Econ 302 Final Exam Guide

In the terminology of Chapters 9 and 10, a temporary stimulus check is most likely to benefit households if... (Discussion version)

Financial markets are risky Temporary: The change in one period is undone in the next period

Hope VI is a federal housing program that offers lower income families _____. Moving to Opportunity is a federal housing program that offers lower income families _____.

Housing vouchers; counseling about what regions offer the highest upward mobility for children

If a consumer choose the endowment point, how much do they consume in each period, and how much do they save?

If a consumer chooses to consume at the endowment point, their consumption in each period The consumer consumes his first period income, y-t, in the first period The consumer consume his second period income, y'-t', in the second period

What is the price of future consumption in terms of current consumption?

If the consumer gives up 1 units of current consumption, they get 1+r units of extra income in the future period, where r is the real-rate of interest Therefore, the cost or price of 1 unit of future consumption in terms of current consumption is 1/1+r

What are the horizontal and vertical intercepts of a consumer's lifetime budget constraint

In the two-period model, the lifetime budget constraint of the consumer is: c+c'/1+r = we - r is the real interest rate - we is the consumer's lifetime wealth In other words, this states that the present value of lifetime consumption equals lifetime wealth. This can be rearranged to give the slope-intercept form of the budget constraint c' = -(1+r)c + we(1+r)

What's the slope of the consumer's lifetime budget constraint?

In the two-period model, the lifetime budget constraint of the consumer is: c+c'/1+r = we - r is the real interest rate - we is the consumer's lifetime wealth In other words, this states that the present value of lifetime consumption equals lifetime wealth. This can be rearranged to give the slope-intercept form of the budget constraint c' = -(1+r)c + we(1+r)

Increased demand for mortgage-backed securities

Makes it less risky for banks to make home-loans

Redlining refers to...

Maps published by the federal government that outlined non-white neighborhoods in red; Fannie Mae considered such neighborhoods high-risk

If the default premium increases, what is the effect on the consumption and savings of an individual consumer?

Refer to the graph: Remember that, this default premium occers when "a" decreases - Before the decrease, the budget constraint is AED with E level of endowment - After the decrease, the budget constraint shifts to AEF Now, for a consumer, who is a borrower (who chooses a consumption bundle on ED, before the decline in "a"), would face a decline in the consumption levels and borrowing levels, when "a" decreases. This implies that, the savings would increase in the current period

What are the two sources of credit market imperfections?

Remember, credit market imperfections are the constraints on borrowings, or differences between borrowing and lending rates of interest Two major sources of credit market imperfections are: - Asymmetric info - Limited Commitment Aysmmetric info is the inability of banks to distinguish the good borrowers, who can pay off their loans, from bad borrowers, this signals the existence of asymmetric information in the market. This leads to credit market imperfection varying interest rate levels for good and bad borrowers. The good borrower will have to pay a default premium on a loan from the bank in order to distinguish them from bad borrowers and this grows as the fraction of good borrowers in the population decreases. Limited commitment is when it isn't possible for a market participant to commit in advance to future action In credit market, there can be a lack of commitment in future repayment of the loan from the borrower's side If there were no penalty attached to defaulting on a loan, a rational consumer would choose to default. Due to this, most lending in credit markets is collateralized. Note that, any default the loan gives lender the right to seize the collateral.

For a borrower who is collateral-constrained, what happens when the value of collateralizable wealth falls? How does this matter for the financial crisis?

The budget constraint shifts inward from the previous level with a fall in the collateralized wealth resulting from the decrease in the price of collateral. For a constrained borrower, this causes no change in future consumption, but current consumption drops by the same amount, as there is a decrease in the value of collateral If the borrower is credit constrained the following equality holds: c = y-t+(pH/(1+r)) This reflects the one-for-one reduction in the current consumption for any reduction in the present value of collateralizable wealth (pH/1+r)

A consumer receives income y in the current period, income y' in the future period, and pays taxes of t and t' in the current and future periods, respectively. The consumer can borrow and lend at the real interest rate "r". This consumer faces a constraint on how much he or she can borrow, much like the credit limit typically placed on a credit card amount. That is, the consumer cannot borrow more than x, where x < we -y+t, determine the effects on consumer's current consumption, future consumption, and savings of a change in x.

