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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 consumptionsmoothing 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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 Spring '08
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