178.200 06-10

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178.200 Intermediate MacroeconomicsTutorial (10)

Consumption

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Short Answer Questions (from textbook)

1. Question 2 of Problems and Applications on P460.

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a. We can use Jill’s intertemporal budget constraint to derive interest rate r.

Jill borrowed $100 for consumption in the 1st period and in the 2nd period used her $210 income to pay $100 (1+r) on the loan and consume the remained.

C1 + C2/(1+r) = Y1 + Y2/(1+r) 100 + 100/(1+r) = 0 + 210/(1+r) 100(1+r) = 210 – 100 r = 10%

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b. The rise in interest rates leads Jack to consume less today and more tomorrow due to the substitution effect.

At the new interest rate he could still consume $100 in 2nd period or even more. Thus, Jack is better off.

I2I1

C2

C1

BA

100

100

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c. Jill consumes less today because consumption today is more expensive. Meanwhile, since all her income is in the 2nd period, the higher interest rate raises her cost of borrowing and then lowers her income. Therefore, Jill is worse off.

100

100

BA

I1

I2

C2

C1

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2. Question 4 of Problems and Applications on P460.

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a. A temporary tax cut means an increase in 1st period disposable income Y1.

The consumer’s consumption rises (I1 to I2) by the full amount that taxes fall. The consumer who is constrained thus increases 1st period consumption C1 by more than the consumer who is not constrained (indicated by green arrow). Therefore, fiscal policy is more potent with binding borrowing constraints than it is without them.

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Y1 Y1+ΔY

Y2

C2

C1

A

B

I1

I2

A BY2

I1

I2

Y1 Y1+ΔY

C2

C1

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b. The announcement of a future tax cut increases Y2.

The consumer who is not constrained immediately increases consumption C1. The consumer who is constrained cannot increases C1 because disposable income has not changed. Therefore, fiscal policy is less potent if consumers face binding borrowing constraints.

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AB

Y1

Y2

Y2+ΔY

C1

C2

I1

I2

Y2+ΔY

Y2 A

B

C2

Y1 C1

I1

I2

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Short Answer Questions

3. Suppose that Jan expects to live for 25 more years and work for 10 of those years.

a. Derive Jan’s consumption function in terms of her annual income Y and initial wealth W according to the life-cycle model.

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Answer: According to the life-cycle model, Jan’s

consumption function can be written as follows if she wishes to achieve the smoothest possible path of consumption over her lifetime:

C = (1/T)W + (R/T)Y where T = 25 and R = 10. Thus

C = (1/25)W + (10/25)Y = 0.04W + 0.4Y

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b. Suppose that Jan expects her income to be $50,000 per year until she retires. In addition, she has accumulated $250,000 in wealth. Calculate her annual level of consumption.

Answer:

C = 0.04W + 0.4Y

= 0.04*250,000 + 0.4*50,000

= $30,000

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Multiple-Choice Questions(2005 Exam Question)

(1) According to the Keynesian theory of consumption, when individuals experience an increase in their income their:

a. consumption will rise by the total amount of the increase in income.

b. consumption will rise by less than the increase in income.

c. average propensity to consume will increase.d. marginal propensity to consume will increase.Answer: b.Hint: P433.

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(2) According to the Keynesian theory of consumption, the primary determinant of consumption is the:

a. interest rate.b. wealth of the consumer.c. consumer’s ability to borrow.d. consumer’s income.Answer: d.Hint: P434.

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Multiple-Choice Questions(2005 Exam Question)(3) According to Fisher’s model of consumption, all of the

following statement about the intertemporal budget constraint are true EXCEPT:

a. if current consumption rises, the resources available for future consumption will fall.

b. consumption in Period 1 must be less than or equal to consumption in Period 2.

c. in the first period, saving is equal to first-period income minus consumption.

d. consumers take into account both current income and expected future income when making consumption choices.

Answer: b.

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(4) In the Fisher model, if the real interest rate is positive:

a. second-period consumption costs less in terms of of first-period income than the same amount of first-period consumption.

b. second-period income is worth more than an equal amount amount of first-period income.

c. consumers will be unwilling to borrow money, so their consumption in Period 1 will be less than their income in Period 1.

d. all of the above.Answer: a. Hint: P443.

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(5) All of the following statements about indifference curves are true EXCEPT:

a. if first-period consumption is decreased, second-period consumption must be increased in order for the consumer to remain equally satisfied.

b. the slope is equal to the marginal rate of substitution.c. the greater the decrease in first-period consumption, the

less second-period consumption must increase to keep the consumer’s utility constant.

d. the consumer prefers to be on a higher indifference curve than a lower one.

Answer: c.Hint: P440.

