University of Toronto Mississauga Department of Economics

ECO 209Y - Macroeconomic Theory and Policy Prof. Kambourov Tutorial 6 Suggested Answers
November 5-7, 2012. 1. Williamson, Chapter 8, Problem 5. Suppose that the government introduces a tax on interest earnings. That is, borrowers face a real interest rate of r before and after the tax is introduced, but lenders receive an interest rate of (1 x)r on their savings, where x is the tax rate. Therefore, we are looking at the eects of having x increase from zero to some value greater than zero, with r assumed to remain constant. (a) Show the eects of an increase in the tax rate on a consumers lifetime budget constraint. Answer. Initially, AB in Figure 1 depicts the consumers 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, (1 x)r, is now smaller than the interest rate at which the consumer borrows, r. The kink occurs at the endowment point, p. E . (b) How does the increase in the tax rate aect the optimal choice of consumption (in the current and future periods) and saving for the consumer? Show how income and substitution eects matter for your answer, and show how it matters whether the consumer is initially a borrower or a lender. Answer. The top panel of Figure 1 shows the case of a consumer who was a borrower before the imposition of the tax. This consumer is unaected by the introduction of the tax. The bottom panel of Figure 1 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 eect that results in an increase in rst-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 eect is the movement from point J to point H , and the income eect reduces 1

Instructors Manual for Macroeconomics, Third Canadian Edition

Figure 8.5

2.

b) The top panel of Figure 8.5 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 and bottom panel of Figure 8.5 shows the case of a consumer whosavings. was both rst-period second-period consumption and increases On net, a lender before the imposition of the tax. Initially the consumer chooses point G, consumption must fall in period 2, but in period 1 consumption may rise or fall. and then chooses point H after the imposition of the tax. There is a substitution Figureeffect 1 shows the in case in which rst-period consumption increases, which is a that results an increase in first-period consumption and a reduction in second-period consumption, and moves the consumer from point G to point J. case where the substitution eect dominates. 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 secondperiod consumption and increases savings. On net, consumption must fall in Williamson, Chapter 8, Problem 6.may A rise consumer receives income y in the current period 2, but in period 1 consumption or fall. Figure 8.5 shows the case

Figure 1:

period and 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 Copyright 2010 Pearson Education Canada rate r. This consumer faces a constraint - 90 - on how much he or she can borrow, much like the credit limit typically placed on a credit card account. That is, the consumer cannot borrow more than x, where x < we y t, with we denoting lifetime wealth. Use diagrams to determine the eects on the consumers current consumption, future consumption, and saving of a change in x, and explain your results. Answer. The consumer faces a borrowing constraint that places a ceiling on the level of 2

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.

Figure 8.6 Figure 2: 7. This problem contrasts two alternate forms of credit market imperfections. As one possibility, consumers may either borrow or lend at the same real interest rate, but current consumption. The consumer may consume more than the current endowment, face a maximum amount of borrowing. The alternate possibility allows unlimited yborrowing, t, but less than the amount of the endowment, we . The rate consumers but the interest rate paid on lifetime borrowing exceeds the interest earned budget line is lending. as shown in Figure 2. The who budget line to becomes vertical at c = x. by An example of from Clearly, consumers choose be lenders are unaffected such such a budget line is depicted in the two panels of Figure 2 as ABD . As one possibility, constraints. We therefore only need to be concerned about the behaviour of the constraint is non-binding in the left panel of Figure 2. The consumer chooses borrowers. In the two panels of as Figure 8.7, below, point B represents the endowment point . An increase the level of x has no eect on such of a consumer. point.H The first type of in constraint imposes a maximum amount borrowing. This constraint is the depicted as budget line ABCJ Figure 8.7. The second type of Alternately, consumer depicted in the in right panel originally chooses the corner solution, point B . The consumer achieves the level of utility corresponding to indierence curve I 1. An increase in x produces the new budget line, ACJ . This consumer now Copyright 2010 Pearson Education Canada chooses point G. She increases current consumption and decreases both current saving - 91 and future consumption. This consumer is able to improve her level of utility to that corresponding to indierence curve I 2.