Quiz IA_Solved - BSc II Macroeconomics II Spring 2011...

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BSc II Macroeconomics II Spring 2011 Quiz 2 (B) Lahore School of Economics Macroeconomics II Spring Term 2011 Quiz 1A:  BSc. 2 Instructions:  Answer all questions in the spaces provided below. For full marks,  make sure to show all calculations.  Calculators, pencils, pens, rulers, etc. cannot be  shared and cell phones cannot be used as calculators. Total points: 85 – Suggested  Solutions Question 1 A. Qasim obeys two-period Fisher Intertemporal Choice model. He is consumption- oriented and faces no borrowing constraints. Graph his budget line and optimal  consumption bundle. Now assume that he faces borrowing and saving constraints.  He can both save and borrow but only a certain amount. Graph his new budget  constraint on a separate diagram and label the optimal consumption bundle. (8  points) For a borrower: Budget Constraint: C + C / (1+r) = Y + Y / (1+r)  Figure 1: A Borrower Student Name and ID Number: Page 1
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BSc II Macroeconomics II Spring 2011 Quiz 2 (B) Budget line with lending and borrowing constraints: Figure 2: Borrower with borrowing and lending constraints B. Return to the original budget constraint in part A. Suppose interest rate goes up.  Is Qasim better off or worse off? Explain also the subsequent effects on C and C 2 Show the effects of rise in interest rate on both periods’ consumption and budget  line when Qasim faces constraints in part A. (7 points) If interest rate increases, then a borrower is worse off. Hence, his consumption in period  one falls as per the income effect. So savings increase. Since the price of consumption  increases, C still falls because of substitution effect. However, the affect on C 2  remains  ambiguous. The budget line is steeper. Without any constraints: Student Name and ID Number: Page 2
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BSc II Macroeconomics II Spring 2011 Quiz 2 (B) Figure 3: Rise in Interest Rate and it's effect on C and C 2 With borrowing and lending Constraints: Figure  4: Rise in interest rate and it's effect on the borrower (with lending and  borrowing constraints) Student Name and ID Number: Page 3
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BSc II Macroeconomics II Spring 2011 Quiz 2 (B) C. Suppose that the government imposes a tax rate of t% on the interest rate. What  will be the new interest rate and how will it affect the budget line? Write the new  budget constraint and graph the model for Qasim after the tax imposition. Assume  there are no borrowing and saving constraints. (5 points) If the government levies tax on interest rate, it will be given by (1-t)r; the new interest  rate is lower so r falls making the budget constraint  flatter .
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