The consumer faces a borrowing constraint that places a ceiling on the level of current consumption. The consumer may consume more than the current endowment, but less than the amount of the lifetime endowment, we. The consumer's budget line is as in the first of the following figures. The budget line becomes vertical at c = x. An example of such a budget line is depicted in the two panels of the figure as ABD. As one possibility, the constraint is nonbinding as in the figure below. The consumer chooses point H. A change in the level of x has no effect on such a consumer. Alternatively, the consumer depicted in the second of the following figures originally chooses the corner solution, point B. The consumer achieves the level of utility corresponding to indifference curve, I1. An increase in x produces the new budget line, ACJ. This consumer now chooses point G. She increases current consumption and decreases both current saving and future consumption. This consumer is able to improve her level of utility to that corresponding to indifference curve, I2.

HUD's "Moving to Opportunity" program shows that

The earlier a child moves to a neighborhood with a history of higher upward-mobility, the better

What are the effects of an increase in the real interest rate on consumption in each period, and on savings? How does this depend on income and substitution effects and whether the consumer is a borrower or lender

The effect of an increase in the real interest rate on current and future consumption consists of a substitution effect and an income effect Figure 1 - For all consumers, the substitution effect leads to lower first-period consumption, higher second-period consumption, and increased savings Figure 2 - The income effect depends on whether the consumer is initially a borrower or a lender. For a borrower, the increase in the interest rate is equivalent to a reduction in his wealth. The income effect reduces both current and future consumption, and increases savings (reduces borrowing) The substitution effect is reflected in figure-2 a movement from A to D. With an increase in interest rates, there is shift in the income from D to B. Therefore, for a borrower both the substitution and income effects results in reduction of current consumption, and increased savings, while future consumption may either increase or decrease, depending on whether the substitution effect is stronger or weaker than the income effect. Figure 3 - For a lender, the increase in the interest rate is equivalent to an increase in his wealth, and the income effect increases both current and future consumption and reduces savings. The substitution effect is reflected in the graph as a movement from A to D. With an increase in interest rate, there is a shift in the income from D to B. Therefore, for a lender both the substitution and income effects result in higher future consumption, while current consumption may either increase or decrease (and savings either decreases or increases), depending on whether the income effect is stronger or weaker than the substitution effect.

Give two reasons why consumption is more variable in the data than theory seems to predict

The fact that, in reality, aggregate consumption expenditure is found to vary more (relative to variation in GDP) than what is predicted by economic theory. There are two main reasons for this: 1. Credit market imperfections: Consumers cannot borrow or invest as much as they would like, and they face different interest rates for borrowing and lending. This prevents them from smoothing their consumption as much as they would like 2. Changes in interest rates induced by changes in aggregate borrowing and lending: When all consumers simultaneously try to smooth consumption, the equilibrium real interest rate changes, and thus any single consumer is unable to smooth consumption as much as he would like to

What does theory tell us about how the value of stocks held by consumers should be related to consumption behavior? Does the data support this?

The market value of stocks is a proxy for the expected present value of lifetime wealth. Therefore, theory would predict that a rise in the level of stock prices should cause an increase in consumption. This is in fact observed in the data, positive correlation between stock prices and aggregate consumption

How is the consumer's motive to smooth consumption captured in the indifference curve?

The preference for a smooth consumption stream is captured by indifference curves, which are convex toward the origin This means that the slope of an indifference curve decreases (in absolute value) as you move down the curve

What factors are important to a consumer in making his or her consumption-savings decision?

There are three important factors 1. Preference for present versus future consumption: the more future consumption is preferred, the larger the savings 2. Current & future incomes: larger the current income, the larger the savings 3. Real interest rate: greater the interest rate, larger the savings

If borrowers are paying a higher interest rate (r2) than lenders are receiving (r1), where does the money go?

