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Unformatted text preview: Economics 101 Marek Kapi cka Macroeconomics Spring 2010 Problem Set 5 Answers 1 Tax on Interest Solve question 8.5 in Williamson (page 311) a. Initially, AB in figure 1 depicts the consumers budget constraint. The intro- duction of the tax results in a kink in the budget constraint, since the interest rate at which the consumer can lend, r (1- t ), is now smaller than the interest rate at which the consumer borrows, r . The kink occurs at the endowment, E. b. Figure 1 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. Figure 2 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 of the 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 J. The income effect is the movement from point J to point H, and the income effect reduces both first-period and second-period consumption, and...
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- Spring '08