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The effect of interest rates on consumption in an income fluctuation problem

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  • Lehrer, Ehud
  • Light, Bar

Abstract

We examine the effect of a change in interest rates on an agent’s consumption and savings decisions when her income is fluctuating. In each period, a long-lived agent decides how much to save (i.e., invest in a risky bond) and how much to consume while her income and the rate of return on her savings are uncertain and depend on the state of the economy. We show that under the concavity of the consumption function, a condition that ensures that the substitution effect dominates the income effect, lower interest rates encourage the agent’s consumption across all states.

Suggested Citation

  • Lehrer, Ehud & Light, Bar, 2018. "The effect of interest rates on consumption in an income fluctuation problem," Journal of Economic Dynamics and Control, Elsevier, vol. 94(C), pages 63-71.
    • Handle: RePEc:eee:dyncon:v:94:y:2018:i:c:p:63-71
    DOI: 10.1016/j.jedc.2018.07.004
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    3. Bayer, Christian & Rendall, Alan D. & Wälde, Klaus, 2019. "The invariant distribution of wealth and employment status in a small open economy with precautionary savings," Journal of Mathematical Economics, Elsevier, vol. 85(C), pages 17-37.
    4. Ma, Qingyin & Toda, Alexis Akira, 2022. "Asymptotic linearity of consumption functions and computational efficiency," Journal of Mathematical Economics, Elsevier, vol. 98(C).
    5. Thomas J. Sargent & John Stachurski, 2024. "Dynamic Programming: Finite States," Papers 2401.10473, arXiv.org.
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    7. Bar Light, 2020. "Uniqueness of equilibrium in a Bewley–Aiyagari model," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 69(2), pages 435-450, March.
    8. Bar Light, 2019. "Stochastic Comparative Statics in Markov Decision Processes," Papers 1904.05481, arXiv.org, revised Jan 2020.

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    More about this item

    Keywords

    Consumption; Savings; Interest rates; Income fluctuation problem; Dynamics;
    All these keywords.

    JEL classification:

    • C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General
    • C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models

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