Midterm Topic 6

Question 1

household relationship between current and future consumption and saving

Answer 1

tradeoff: positive saving transforms current income into future consumption opportunities, negative saving increases current consumption opportunities but decreases future consumption opportunities.

Question 2

main motives for positive saving

Answer 2

1. smoothing consumption given fluctuating income

2. leaving bequests for off-springs.

Question 3

C1 < Y1 + W

Answer 3

implies that individual consumes less than current resources (net lending, remaining assets are greater than liabilities, W12>0)

Question 4

C1 > Y1 + W

Answer 4

implies more consumption than current resources (net borrowing, remaining assets are lower than liabilities, W12<0)

Question 5

household optimal consumption-saving decision depends on… (6 items)

Answer 5

1. preferences U(.)
2. patience (beta)–>indifference curve with MRS as slope)
3. current income (Y1)
4. future income (Y2)
5. Initial wealth, W
6. real interest rate, r. intertemporal budget line with opportunity cost -(1+r)

Question 6

increase in current income

Answer 6

positive income effect only.

household’s current and future consumption opportunities increase and there is no change in the opportunity costs of current consumption (real interest rate) and the intertemporal budget line shifts parallel.

saving increases

Question 7

increase in future income, increase in wealth

Answer 7

positive income effect only.

household’s current and future consumption opportunities increase and there is no change in the opportunity costs of current consumption (real interest rate) and the intertemporal budget line shifts parallel.

saving decreases.

Question 8

real interest rate increasing

Answer 8

1. a positive income effect for lenders (greater returns on lending increase consumption opportunities)
2. a negative income effect for borrowers (cannot afford the same bundles anymore.

for lenders: more current and future consumption, less saving.
for borrowers: less current and future consumption, more saving.

not clear for households with various preferences

3. substitution effect: current consumption in terms of future consumption is now more expensive (opportunity costs).
   more saving, less current consumption
   assume SE dominates IE (saving goes up)