PROFESSOR XAVIER PRESENTS...

PROBLEM SET 4
THIS PROBLEM SET IS DUE ON WEDNESDAY, OCTOBER 30TH DURING THE LECTURE. YOU MUST BRING A HARD
COPY OF YOUR SOLUTIONS. NO ELECTRONIC SUBMISSIONS. NO LATE PROBLEM SETS. PLEASE, STAPLE ALL THE PAGES
IN YOUR PROBLEM SET. ABOVE ALL, SUIT UP AND HAVE FUN!!!!! THIS PROBLEM SET IS AWESOME!
1
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,-./- 012*3%*4'(2* 5(63"*6"1"%'67
83"9*77"3 :(;'*3
83"&#*% <*2 =
>/? @2'#'2A B$162'"17 (14 014'99*3*16* 6$3;*7
(a) WhaL ls a uLlllLy luncLlon?
(b) Show how Lo represenL levels of uLlllLy by a lamlly of lnulllL8LnCL Cu8vLS.
(c) Can Lhese curves shlfL ln a way LhaL Lhe budgeL consLralnL can?

>.? C(D*7
lmaglne LhaL a worker recelves a wage raLe w and works L hours. 1he governmenL Laxes
hls lncome aL Lhe consLanL raLe 1. Pe spends all hls lncome ln cookles so hls budgeL
consLralnL ls C=wL(1-1). 1he worker has normal preferences over lelsure and cookles
(represenLed by Lhe usual lndlfference curves).
(a) uraw Lhe budgeL consLralnL of Lhls lndlvldual.
(b) ulsplay graphlcally whaL Lhe opLlmal consumpLlon-labor cholce ls for Lhls worker.
(c) lmaglne LhaL Lhe governmenL lncreases Lhls guy Lax raLe from 1 Lo 1'. WhaL ls Lhe
new budgeL consLralnL? ln Lhe new opLlmum, ls he golng Lo consume more or less? ls he
golng Lo work more or less? (Lxplaln your answers ln Lerms of wealLh and subsLlLuLlon
effecLs)

>-? C3(179*37
Conslder Lhe worker descrlbed ln Lhe prevlous quesLlon. Suppose now LhaL, on Lop of
belng Laxed by Lhe governmenL, Lhe worker also recelved a 18AnSlL8, whlch we call S,
from Lhe governmenL. 1he Lransfer ls nC1 relaLed Lo how much he works (Lransfers
LhaL are noL relaLed Lo how much you work are ofLen called LuM SuM Lransfers).
Pence, Lhe guy's LoLal revenue ls hls lncome (afLer Lax, llke ln problem 3) plus Lhe
Lransfer.
(a) wrlLe down an expresslon for Lhe budgeL consLralnL.
(b) uraw Lhe budgeL consLralnL of Lhls lndlvldual.
(c) ulsplay graphlcally whaL Lhe opLlmal consumpLlon-labor cholce ls for Lhls worker.
(d) lmaglne LhaL Lhe governmenL lncreases Lhls guy Lax raLe from 1 Lo 1' and, A1 1PL
SAML 1lML, lL lncreases Lhe 18AnSlL8, S, so as Lo allow hlm Lo achleve Lhe SAML
CuAn1l1? Cl CCnSuM1lCn Anu LLlSu8L LhaL he had prevlous Lo Lhe lncrease. WhaL
ls Lhe new budgeL consLralnL? ln Lhe new opLlmum, ls he golng Lo consume more or
less? ls he golng Lo work more or less? ls your answer dlfferenL from (3c)? lf so, why?
(Lxplaln your answers ln Lerms of wealLh and subsLlLuLlon effecLs)

>E? FG*1 H6"1"%'*7 (14 ,*(#2I H99*627
ln Lhls problem we conslder Lhe aggregaLe consumpLlon behavlor of Lwo CLn
economles. 1he flrsL economy ls called 8ollvla. 8ollvla, ls a poor economy where
everybody belleves LhaL lncome ln Lhe fuLure wlll be much larger Lhan ln Lhe presenL.
1he opLlmal consumpLlon ln perlod 1 and perlod 2 ls dlsplayed ln llgure 1.















8ollvla has access Lo lnLernaLlonal credlL markeLs because Lhere are oLher counLrles ln
Lhls world llke !apan.








C
1

C
2

C
1
*
C
2
*
Y
1

Y
2

llgure 1: 8ollvla
!apanese lncome ls huge Loday buL ls expecLed Lo fall ln Lhe fuLure. 1he behavlor of Lhe
!apanese economy ls dlsplayed ln llgure 2.
