There isn't any "extra" money -- the reason borrowers are receiving less than r2 is that only a fraction of lenders are actually paying r2 The source of inefficiency in this market is that price paid (r2) is not price received (r1) but is it not the result of a tax or of an externality (additional cost). Instead, it is simply that some borrowers are not paying anything even though they had promised to pay r2, so that on average the lender only earns r1 even though good borrowers are paying r2

A consumer receives income y in the current period, income y' in the future period, and pays taxes of t and t' in the current and future periods, respectively. The consumer can lend at the real interest rate r. The consumer is given two options. 1. They can borrow at the interest rate r but can only borrow an amount x or less, where x<we-y+t 2. They can borrow an unlimited amount at the interest rate r2, where r2>r Use a diagram to determine which option the consumer chooses, and explain your results

This problem contrasts two alternative forms of credit market imperfections. As one possibility, consumers may either borrow or lend at the same real interest rate, but face a maximum amount of borrowing. The alternative possibility allows unlimited borrowing, but the interest rate paid on borrowing exceeds the interest rate earned from lending. Clearly, consumers who choose to be lenders are unaffected by such constraints. We therefore only need to be concerned about the behavior of borrowers. In the following figures, the point B represents the endowment point. The first type of constraint imposes a maximum amount of borrowing. This constraint is depicted as budget line ABCJ in the figures. The second type of constraint imposes a higher interest rate on borrowing. This constraint is depicted as budget line ABD in the figures. The first of the following figures depicts the case of a consumer who prefers to pay the higher interest rate on borrowing. This consumer picks point G, a point that is preferred to any of the points along ACJ. The second figure depicts the case of a consumer who prefers the maximum borrowing constraint. This consumer picks point C (or alternatively a point along segment BC). Clearly the second consumer prefers point C to any of the points along BD.

In any case, in which there is a kink in the inter-temporal budget constraint, borrowers are affected by a change in the location of the kink The location of the kink depends on the timing of income and the timing of taxation and therefore Ricardian Equivalence fails if there is a kink in the intertemporal budget constraint

True

In any case, in which there is a kink in the inter-temporal budget constraint, borrowers are affected by a change in the location of the kink The location of the kink depends on the timing of income and the timing of taxation and therefore Ricardian Equivalence fails if there is a kink in the intertemporal budget constraint (Discussion version)

True Ricardian equivalence fails in Ch 10 imperfect markets Tax policies are more likely to affect the welfare of borrowers or credit-constrained households

On average, increases in public 4-year institution tuition over the past 17 years has matched decreases in state support

True -- tuition increases have been made to offset reductions in per-student support rather than to increase quality of services

In the US, there is considerable chance for advancement unless you are born in the lowest 20%

True. People born to the lowest end of the income distribution tend to stay there

Chapter 9 - Two period model: The Consumption-Savings Decision and Credit Markets Figure 9.5 - The Effects of an Increase in Current Income for a Lender

When current income increases, lifetime wealth increases from we1 to we2. The lifetime budget constraint shifts out, and the slope of the constraint remains unchanged, because the real interest rate does not change. Initially, the consumer chooses A, and he or she chooses B after current income increases. Current and future consumption both increase (both goods are normal), and current consumption increases by less than the increase in current income.

Which of the following is NOT positively correlated with per capita GDP growth?

Widening of the income distribution

Does the existence of credit market imperfections imply there is a useful role for government tax policy?

Yes, the credit market imperfection does imply that there is a useful role for government tax policy. This because; during a tax cut, the government acts like a bank to the consumer that makes loans available to them at below-market interest rates.

Chapter 9 What is the formula for the maximum amount that can be borrowed?

[Maximum borrowing today]*(1+r) = y'-t'-c'

All other things being equal, if markets are efficient as in the Chapter 9 model, then lower interest rates are _____ for lenders, whereas if there is uncertainty/risk, and markets are inefficient as in the Chapter 10 model, then lower interest rates (r1) are _____ for lenders.

bad bad

All other things being equal, if markets are efficient as in the Chapter 9 model, then lower interest rates are _____ for lenders, whereas if there is uncertainty/risk, and markets are inefficient as in the Chapter 10 model, then lower interest rates (r1) are _____ for lenders. (Discussion version)

bad; bad

Even in the absence of income-based discrimination in lending markets, college costs more for the poor than the rich

because the cost of borrowing at r2 is higher than the implicit opportunity cost of earning r1 if there is default risk If there is no default risk then r1=r2 and the opportunity cost of giving up investment income (rich people) is the same as the borrowing cost (poor people). Imperfect information causes r2>r1 and for borrowers to therefore pay more for loans than the lenders are giving up in terms of implicit costs. This is true even in the absence of profiling poor borrowers with higher borrowing rates based on their income/collateral

