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Select Topics in Macroeconomics – 2015
Questions and Answers
Section A
Question 1
The Modigliani-Brumberg theory of consumption in a closed economy posits that consumers make
decisions over a long but finite planning horizon. This model assumes that:
The interest rate is zero for all periods, so that initial wealth is B/P + K
This discount rate is 1, which implies that individuals care as much about consumption today
and consumption in future periods.
Individuals earn a flat income of L(w/p) in each period.
Individuals retire after R periods
Individuals die after T periods
If we further impose the reasonable assumption that the utility function of individuals is concave,
such that they experience diminishing returns to consumption, then this results in full consumption
smoothing. That is, their consumption in each period is equal:
𝐶 = 𝐶 = 𝐶 = ...𝐶 = 𝐶
1 𝐵 𝑤
𝐶 = [ + 𝐾 + 𝑅 𝐿]
𝑇 𝑃 𝑃
This result describes how individuals act. They accumulate assets during their working years by
saving, and then de-cumulate during retirement (i.e. spending their savings) When everybody within
a closed economy acts in this way, then this implies that young people buy the assets of the old.
This theory can be used to explain why aggregate savings rates in many European economies are
much lower in China because (1) there is more population growth in China, which leads to the
number of savers being much larger than the number of dis-savers (because there are more young
people than old and (2) income growth is higher in China, meaning that the savings of young
households are larger than the dis-savings of old households.
Question 2
The neoclassical intertemporal model of consumption and leisure choice posits that individuals value
both consumption and leisure, and would like to consume more. This is captured within their utility
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
Select Topics in Macroeconomics – 2015
Questions and Answers
Section A
Question 1
The Modigliani-Brumberg theory of consumption in a closed economy posits that consumers make
decisions over a long but finite planning horizon. This model assumes that:
The interest rate is zero for all periods, so that initial wealth is B/P + K
This discount rate is 1, which implies that individuals care as much about consumption today
and consumption in future periods.
Individuals earn a flat income of L(w/p) in each period.
Individuals retire after R periods
Individuals die after T periods
If we further impose the reasonable assumption that the utility function of individuals is concave,
such that they experience diminishing returns to consumption, then this results in full consumption
smoothing. That is, their consumption in each period is equal:
𝐶 = 𝐶 = 𝐶 = ...𝐶 = 𝐶
1 𝐵 𝑤
𝐶 = [ + 𝐾 + 𝑅 𝐿]
𝑇 𝑃 𝑃
This result describes how individuals act. They accumulate assets during their working years by
saving, and then de-cumulate during retirement (i.e. spending their savings) When everybody within
a closed economy acts in this way, then this implies that young people buy the assets of the old.
This theory can be used to explain why aggregate savings rates in many European economies are
much lower in China because (1) there is more population growth in China, which leads to the
number of savers being much larger than the number of dis-savers (because there are more young
people than old and (2) income growth is higher in China, meaning that the savings of young
households are larger than the dis-savings of old households.
Question 2
The neoclassical intertemporal model of consumption and leisure choice posits that individuals value
both consumption and leisure, and would like to consume more. This is captured within their utility
