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Unformatted text preview: Problems 1. Given information: y=lﬂﬂ y'=]2 I=ZD t'=]0 r=lll (a) To calculate wealth, we compute:
w=y—r+yr_tl=so+ﬂ=tso +r LI 8’ (c) The consumer's optimal consumption bundle is at point A. Point A simultaneously solves: 12:42, and C
1+!“ c+ =c+i}.91c'=13i} Upon solving, we find that c = c' = 94.2. Savings is therefore given by:
s=y—I—c=BD—9¢2=—14.2 The consumer is a borrower. In the figure above, the endowment point is EI and the consumer
chooses A. (d) First—period income rises from IDE to MD. We now recompute w = 22!]. Solving as in part (c), we
ﬁnd that r: = c': 115.2, and s = 4.3. In the ﬁgure above, the endowment point is EI and the
consumer chooses B. (e) In part {c}, the consumer is a borrower. In part [d], ﬁrstperiod income increases and savings has
consequently increased enough that the consumer is now a lender. 4. Temporary.r and Permanent Tar. Increases. (a) The increase in ﬁrstperiod taxes induces a parallel leftward shift in the budget line. The original budget line passes through the initial endowment, E1. The new budget line passes through E. The
consumer reduces both current and future consumption. In the ﬁgure below the consumer's optimum point moves from point A to point B. Firstperiod consumption falls by less than the
increase in taxes and so savings falls. 15’ {b} Next consider a permanent increase in taxes. A permanent tax increase adds a second tax increase
to the ﬁrst tax increase, the currentperiod tax increase. The increase in secondperiod taxes
induces a parallel downward shift in the budget line. The new budget line passes through E: in
the ﬁgure above. The second part of the tax increase also reduces both ﬁrstperiod and second—
period consumption. The consumer moves from point B to point D. Because the second tax
increase reduces ﬁrstperiod consumption holding ﬁrstperiod disposable income ﬁxed, savings
must rise. Since the permanent tax increase is the sum of the two individual tax increases, the
permanent tax increase reduces both ﬁrstperiod and secondperiod consumption, but on net,
savings ma}.r either rise, faJI, or remain unchanged. 5. A tax on interest income. (a) Initially, AB in the ﬁrst ﬁgure below depicts the consumer‘s budget constraint. The introduction
ofthe tax results in a kink in the budget constraint, since the interest rate at which the consumer
can lend, ril —!), is new smaller than the interest rate at which the consumer borrows, r. The
kink occurs at the endowment, E. r.’ {b} The ﬁrst ﬁgure above shows the case of a consumer who was a borrower before the imposition of
the tax. This consumer is unaffected by the introduction of the tax. The second ﬁgure above
shows the case of a consumer who was a lender before the imposition of the tax. Initially the
consumer chooses point G, and then chooses point H after the imposition ofthe tax. There is a
substitution effect that results in an increase in ﬁrst—period consumption and a reduction in
second—period consumption, and moves the consumer from point G to point J. Savings also fall
from point G to point]. The income effect is the movement from point D to point B, and the
income effect reduces both ﬁrst—period and secondperiod consumption, and increases savings.
(in net, consumption must fall in period 2, but in period 1, consumption may rise or fall. The
ﬁgures above show the case in which ﬁrstperiod consumption increases, which is a case where
the substitution effect dominates. E. Given information: y=2m y'=]5lZI
1:40
I'=SD
rzﬂﬂﬁ (a) If the consumer could borrow and lend at the real interest rate, .r = 0.05, then the consumer’s
lifetime budget constraint would be given by: c =}'—i‘+}I _r.
{1+r} {1+r} Plugging in the numbeis from this problem, we obtain:
r: + 0.956 = 255.2. In the ﬁgure below, the initial budget constraint is given by BEID. The budget constraint has a kink at the initial endowment point EL = (160,100), because the consumer cannot borrow, and
therefore cannot consume more than 160 in the ﬁrst period. Because the consumer has perfect— complements preferences, the indifference curves are kinked at c = c'. C+ c‘ :b) TWith perfectcomple ments preferences, the consu mer picks point A in ﬁgure on the previous
page. Plugging in c = 13' into the budget constraint and solving, we ﬁnd that c = c' = 130.? and
so 3 = y — :t — c 2160—130? = 29.3. In this case, the fact that the consumer cannot borrow does not matter for the consumer‘s choice, as the consumer decides to be a lender. :c) When1= 2] and t“ 2T], the consumer‘s lifetime wealth remains unchanged at 255.2. However,
the budget constraint shifts to BEIF, ﬁgure on the previous page, with the new endowment point at E2 = [180,7'9). This change does not matter for the consumer's choice, again because he or she
chooses to be a lender. Consumption is still 130$, but now savings is s=y—t—c=lBD—l30.T=49.3. :d} Now ﬁrstperiod income falls to 100. Wealth is now equal to w = 155.2. In the ﬁgure above, the
budget constraint for the consumer is AE1D, so when the consumer chooses the point on his or
her budget constraint that is on the highest indifference curve, any point on the line segment BE1
will do. Suppose that the consumer chooses the endowment point E], where r: = 61] and c' = 100.
This implies that s = i}, and the consumer is credit—constrained in that he or she would like to
borrow, but cannot. Now with the tax change, the budget constraint shifts to AEit}, with the
endowment point E1 = (30,79). Thus the consumer can choose c = c‘ on the new budget
constraint, and solving for consumption in each period using the budget constraint c+ [1.956 =155.2, we get I: = c' = Tr'9.5, and s = [1.5. Here, notice that ﬁrst—period consumption increased by almost
the same amount as the tail. cut, although lifetime wealth remains unchanged at 155.2.
Effectively, the budget constraint for the consumer is relaxed. Therefore, for tax cuts that leave lifetime wealth unchanged, lenders will not change their current consumption, but credit
constrained borrowers will increase current consumption. ...
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 Fall '08
 Staff
 Economics

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