The mpc is likely to be _____ if there is asymmetric information than if there is not and the impact of recessions on welfare is likely to be _____

bigger bigger

Americans are relatively strong in their belief that government should provide opportunities

but otherwise isn't responsible for evening out the income distribution

College education widens the income distribution because the poor are unlikely to go to college

but positive externalities from education benefit less-educated workers more than highly-educated ones, which helps reduce income gaps

If lifetime disposable income increases because of an increase in current disposable income then...

c, c', s - all increase Both c and c' are normal goods and wealth has increased, so we expect both c and c' to increase. C' can only increase in this case if there is more saving (or less borrowing) in the current period -- either way "s" goes up (if "s" was negative it is now less negative, which "s" going up)

For some households, the value of collateral is rising, as house prices continue to rise. In the Chapter 10 model with limited commitment, an increase in the value of collateral implies...

current consumption will rise the effect on future consumption is ambigous

In the terminology of chapter 10, the spring 2020 spike in r2 on junk (risky) bonds is most likely explained by an expected _____ and most likely _____ for borrowers in that market

decline in "a" (fraction of good borrowers) reduced welfare

In the terminology of chapter 10, the spring 2020 spike in r2 on junk (risky) bonds is most likely explained by an expected _____ and most likely _____ for borrowers in that market (Discussion version)

decline in "a" (fraction of good borrowers); reduced welfare Lenders return = Amount expected to receive from borrowers 1+r1 = a*(1+r2) +(1-a)*0 1+r2 = (1+r1)/a When r2 increases, cost of borrowing goes up Borrower's welfare (down)

If a country is a net lender in international financial markets, then it has a capital and financial account _____ and a current account and trade _____

deficit surplus If there are net flows IN then it is defined as a SURPLUS. If there are net flows OUT then it is defined as a DEFICIT.

tf According to the data seen in this video, people are much more likely to have to move to find a new job than they used to be

f

tf Although overall borrowing by firms has increased, these are generally considered riskless investments that will likely survive the post-pandemic recovery

f

tf Parental disadvantage (penalty from having poor parents) is about the same in the US as in other OECD countries...

f

tf The federal government imposed the mortgage interest payment deduction for income taxes in order to get housing prices to rise again after the Great Depression

f

tf US government borrowing increased since the Great Recession but borrowing borrowing by private sector has decreased

f

tf If housing prices fall, then borrowers will reduce current spending but lenders will be unaffected

f If the value of collateral (pH) falls then this is a leftward shift of the budget constraint and a negative income effect for both borrowers and lenders: c and c' are both normal goods and both fall; s rises as y-t in unchanged but current consumption is lower (people borrow less, save more)

In the real world, federal stimulus checks to households during the pandemic offset by future tax increase imply if domestic spending increases the trade balance must _____

fall

In the real world, federal stimulus checks to households during the pandemic offset by future tax increase imply if domestic spending increases the trade balance must _____ (Discussion version)

falls If domestic spending increases, it implies that the government borrows from foreigners. There is a capital/financial account surplus There is a corresponding trade/current account deficit i.e. there are extra import and trade balance falls - The extra money has to be spent somewhere - The desire to buy more than the country's income (value of production) is the reason why the country needs to borrow in the beginning

In the terminology of Chapters 9 and 10, a temporary stimulus check is most likely to benefit households if...

financial markets are risky

The Romer model predicts convergence in _____ where as the Solow model predicts convergence in _____

growth rates levels

In the closed economy model from Chapter 9, it is not possible to borrow from foreigners. This implies that if the government borrows to stimulate the economy, private savings will _____ and there will be _____ in domestic spending and domestic utility. This is know as Ricardian Equivalence.

