{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Econ 154a Problem Set 3

Econ 154a Problem Set 3 - I Problem 1 Two-Period Model of...

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
I. Problem 1: Two-Period Model of Savings and Investment 1. Analysis of a decrease in current income, X (X 0 and X f are set to 100; X 1 is set to 50; r is set to 0.05 and the consumer’s utility function is maximized when C = C f ): Two-Period Model of Savings and Investment 0 50 100 150 200 250 0 50 100 150 200 250 Present Consumption (C) Future Consumption (Cf) Original Lifetime Budget Constraint Original Utility Indifference Curve Shifted Lifetime Budget Constraint Shifted Utility Indifference Curve Current consumption, C, decreases (from 100 to 74.39 in this case); future consumption, C f , decreases (from 100 to 74.39 in this case); saving, S, decreases (from 0 to -25.61 in this case). Since, C = X – S, Δ C = Δ X – Δ S. As stated above, Δ S is negative, so – Δ S is positive and Δ C > Δ X. However, because Δ C and Δ X are both negative, | Δ C| < | Δ X|. 2. Analysis of a decrease in the real interest rate, r (X and X f are set to 100; r 0 is set to 0.50; r 1 is set to 0.05 and the consumer’s utility function is maximized when C = 2C f ):
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Two-Period Model of Savings and Investment 0 50 100 150 200 250 0 20 40 60 80 100 120 140 160 180 200 Present Consumption (C) Future Consumption (Cf) Original Lifetime Budget Constraint Original Utility Indifference Curve Shifted Lifetime Budget Constraint Shifted Utility Indifference Curve Intermediate Budget Line When the real interest rate drops for a borrower, the price of present consumption decreases relative to the price of future consumption. Thus, the borrower will substitute present consumption for future consumption (lowering saving and future consumption while increasing present consumption). Additionally, when the interest rate drops, the borrower will pay less in interest than he had originally projected, this is equivalent to a rise in the total income available for consumption; acting to smooth consumption, the consumer will split the additional income between present and future consumption. Also, the increase in present consumption implies a decrease in saving. Taken together, these effects predict a decrease in saving and an increase in present consumption; the effect on future consumption is indeterminate.
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern