal to the present value of income. The consumer can thus not spend more than she earns, but will spend all of her income since more consumption is always assumed to increase her utility.

In future videos we shall look at borrowers and savers in more detail, examining what happens with a change in the interest rate, changes in income and other exogenous changes.
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