increase no change

In the closed economy model from Chapter 9, it is not possible to borrow from foreigners. This implies that if the government borrows to stimulate the economy, private savings will _____ and there will be _____ in domestic spending and domestic utility. This is know as Ricardian Equivalence. (Discussion version)

increase; no change If the government borrows from domestic citizen, domestic spending should not change - No extra capital inflow - No desire to buy more than the country's income - Lifetime budget constraint remains the same, so optimal decision to c, c' remains the same Saving = income today - c Domestic spending = c (or c', if we're asking the spending in the future)

The "stickiness" of people born at the very top and very bottom staying in their income bracket...

is correlated with attending college. College-educated people have more opportunities no matter what income bracket they are born into

According to our Chapter 10 model with limited commitment, reduced home ownership would most likely lead to _____ aggregate consumption-smoothing and make aggregate consumption _____ pro-cyclical....

less more

Correcting for measurement errors in the trade balance due to profit-shifting and correct measurement of intangibles would make the US estimate of net lending....

net lending by private households and the firm would look more positive If those measurement corrections make the trade balance less negative, then less money is flowing out on the trade balance and less money is flowing in as loans from foreigners. We borrow less from foreigners and more from ourselves.

As the fraction of good borrowers (a) increases...

r2 decreases 1+r2 = (1+r1)/a so as an increase (1+r2) decreases. This is also logical -- as the fraction of good borrowers goes up, risk goes down, so lenders don't have to charge as much to compensate for risk. We approach the risk-free (perfect information) efficient case from Ch9 as an approach to 1

Explain how a default premium can arise, and what would cause it to increase

r2>r1 the difference of these two is the amount that compensates the bank from lending in the market L is the amount of the loan and "a" is the fraction of good borrowers Therefore L(1+r1) is the amount that the bank has to pay to the depositors in the future period. aL(1+r2) is the average payoff that the bank will receive from good borrowers.

In the Ch10 graph, the risk that a borrower might not repay its debt

reduces the welfare of borrowers but leaves the welfare of lenders unchanged

All other things being equal if interest rates rise households will...

substitute into future consumption (c') MRS(c,c') = 1+r so as r increases U(C)/U(C') increases, which happens if C falls and C' rises (diminishing returns to C and C' in utility). Also logically the opportunity cost of consuming today rises and households are more likely to save more (or borrow less) in order to get the higher return (not pay so much for borrowing)

tf A homeowner is less likely to be credit-constrained than is a renter

t

tf Americans are relatively strong in their belief that they have opportunities for advancement

t

tf By the 2000's Fannie Mae (and Freddie Mac) were competing with private institutional investors that were speculating, trading, and investing in Mortgage-Backed Securities (MBS)

t

tf Credit market failures may add to the market failures unique to education, getting us further from the optimum

t

tf Fannie Mae provides liquidity in housing markets by giving private banks money in exchange for mortgages. The bank then has money (to lend out or keep in reserves) instead of mortgages. Fannie then sells groups of mortgages to other investors

t

tf Home equity loans are a type of mortgage against the value of your house. Mortgages are a way for homeowners to avoid being credit-constrained during times of economic uncertainty, and to avoid paying risky interest rates if there is both uncertainty and chance of default

t

tf In the presence of imperfect information about which borrowers will default, a temporary tax cut acts as a low-cost loan

t

tf Only 11% of Americans born to the lowest quintile of the US income distribution go to college

t

tf Our trade deficit with China would look smaller if we both accounted for profit-sharing of intangibles and if we measured the trade data in Value-Added rather than Final-Product terms

t

tf Parental advantage to those born to the top of the US is about the same as in other OED countries

t

tf The current consumption of credit-constrained households will be affected by temporary changes in their current disposable income, thus violating both the Permanent Income Hypothesis and Ricardian Equivalence; mpc>0 for those people

t

tf The data problem we have with the production of intangibles is that it is hard to observe where they are really produced, and firms have an incentive to pretend they are produced in low-income tax countries, thus distorting our national income accounting data

t

tf The federal government borrowed around 3.2tn over 2017 through 2019, and will borrow at least another 3.7tn in 2020. Added together, the borrowing over years 17-20 comes to over one-third of US annual GDP

t

tf The share of good borrows "a" in the student loan market is about 2/3

t

tf Banks and other financial intermediaries exist in part as a response to the presence of risk in the market for loans

t Banks and other financial intermediaries "pool" resources from many savers and then can spread loans around to a large group of borrowers. By spreading risk across the larger group than would be possible for most households, the bank is likely to actually earn the market average rate of return and is less exposed to repayment by any one or small group of borrowers

tf According to Ch9 model, if interest rates increase, lenders are better off...

