CHAPTER 8 MICRO

As long as both current and future consumption are normal goods, a decrease in the interest rate will result in a drop in savings.

ANS: F A decrease in the interest rate will cause a substitution effect that points in the direction of less savings but a wealth effect that points in a direction of more savings. Which dominates depends on the size of the substitution effect relative to the wealth effect.

When the elasticity of substitution in the constant elasticity of substitution utility function lies above 1, an increase in the interest rate will cause a saver to save less.

ANS: F Cobb-Douglas tastes --- which are CES tastes with elasticity of substitution of 1, represent the borderline case where an increase in the interest rate causes no change in savings behavior. For higher elasticities of substitution, the substitution effect dominates --- causing savings to increase with the interest rate.

For decreases in wage taxes, substitution effects put negative pressure on tax revenues while wealth effects put positive pressure on tax revenues.

ANS: F Decreases in wage taxes cause increases in after-tax wages -- and increases in wages cause substitution effects that cause increases in work hours. If people work more, then this causes upward pressure on tax revenue, not negative pressure. At the same time, the wealth effect from higher wages suggests people will work less (assuming leisure is a normal good) -- pushing in the opposite direction.

In a model of consumption and leisure, a drop in the wage will cause workers to work more if tastes are quasilinear in consumption.

ANS: F If tastes are quasilinear in consumption, then leisure is a normal good --- and how workers respond to changing wages will therefore depend on the relative size of substitution and wealth effects on the leisure axis.

A friend is currently earning income but does not expect to earn income in the future. When the interest rate rose, I observed him saving less. From this, I can conclude that current consumption is an inferior good for my friend.

ANS: F In this graph, both current and future consumption are normal goods -- and current consumption now increases, implying savings decrease.

Taxing savings in ways that lower the interest rate received by savers will lower savings

ANS: F It depends on whether wealth effects outweigh substitution effects.

When tastes over current and future consumption take the Cobb-Douglas form, interest rates have no impact on savings when income is earned in the current period but not in the future.

ANS: T For Cobb-Douglas tastes, the substitution and wealth effects are exactly offsetting.

If leisure is an inferior good, then an increase in wages will cause workers to work more

ANS: T In this case, both the substitution and wealth effect cause the worker to reduce leisure consumption as wages increase.

Assuming no kinks in indifference curves and assuming our usual assumptions about tastes hold, someone who currently neither saves nor borrows will begin to borrow when the interest rate falls.

ANS: T The new (dashed) budget will pass through the original optimum A -- with the new optimum involving more consumption and thus borrowing.

The more substitutable current consumption is with future consumption, the more likely it is that an increase in the interest rate will cause an increase in savings.

ANS: T The substitution effect causes a decrease in current consumption when the interest rate increases, while the wealth effect causes the opposite (assuming current consumption is a normal good).

In a model of consumption and leisure, a drop in the wage will cause workers to work less if tastes are quasilinear in leisure

ANS: T The substitution effect points in the direction of more leisure (i.e. less work), and the wealth effect is zero on the leisure axis.

In a model with leisure hours and a composite consumption good, you cannot tell whether workers will work more or less if tastes are quasilinear in the consumption good.

ANS: T The substitution effect will cause workers to work less -- but leisure is a normal good (since tastes are quasilinear in consumption), and this implies a wealth effect in the other direction.

If you earn income now and expect to live off savings in the future, then a raise now will cause you to save more so long as consumption -- now and in the future -- is a normal good.

ANS: T This is a pure wealth effect with no substitution effect. Thus, consumption now and in the future will increase, implying that you will save more (which is the only way future consumption can increase in the absence of a change in the interest rate.)

When tastes over current and future consumption are characterized by Cobb-Douglas utility functions, a borrower who has no income now and all income in the future will borrow more when the interest rate falls.

ANS: T When the interest rate falls, the substitution effect tells us to borrow less while the wealth effect tells us to borrow more. For Cobb-Douglas tastes, these effects are exactly offsetting on the "future consumption" axis -- which implies that current consumption increases (because more can be borrowed under the lower interest rate while keeping future consumption constant.)