(a) !apan and 8ollvla: who ls borrowlng and who ls lendlng? Why dld we say ln class LhaL
Lhe macroeconomy as a whole cannoL borrow or lend? ls Lhls always Lrue?
(b) 8ollvla ls a well known producer of Lln. lmaglne LhaL Lhe prlce of Lln lncreases
Lemporarlly so Loday's lncome ln 8ollvla lncreases by 10 mllllon dollars, buL Lomorrow's
remalns Lhe same. WhaL wlll happen Lo 8ollvlan aggregaLe consumpLlon Loday? (1oday
ls perlod 1) Lxplaln your answer graphlcally and provlde Lhe economlc lnLulLlon.
(c) Suppose LhaL Lhere ls an lncrease ln world real lnLeresL raLes. WhaL ls Lhe behavlor of
aggregaLe consumpLlon Loday and Lomorrow for boLh 8ollvla and !apan? (Make sure
you decompose Lhe overall effecLs lnLo wealLh and subsLlLuLlon effecLs). ls consumpLlon
a decreaslng funcLlon of lnLeresL raLes as we derlved ln class? Lxplaln.
(d) Suppose LhaL 8ollvla does nC1 have access Lo lnLernaLlonal credlL markeLs buL ?
1
and
?
2
are sLlll Lhe ones dlsplayed ln llgure 1. WhaL wlll C
1
and C
2
be ln Lhls case? WhaL
would Lhe lncrease ln C
1
when 8ollvla experlences a Lemporary lncrease ln lncome as
descrlbed ln quesLlon (b)? ls your answer dlfferenL from Lhe one you gave ln (b)? lf so,
why?

>=? J'6(34'(1 HK$';(#*16*

Conslder a consumer who recelves lncomes ?
1
and ?
2
ln perlods 1 and 2 respecLlvely.
lmaglne LhaL Lhere ls a governmenL who levles a Lax on Lhls lndlvldual. 1he LoLal Laxes
pald ln perlod 1 and 2 are 1
1
and 1
2
respecLlvely. 1he lndlvldual has access Lo banks so
he can borrow and lend any amounL he deslres aL Lhe lnLeresL raLe r. lmaglne LhaL Lhe
amounL of bonds he lnherlLs when he sLarLs ls zero and he wanLs Lo leave no asseLs
C
1
C
1
*
C
2
*
Y
1

Y
2

llgure 2: !apan
C
2

when he dles afLer perlod 2. 1he lndlvldual needs Lo choose Lhe amounL of consumpLlon
ln perlods 1 and 2 LhaL maxlmlze hls uLlllLy sub[ecL Lo a budgeL consLralnL.

(a) WrlLe Lhe dynamlc budgeL consLralnLs (u8C) for perlods 1 and 2 (keep ln mlnd LhaL
parL of hls expendlLures are now Laxes).
(b) WrlLe Lhe lnLerLemporal budgeL consLralnL (l8C). rovlde an lnLerpreLaLlon.
(c) uraw Lhe budgeL consLralnL ln a dlagram LhaL has C
1
and C
2
ln Lhe axls.
(d) lmaglne LhaL Lhe lndlvldual llkes Lo smooLh consumpLlon. Pow would hls lndlfference
curves look llke? Why?
(e) WhaL would be hls opLlmal cholce of consumpLlon for perlod 1 and 2 respecLlvely?
(f) lmaglne LhaL Lhe governmenL decreases Lhe Lax raLe ln perlod 1, 1
1
, and ln perlod 2,
1
2
, boLh by one dollar. Would hls consumpLlon ln perlod 1 change? 8y how much?
(g) lmaglne LhaL Lhe governmenL decreases Lhe Lax raLe ln perlod 1, 1
1
, by one dollar and
1
2
remalns Lhe same. Would hls consumpLlon ln perlod 1 change? 8y how much?
(h) lmaglne LhaL Lhe governmenL decreases 1
2
by one dollar and keeps 1
1
. Would hls
consumpLlon ln perlod 1 change? 8y how much?
(l) lmaglne LhaL Lhe governmenL decreases 1
1
by CnL dollar Anu lL lncreases 1
2
by (1+r)
dollars. Would hls consumpLlon ln perlod 1 change? 8y how much?

>L? M3'*#
llnd Lhe 12 ulfferences beLween Lhe followlng Lwo plcLures.