t The income effect determines if they are better or worse off, and there is a positive income effect for the lender. There is also a substitution effect, which is a movement along the IC rather than a shift

If there is perfect information and everyone knows future incomes and has no barriers to getting loans then...

temporary changes in disposable income that do not affect lifetime wealth will not affect either c or c'

Ricardian Equivalent is the concept...

that the timing of taxation doesn't really matter

Externalities in the accumulation of human capital are a source of market failure because...

the Social Planner would choose a higher level of education -- the one that maximized the country's welfare -- than the market would There is no presumption that the public sector is either better or worst at providing education services. The issue is not about public vs. private schools or voucher programs or charter schools or things like that. The issue treated here is about how to get people to invest as much in education as is socially optimal for the country as a whole

Compared to other OECD (Organization for Cooperation and Development) countries,

the US has lost its lead in the number of college graduates

All other things being equal, an increase in the real interest rate causes...

the present value of future income to fall (higher discount of future earnings) Discounting future variables means that we reduce their value by putting them in present-value terms. The value is reduced because in order to put future variables in present value terms we multiply by a fraction equal to 1/(1+r)

Most Americans feel that there is opportunity for advancement no matter where an American is born into the US income distribution and that there is no need for government involvement in addressing income inequality

true true

Poor people are more likely to drop out of college for financial reasons, and drop-outs have higher default rates

unregulated private markets will tend to charge the poor a higher interest rate than they charge the rich because of the higher default rate If "a" is lower for college drop-outs, then r2 for expected dropouts is greater than r2 for expected graduates. Private lenders, knowing how expensive college is, would logically charge poor people a higher interest rate because they are riskier. That higher interest rate increases the cost of attending college and makes dropping out more likely (self-reinforcing equilibrium)

There are at least 2 types of externality that cause the private market outcome to be below the efficient outcome

we are considering both of these in our model

The economy is likely to be _____ if there is asymmetric information than if there is not. Policy is likely to be _____ in improving welfare if there is asymmetric information than if there is not...

worse off more effective

In order to make recommendations about education policy and student loan policy...

you need to know a lot about the micro-foundation of the market; policy recommendations are not straightforward

In Econ102 you likely saw a Consumption Function where current changes in Consumption spending varied with temporary changes in disposable income according to a marginal propensity to consumer (mpc). In the Chapter 9 model the mpc is _____ but if there is either asymmetric information or collateralized borrowing the mpc may be _____

zero greater than zero

In Econ102 you likely saw a Consumption Function where current changes in Consumption spending varied with temporary changes in disposable income according to a marginal propensity to consumer (mpc). In the Chapter 9 model the mpc is _____ but if there is either asymmetric information or collateralized borrowing the mpc may be _____ (Discussion version)

zero; greater than zero Temporary: The change in one period is undone in the next period Suppose there is a temporary decrease in disposable income For borrowers: Negative income effect mpc > 0: Decrease in (y-t) makes c lowe For lenders in E, E' IE(-): c down, c' down | SE: c down, c' down mpc > 0: Decrease in (y-t) makes c lower

Suppose that the government introduces a tax interest earnings. That is, borrowers face a real interest rate of (1-x)r on their savings, where x is the tax rate. Therefore, we are looking at the effects of having x increase from zero to some value greater than zero, while "r" remains constant (a) Show the effects of the increase in the tax rate on a consumer's lifetime budget constraint (b) How does the increase in the tax rate affect the optimal choice of consumption (in the current and future periods) and saving for the consumer? Show how income and substitution effects matter for your answer, and show how it matters whether the consumer is initially a borrower or a lender

(a) Initially, AB in the left figure in the following set depicts the consumer's budget constraint. The introduction of the tax results in a kink in the budget constraint, since the interest rate at which the consumer can lend, is now smaller than the interest rate at which the consumer borrows, r. The kink occurs at the endowment, E. (b) The first figure in the preceding set 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 in the preceding 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 D to point B, and the income effect reduces both first-period and second-period consumption, and increases savings. On net, consumption must fall in period 2, but in period 1, consumption may rise or fall. The figures above show the case in which first-period consumption increases, which is a case where the substitution effect dominates.

