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exam2_ans

# exam2_ans - Department of Economics University of...

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Department of Economics University of California, Davis ECONOMICS 131 Spring 2008 L. Jay Helms Answers to the Final Exam 1. Two Period Consumption Model With Taxation a. The endowment point (I o ,I 1 ) is the consumption combination the consumer would have if consuming all present income in the present and all future income in the future. The slope of the budget line is -(1+r) because 1 dollar saved in the present enables added consumption of 1+r dollars in the future when the interest rate is r. C o C 1 I o I 1 endowment slope = -(1+r) slope = -(1+(1-t)r) b. For a saver, the slope of the dashed budget line is -(1+(1-t)r) because 1 dollar saved in the present enables added consumption of 1+(1-t)r dollars in the future when the interest rate of r. This is because the r dollars of interest is subject to tax at rate t, leaving net interest of r-rt = (1-t)r. For a borrower, 1 dollar borrowed must be paid back with interest at rate r. However, if this interest is deductible the deduction of r generates tax savings of rt. So the net amount that needs to be paid back in the future period is 1+r-rt. This makes the slope of this segment of the budget line - (1+(1-t)r) also.

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Economics 131 Spring 2008 — Answers to the Final Exam Page 2. c. C o C 1 I o I 1 new endowment (1-t)I 1 (1-t)I o slope = -(1+r) slope = -(1+(1-t)r) d. C o C 1 I o I 1 endowment slope = -(1+r s ) slope = -(1+r b )
Economics 131 Spring 2008 — Answers to the Final Exam Page 3.

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