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READ THE INSTRUCTIONS CAREFULLY : SECTION 1. (5 questions, 30 points TOTAL, all questions worth the same) If you dropped your first midterm then you MUST answer all questions in section 1. If you did not you MUST answer at least one true or false question and one multiple choice question. I. MULTIPLE CHOICE 1. Ike's utility function is U(x, y) = x 1/2 y 1/2 . He has 11 units of good x and 7 units of good y. Ben's utility function for the same two goods is U(x, y) = 2x + 2y. Ben has 8 units of x and 12 units of y. (a) Ben prefers Ike's bundle to his own, but Ike prefers his own bundle to Ben's (b) Each prefers the other's bundle to his own. (c) Ike prefers Ben's bundle to his own bundle, but Ben prefers his own bundle to Ike's. (d) Since they have different preferences, there is not enough information to determine who envies whom. (e) Neither prefers the other's bundle to his own. What is the utility that Ike gets with his own bundle: 11 1/2 *7 1/2 =8.77. And with Ben’s bundle: 8 1/2 *12 1/2 =9.79. What is the utility that Ben gets with his bundle: 2*8+2*12=40. And with Ike’s bundle: 2*11 + 2*7=36. 2. Ollie has a utility function U ( x , y ) = ( x + 2)( y + 3). The price of x is \$1 and the price of y is \$1. When he maximizes his utility subject to his budget constraint, he consumes positive amounts of both goods. Ollie consumes (a) exactly as many units of x as of y . (b) 1 more unit of x than he consumes of y . (c) 1 more unit of y than he consumes of x . (d) 2 more units of x than he consumes of y . (e) None of the above. This means he will set MRS=-p 1 /p 2 . Now MRS=-(y+3)/(x+2) and -p 1 /p 2 =-1 so (y+3)/(x+2)=1 or y+3=x+2 or y=x-1. 3. The nominal interest rate is 5% and the inflation rate is 6%. A rational consumer will: (a) Never save money since the real interest rate is negative (b) Will use his future value budget constraint instead of his present value budget constraint (c) It depends on whether his endowment is larger in period 1 or 2 (d) Will save or borrow depending on his preferences (e) None of the above Let r be the real interest rate (approx. -1% in this example). The slope of his budget constraint is -(1+r) which is approx. -0.9 so the budget constraint still has a negative slope. So our usual analysis applies and he may save or borrow depending on whether the indifference curve is above or below the endowment point (same as always). Draw the graph and you’ll see it! II.

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