Consider the following effects of an increase in taxes for a consumer (a) The consumer's taxes increase by Delta t in the current period. How does this affect current consumption, future consumption, and current savings? (b) The consumer's taxes increase permanently increasing by Delta t in the current and future periods. Using a diagram, determine how this affects current consumption, future consumption, and current saving. Explain the differences between your results here and in part (a)

(a) The increase in first-period 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 E2. The consumer reduces both current and future consumption. In the following figure the consumer's optimum point moves from point A to point B. First-period consumption falls by less than the increase in taxes and so savings falls. (b) Next consider a permanent increase in taxes. A permanent tax increase adds a second tax increase to the first tax increase, the current-period tax increase. The increase in second-period taxes induces a parallel downward shift in the budget line. The new budget line passes through E2 in the preceding figure. The second part of the tax increase also reduces both first-period and second-period consumption. The consumer moves from point B to point D. Because the second tax increase reduces first-period consumption holding first-period 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 first-period and second-period consumption, but on net, savings may either rise, fall, or remain unchanged.

An employer offers their employee the option of shifting x units of income from next year to this year. That is, the option is to reduce income next year by x units and increase income this year by x units (a) Would employee take this option (b) Determine with graph, how this shift in income will affect consumption this year and next year and savings this year

(a) the employee should take the option if r>0 (b) kinked graph, but doesn't change the future consumption

In the real world, federal stimulus checks to households during the pandemic offset by future tax increase imply that... (Discussion version)

1. Federal government owes (1+r) times the amount of the stimulus in the future Suppose the stimulus amount is "B" dollars The government pays this back by future tax, so it implies the government is borrowing "B" today In the future, the government pays back "B*(1+r)" 2. Private sector is lending the amount of the stimulus to the government today Where does "B" come from? The money the government borrows comes from somewhere - domestic or foreign people (private sector) 3. Think about the bathtub model of capital flows... U.S. Income = Option 1: Total production within US Option 2: Total expenditure on US goods and services - Inflow: Borrow from foreigners - Outflow: Imports If B comes from domestic citizens... Domestic citizens lend B to the government, and get B back from the stimulus check In aggregate, no change in domestic income! No change in aggregate spending Key here is that households may have different income - when the government borrows money through debt, only those wealthy households would lend money to the government. So it leads to a transfer of money between wealthy and poor households

What are the three properties of a consumer's prefernces?

1. More is preferred to less, an increase in current or future consumption will always make the consumer better off 2. Consumer likes their consumption to be smooth over time, they don't like too much variation in consumption in different time periods 3. Both current and future consumption are normal goods, given an increase in wealth, the consumer will choose to increase both their current & future consumptions

Government could try to address the gap between r2 and r1 by

1. Subsidizing student loans so that r2 falls toward r1 2. Improving the quality of high school education in order to increase college graduation rates, which is associated with raising the "a" 3. Providing standardized testing to allow lenders to better predict the odds of graduation and loan repayment

In the real world, federal stimulus checks to households during the pandemic offset by future tax increase imply that...

1. The private sector is lending the amount of the stimulus to the government today 2. The federal government owes (1+r) times the amount of the stimulus in the future 3. There is no change in domestic household spending today unless the federal government borrows money from foreigners

What produces a larger increase in a consumer's current consumption, a permanent increase in the consumer's income or a temporary increase?

A permanent increase in income produces a larger increase in current consumption than temporary increase It is clear in the graph that with a temporary increase in (current) income, there is a shift in the budger constraint from AB to ED. As a result, the consumption bundle shift from K to J. Thus, the consumer increases both consumption and saving in the current period, so that he can also increase his future consumption, which smooths his consumption over time. On the other hand, with a permanent increase in income, there is a shift in the budget constraint from AB to FG. As a result, the consumption bundle shifts from K to H. In both situations, the consumer would not need to increase his savings to achieve a higher level of consumption in both periods.

