Solution of Problem 1.

C1

UL0
UL1
UL2
A1 UB2
A0
UB1
UB0
C0
I1 I0 W0 W1

(a) An exogenous decrease in the interest rate shifts the capital market line from the
line A0 W0 to the line A1 W1 . The utility of most borrowers has increased from UB0
to UB1. The utility of most lenders has decreased from UL0 to UL1. However, some
individuals who were lenders become borrowers under the new, lower rate and
experience an increase in utility from UL2 to UB2 .
(b) Because borrowers and lenders face the same investment opportunity set and
choose the same optimal invest, current wealth is the intercept of the capital
market with the C0 axis. Originally, it is at W0 , then it increases to W1 .
(c) The amount of investment increases from I0 to I1 .
Solution of Problem 1.6

In order to graph the production opportunity set, first order the investments by their
rate of return and sum the total investment required to undertake the first through the
ith project. This is down below.
One Plus the Outlay for the
Project Rate of Return ith Project Sum of Outlays
D 1.30 $3,000,000 $3,000,000
B 1.20 $1,000,000 $4,000,000
A 1.08 $1,000,000 $5,000,000
C 1.04 $2,000,000 $7,000,000

The Production opportunity set plots the relationship between resources utilized today
and the extra consumption provided at the end of the investment period. For example,
if only project D were undertaken then $3,000,000 in current consumption would be
foregone in order to receive $3,900,000 (1.30x$3,000,000=$3,900,000) in
end-of-period consumption. If we aggregate all investment opportunities then
$7,000,000 in consumption could be fore gone and the production opportunity set
looks like follows. The capital market line is tangent to investment opportunity set at
point B. Hence, the optimal production decis ion is to undertake projects D and B.

C1

8C
7
6
A
5 B (3,5.1)
4
3 D
2
1

C0
1 2 3 4 5 6 7 8