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178.

200 Intermediate Macroeconomics


Tutorial (10)
Consumption

1
Short Answer Questions (from textbook)

1. Question 2 of Problems and Applications


on P460.

2
Short Answer Questions (from textbook)
• 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%
3
Short Answer Questions (from textbook)

b. The rise in interest rates C2


leads Jack to consume less
today and more tomorrow
due to the substitution
effect. B
At the new interest rate he A
could still consume $100 100
I2
in 2nd period or even more. I1
Thus, Jack is better off.
100 C1

4
Short Answer Questions (from textbook)

c. Jill consumes less today C2


because consumption
today is more expensive.
Meanwhile, since all her
income is in the 2nd period,
the higher interest rate 100 A
raises her cost of B
borrowing and then lowers I1
her income. Therefore, Jill I2
is worse off.
100 C1
5
Short Answer Questions (from textbook)

2. Question 4 of Problems and Applications


on P460.

6
Short Answer Questions (from textbook)

• 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.
7
Short Answer Questions (from textbook)

C2 C2

A B
Y2 Y2
B I2
A I1
I2
I1

Y1 Y1+ΔY C1 Y1 Y1+ΔY C1
8
Short Answer Questions (from textbook)

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.

9
Short Answer Questions (from textbook)

C2 C2

Y2+ΔY Y2+ΔY B
B
A
A I2
Y2 I2 Y2
I1 I1

Y1 C1 Y1 C1

10
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.

11
Short Answer Questions

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
12
Short Answer Questions

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

13
Multiple-Choice Questions
(2005 Exam Question)
(1) According to the Keynesian theory of
consumption, when individuals experience an
increase in their income their:
b. consumption will rise by the total amount of the
increase in income.
c. consumption will rise by less than the increase
in income.
d. average propensity to consume will increase.
e. marginal propensity to consume will increase.
Answer: b.
Hint: P433. 14
Multiple-Choice Questions
(2005 Exam Question)

(2) According to the Keynesian theory of


consumption, the primary determinant of
consumption is the:
b. interest rate.
c. wealth of the consumer.
d. consumer’s ability to borrow.
e. consumer’s income.
Answer: d.
Hint: P434.
15
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:
b. if current consumption rises, the resources available for
future consumption will fall.
c. consumption in Period 1 must be less than or equal to
consumption in Period 2.
d. in the first period, saving is equal to first-period income
minus consumption.
e. consumers take into account both current income and
expected future income when making consumption
choices.
Answer: b.
16
Multiple-Choice Questions
(2005 Exam Question)
(4) In the Fisher model, if the real interest rate is
positive:
b. second-period consumption costs less in terms
of of first-period income than the same amount
of first-period consumption.
c. second-period income is worth more than an
equal amount amount of first-period income.
d. consumers will be unwilling to borrow money,
so their consumption in Period 1 will be less
than their income in Period 1.
e. all of the above.
Answer: a. Hint: P443. 17
Multiple-Choice Questions
(2005 Exam Question)
(5) All of the following statements about indifference curves
are true EXCEPT:
b. if first-period consumption is decreased, second-period
consumption must be increased in order for the
consumer to remain equally satisfied.
c. the slope is equal to the marginal rate of substitution.
d. the greater the decrease in first-period consumption, the
less second-period consumption must increase to keep
the consumer’s utility constant.
e. the consumer prefers to be on a higher indifference
curve than a lower one.
Answer: c.
Hint: P440.
18
Multiple-Choice Questions
(2005 Exam Question)