What are the effects of an increase in the future income on consumption in each period, and on savings?

An increase in future income increases both current and future consumption, and reduces saving Future consumption increases because it is a normal good. However, the consumer also wants to smooth his consumption over time. It is clear in the graph that an increase in income has led to an increase in the wealth of the individual, from we1 to we2 With an increase in the future income, consumer has shifted his consumption from A to B. Thus, there is an increase in current consumption (c1 to c2) and an increase in future consumption (c1' to c2') Due to the shift in the budget constraint, there is an increase in current and future income. However, the increase in future consumption is less than the future income, as current consumption has increased than before. Therefore, he would like to use part of his higher future income to borrow and increase his current consumption. Since current income is the same as before, a higher current consumption means lower saving

What are the effects of an increase in current income on consumption in each period, and on savings?

An increases in current income results in increases in first-period consumption, second-period consumption, and saving. This is because the increase in current income increases the consumer's lifetime wealth by an equal amount It is clear from the graph that an increase in the income led to an increase in the wealth from we1 to we2. As a result, there is a shift in the consumption bundle from A to B. Therefore, if both current and future consumption are normal goods, demand for both will increase when wealth increases. However, increase in current consumption is less than the increase in the current income. This is because our future consumption is higher, which means that in addition to increasing the current income, the consumer must have increased his savings, which will increase his future income

What are the effects of a tax cut on consumption and savings in the presence of a credit market imperfection? Does Ricardian Equivalence hold?

Assume that there is a tax cut in the presence of credit market imperfection. This results in a shift in the endowment point from E1 to E2 as period 1 taxes change by Delta T < 0 and future taxes to fall by -Delta t(1+r) Thus, with a tax cut, there is a shift in the budget constraint from AE1B to AE2b. However, with a shift in the bundle shift from E1 to E2, the consumer is able to consume the entire tax cut. The indifference curve the consumer now chooses is l2 and as he chooses the endowment point again just like before the cut in taxes, the current consumption increases by the amount of tax cut. This shows that Ricardian Equivalence doesn't hold in this case, where the current consumption remains constant as the budget constraint remains the same and the consumer saves the entire tax cut. A tax cut of -Delta t with future liability of -Delta t (1+r)

Chapter 9 - Two period model: The Consumption-Savings Decision and Credit Markets What does the graph look like for the lender?

At point A, the quantity of savings is s=y-t-c* or the distance BD

Chapter 9 - Two period model: The Consumption-Savings Decision and Credit Markets What does the graph look like for the borrower?

Consumer chooses point A. Here, the quantity the consumer borrowers in the first period is -s=c*-y+t, or the distance DB

How do consumers save in the two-period model?

Consumers save by choosing not to consume their entire income in the current period. They lend the excess of income over current consumption in the credit market, thereby increasing their future period income by the amount of the saving, with interest. Thus, they can consume more than their income in the future period

What effects do credit market imperfections have on the interest rates faced by lenders and borrowers?

Credit market frictions bring a gap in the borrowing and lending rates. This happens because it is costly for banks to sort credit risks. Hence, if a bank borrows from the lenders who are the depositors in the bank at the real interest rate r1 and make a loan at real interest rate r2 then r2-r1>0 is the compensation to the banks for the costs of making the loans

Show how to derive the consumer's lifetime budget constraint from the consumer's current-period and future-period budget constraints

Current period budget constraint: c+s = y-t Hence, the future-period budget constraint is: c' = y'-t'+(1+r)s Solving the future-period budget constraint for s, we get: s=(c'-y'+t'/1+r) Substituting for s in the current-period budget constraint, we obtain the lifetime budget constraint: c+s = y-t ---> c+(c'-y'+t'/1+r) = y-t Rearranging this equation, taking terms containing c & c' to one side, we get: c+c'/1+r = y+y'/1+r - t+t'/1+r The present value of lifetime consumption is equal to the present value of lifetime income minus the present value of lifetime tax payments