1. For this question assume that inflation is zero. Consider a 2-period economy. Assume that consumer's lifetime utility is given by: U = log c₁ +0.9 log C₂ Assume that the consumer starts period 1 with the initial wealth of 50,000. The consumer gets labour income yt-T₁ in period t (t=1,2), where: y₁ = 25,000, y₂ = 120,000, T₁= 5,000, T₂ = 12,200 and R=0.05 Initially assume that there are no borrowing constraints. a. Write down the Euler equation (with all values substituted) and explain its meaning. Write the intertemporal budget constraint and explain its meaning. b. Solve the consumer's problem of maximizing lifetime utility subject to the intertemporal budget constraint. Is the present value of consumption in the first and the second periods the same? Explain why.. c. If for some reason the consumer were to face the borrowing constraint, would it be binding? Explain. d. Assume that in the economy described in this part, the government decides to build some new roads in period one that require an increase in spending from 10,000 to 15,000. The government must decide whether to use tax finance or debt finance for this extra spending in period 1. If you were an economic expert asked for advice, what would you recommend and why?
1. For this question assume that inflation is zero. Consider a 2-period economy. Assume that consumer's lifetime utility is given by: U = log c₁ +0.9 log C₂ Assume that the consumer starts period 1 with the initial wealth of 50,000. The consumer gets labour income yt-T₁ in period t (t=1,2), where: y₁ = 25,000, y₂ = 120,000, T₁= 5,000, T₂ = 12,200 and R=0.05 Initially assume that there are no borrowing constraints. a. Write down the Euler equation (with all values substituted) and explain its meaning. Write the intertemporal budget constraint and explain its meaning. b. Solve the consumer's problem of maximizing lifetime utility subject to the intertemporal budget constraint. Is the present value of consumption in the first and the second periods the same? Explain why.. c. If for some reason the consumer were to face the borrowing constraint, would it be binding? Explain. d. Assume that in the economy described in this part, the government decides to build some new roads in period one that require an increase in spending from 10,000 to 15,000. The government must decide whether to use tax finance or debt finance for this extra spending in period 1. If you were an economic expert asked for advice, what would you recommend and why?
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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Transcribed Image Text:1. For this question assume that inflation is zero. Consider a 2-period economy.
Assume that consumer's lifetime utility is given by:
U = log c, + 0.9 log c2
Assume that the consumer starts period 1 with the initial wealth of 50,000.
The consumer gets labour income y, - T; in period t (t=1,2), where:
y1 = 25,000, y2 = 120,000, T, = 5,000, T, = 12,200 and R=0.05
Initially assume that there are no borrowing constraints.
a. Write down the Euler equation (with all values substituted) and explain its meaning. Write the
intertemporal budget constraint and explain its meaning.
b. Solve the consumer's problem of maximizing lifetime utility subject to the
intertemporal budget constraint. Is the present value of consumption in the first and the second
periods the same? Explain why.
c. If for some reason the consumer were to face the borrowing constraint, would it be binding?
Explain..
d. Assume that in the economy described in this part, the government decides to build some new
roads in period one that require an increase in spending from 10,000 to 15,000. The government
must decide whether to use tax finance or debt finance for this extra spending in period 1. If you
were an economic expert asked for advice, what would you recommend and why? -
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Step 1: Define intertemporal choice
VIEWStep 2: Write down the Euler equation and the intertemporal budget constraint
VIEWStep 3: Solve the consumer's problem of maximizing lifetime utility
VIEWStep 4: Examine the scenario of a increase in government spending
VIEWStep 5: Provide a recommendation in this scenario and explain
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