Midterm #2 Review

# Midterm #2 Review - University of California Riverside Econ...

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1 University of California, Riverside Econ 103A Macroeconomic Theory Winter 2008 Review Problems for Midterm #2 Chapter 4 1. Consumption and Saving Question 1 (Short Question) Consider a consumer whose optimal choice is to save 600 units of good in the current period when her current income is 2,500. We know that her marginal propensity to consume is 0.72. Suppose now her current income increases by 1,000 units (from 2,500 to 3,500). All other factors (including her future income, wealth and real interest rate) are unchanged. (a) What is her new optimal level of current consumption ? First, what is the optimal level of current consumption before the change ? Initial level of current consumption = 2,500 – 600. Increase in current consumption = MPC x Increase in current income = 0.72 x 1,000 Her new optimal level of current consumption = 2,500 – 600 + 0.72 x 1,000 . (b) What is her new optimal level of savings in the current period ? Initial level of savings = 600 Increase in savings = 1,000 – 1,000 x 0.72 = (1 – 0.72) x 1,000 New level of savings = 600 + ( 1 – 0.72 ) x 1,000

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Question 2 (Analytical Question) Use a diagram to explain how an increase in future income affects (1) the budget line (2) the point at which the consumer neither saves nor borrows in the current period (3) the optimal choice of current and future consumption. Assume that the real interest rate is unchanged. (1) If the real interest rate is unchanged and there is an increase in future income, the budget line will shift to the right and the slope of the budget line is unchanged. (2) Let point E be the point at which the consumer neither saves nor borrows in the current period before the change. When there is an increase in future income, this point becomes F which is vertically above E. (3) By the consumption-smoothing motive, the consumer would like to spread the increase in income over time. In particular he would increase both his current and future consumption. Let point A be his optimal choice before the change. His new optimal choice is now
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Midterm #2 Review - University of California Riverside Econ...

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