# problem set 4 answers - Economics 100B UCSC Abhijit Sen...

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Economics 100B Abhijit Sen Gupta UCSC Summer 2006 Answer Key to Problem Set 4 1) Problem 3, Chapter 16 of Blanchard Applying equation (16.5) p. 346: a. 18000/.05+.08 = 138,462 > 100,000 so buy b. 18000/.10+.08 = 100,000 so indifferent c. 18000/.15+.08 = 78,261 < 100,000 so do not buy 2) Problem 4, Chapter 16 of Blanchard a. Expected Net Present Value of no-school option: [1-.40][40,000 + 40,000/(1+r t ) + 40,000/((1+r t )(1+r e t+1 )) + 40,000/((1+r t )(1+r e t+1 )(1+r e t+2 ))…] for 38 years. However, as the real interest rate is expected to be zero always this simply becomes [1-.4][40,000]38 = 912,000 - Expected Net Present Value of school-then-work option: [1-.40][1.10][40,000/((1+r t )(1+r e t+1 )) + ….40,000/((1+r t )(1+r e t+1 )(1+r e t+2 )) + . ....] for 36 years. Again using that the expected real interest rate is always zero this simply becomes [1-.40][1.10][40,000]36 = 950,400 - So willing to pay up to 950,400 - 912,000 = 38,400 to go to school b. Tax rate of .3 implies willing to pay 1,108,800 -1,064,000 = 44,800 to go to school. 3) Problem 3, Chapter 17 of Blanchard a) A decrease in expected future real interest rate will increase the present discount value of future earnings. This will increase current consumption and investment and shift the IS curve to the right.

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Economics 100B Abhijit Sen Gupta UCSC Summer 2006 b) An increase in current money supply will lower current interest rate and increase current output. This will cause the LM curve to shift right. c) Within the context of IS-LM, with a fixed capital stock, an increase in expected future taxes causes IS to shift left. However, the increase in future taxes (a deficit reduction program) will lead to lower real interest rates and increased investment in the medium run and higher output in the long run. The expected changes in the real interest rate and output tend to cause the IS curve to shift right. The net effect on the IS curve is ambiguous. d) A decrease in expected future income will lead to a reduction in current consumption and investment and shift the IS curve to the left. 4) Problem 5, Chapter 17 of Blanchard These answers ignore any effect on capital accumulation and output in the long run. a. In the future, tax cuts will lead to a boom. This leads to higher expected output, lower expected taxes, but a higher expected interest rate in the future. The effect on current output is ambiguous. b. This means that the Fed will increase the interest rate in the future (shift LM left). The expected interest rate will increase more, but there is still the effect of lower expected taxes on current consumption. The effect today on output is still ambiguous, but more likely to be negative than in part (a). c. Future output will be higher, the future interest rate will not increase, and future taxes will be lower. The current IS curve definitely shifts right, and current output increases.
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problem set 4 answers - Economics 100B UCSC Abhijit Sen...

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