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(6) According to the Fisher model, the optimal level of consumption for a consumer occurs when the marginal rate of substitution:

a. equals one.b. equals zero.c. equals the slope of the budget line.d. is maximized.Answer: c.Hint: P442.

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(7) An increase in the real interest rate leading to an increase in consumption in all periods because of a movement to a higher indifference curve is an example of:

a. the substitution effect.b. the income effect.c. the life-cycle hypothesis.d. the permanent-income hypothesis.Answer: b.Hint: P443.

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(8) Which of the following may NOT occur when the real interest rate increase?

a. The income effect works to increase consumption in both Periods 1 and 2 for consumers who initially save part of their income in Period 1.

b. Consumption rises in all periods.c. A consumer who saves part of her income in Period 1

will move to a higher indifference curve.d. The substitution effect works to increase second-period

consumption and reduce first-period consumption.Answer: b.Hint: P443.

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(9) If a consumer whishes to consume more than his current income in Period 1:

a. he will be unable to consume anything in Period 2.

b. the real interest rate must be greater than one.c. the decision to consume more must satisfy both

his budget constraint and his borrowing constraint.d. none of the above.Answer: c.Hint: P445.

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Multiple-Choice Questions(2005 Exam Question)(10) If a consumer faces a borrowing constraint:a. she will be unable to consume anything in the

second period.b. she may or may not be less satisfied than if she

was able to borrow.c. consumption in the first period must be less than

consumption in the second period.d. all of the above.Answer: b.Hint: P445.

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(11) The life-cycle consumption function takes into account all of the following EXCEPT the:

a. amount of wealth.

b. government budget deficit.

c. expected number of working years.

d. expected number of years of retirement.

Answer: b.

Hint: P448.

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(12) According to the life-cycle hypothesis, a person who expects to work 40 more years before retiring and who expects to live a total of 50 more years will have the following consumption function:

a. C = 0.2W + 0.6Y.b. C = 0.2W + 0.8Y.c. C = 0.04W + 0.8Y.d. C = 0.02W + 0.8Y.Answer: d.Hint: P448.

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(13) Under the life-cycle hypothesis, the consumption function C = 0.025W + 0.5Y implies that:

a. the individual expects to live 40 more years.b. half of the person’s expected remaining life will

be spent in retirement.c. for every additional dollar of wealth, consumption

increase by 2.5 cents.d. all of the above.Answer: d.Hint: P448.

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(14) An example of precautionary saving is when:a. a newly married couple saves to buy a house in 10 years.b. high interest rates cause a business professional to

reduce investment.c. an individual automatically deposits a fraction of his

weekly income in a Christmas Club to save for the coming holiday.

d. an individual increases her saving in preparation for retirement because she fears that poor health may lead to added expenses.

Answer: d. Hint: P451.

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(15) According to the permanent-income hypothesis:a. the average propensity to consume is the ratio of

transitory income to current income.b. consumption depends equally on permanent and

transitory income.c. people use saving to smooth consumption in

response to transitory changes in income.d. none of the above.Answer: c.Hint: P452.

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(16) A change in permanent income occurs when a(n):a. Florida resort owner enjoys unusually good

business during a particularly harsh winter.b. individual wins $10,000 in a lottery.c. injured worker receives workers’ compensation

benefits for six months.d. tenured college professor receives a $10,000

increase per year in her salary.Answer: d.Hint: P452.

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(17) Which of the following statements is TRUE?a. Studies indicate that households with high

incomes tend to have low average propensities to consume.

b. Over long periods of time, the average propensity to consume is fairly constant.

c. The life-cycle and permanent-income hypotheses can explain most of the empirical facts about the average propensity to consume.

d. All of the above.Answer: d. Hint: P453.

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(18) According to the permanent-income hypothesis, an artist whose income fluctuates from year to year will:

a. have a higher average propensity to consume in years of lower income.

b. have a higher average propensity to consume in years of higher income.

c. have a constant average propensity to consume every year.

d. never save any of her income.Answer: a.Hint: P453.

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(19) According to the permanent-income hypothesis, which of the following is likely to happen if parliament enacts a temporary tax cut?

a. Consumers will view the year as a temporarily good one and will increase their saving by almost the full amount of the tax cut.

b. Consumers will increase their consumption by the full amount of the tax cut.

c. The tax cut will have a large effect on aggregate demand.

d. Both b and c are true.Answer: a. Hint: PP452-453.

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(20) When a consumer borrows money to allow for greater consumption, he is:

a. increasing his total income.

b. escaping his intertemporal budget constraint.

c. borrowing against his future income.

d. able to increase his consumption in all periods.

Answer: c.

Hint: P444.

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current consumption

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consumers income