(6) According to the Fisher model, the optimal level


of consumption for a consumer occurs when the
marginal rate of substitution:
b. equals one.
c. equals zero.
d. equals the slope of the budget line.
e. is maximized.
Answer: c.
Hint: P442.
19
Multiple-Choice Questions
(2005 Exam Question)
(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:
b. the substitution effect.
c. the income effect.
d. the life-cycle hypothesis.
e. the permanent-income hypothesis.
Answer: b.
Hint: P443.
20
Multiple-Choice Questions
(2005 Exam Question)
(8) Which of the following may NOT occur when the real
interest rate increase?
b. 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.
c. Consumption rises in all periods.
d. A consumer who saves part of her income in Period 1
will move to a higher indifference curve.
e. The substitution effect works to increase second-period
consumption and reduce first-period consumption.
Answer: b.
Hint: P443.
21
Multiple-Choice Questions
(2005 Exam Question)
(9) If a consumer whishes to consume more than his
current income in Period 1:
b. he will be unable to consume anything in Period
2.
c. the real interest rate must be greater than one.
d. the decision to consume more must satisfy both
his budget constraint and his borrowing
constraint.
e. none of the above.
Answer: c.
Hint: P445.
22
Multiple-Choice Questions
(2005 Exam Question)
(10) If a consumer faces a borrowing constraint:
b. she will be unable to consume anything in the
second period.
c. she may or may not be less satisfied than if she
was able to borrow.
d. consumption in the first period must be less than
consumption in the second period.
e. all of the above.
Answer: b.
Hint: P445.
23
Multiple-Choice Questions
(2005 Exam Question)

(11) The life-cycle consumption function takes into


account all of the following EXCEPT the:
b. amount of wealth.
c. government budget deficit.
d. expected number of working years.
e. expected number of years of retirement.
Answer: b.
Hint: P448.
24
Multiple-Choice Questions
(2005 Exam Question)
(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:
b. C = 0.2W + 0.6Y.
c. C = 0.2W + 0.8Y.
d. C = 0.04W + 0.8Y.
e. C = 0.02W + 0.8Y.
Answer: d.
Hint: P448.
25
Multiple-Choice Questions
(2005 Exam Question)
(13) Under the life-cycle hypothesis, the
consumption function C = 0.025W + 0.5Y
implies that:
b. the individual expects to live 40 more years.
c. half of the person’s expected remaining life will
be spent in retirement.
d. for every additional dollar of wealth,
consumption increase by 2.5 cents.
e. all of the above.
Answer: d.
Hint: P448.
26
Multiple-Choice Questions
(2005 Exam Question)
(14) An example of precautionary saving is when:
b. a newly married couple saves to buy a house in
10 years.
c. high interest rates cause a business professional
to reduce investment.
d. an individual automatically deposits a fraction of
his weekly income in a Christmas Club to save
for the coming holiday.
e. an individual increases her saving in preparation
for retirement because she fears that poor health
may lead to added expenses.
Answer: d. Hint: P451. 27
Multiple-Choice Questions
(2005 Exam Question)

(15) According to the permanent-income hypothesis:


b. the average propensity to consume is the ratio of
transitory income to current income.
c. consumption depends equally on permanent and
transitory income.
d. people use saving to smooth consumption in
response to transitory changes in income.
e. none of the above.
Answer: c.
Hint: P452. 28
Multiple-Choice Questions
(2005 Exam Question)
(16) A change in permanent income occurs when
a(n):
b. Florida resort owner enjoys unusually good
business during a particularly harsh winter.
c. individual wins $10,000 in a lottery.
d. injured worker receives workers’ compensation
benefits for six months.
e. tenured college professor receives a $10,000
increase per year in her salary.
Answer: d.
Hint: P452.
29
Multiple-Choice Questions
(2005 Exam Question)
(17) Which of the following statements is TRUE?
b. Studies indicate that households with high
incomes tend to have low average propensities
to consume.
c. Over long periods of time, the average
propensity to consume is fairly constant.
d. The life-cycle and permanent-income
hypotheses can explain most of the empirical
facts about the average propensity to consume.
e. All of the above.
Answer: d. Hint: P453.
30
Multiple-Choice Questions
(2005 Exam Question)
(18) According to the permanent-income hypothesis,
an artist whose income fluctuates from year to
year will:
b. have a higher average propensity to consume in
years of lower income.
c. have a higher average propensity to consume in
years of higher income.
d. have a constant average propensity to consume
every year.
e. never save any of her income.
Answer: a.
Hint: P453. 31
Multiple-Choice Questions
(2005 Exam Question)
(19) According to the permanent-income hypothesis,
which of the following is likely to happen if
parliament enacts a temporary tax cut?
b. Consumers will view the year as a temporarily
good one and will increase their saving by
almost the full amount of the tax cut.
c. Consumers will increase their consumption by
the full amount of the tax cut.
d. The tax cut will have a large effect on aggregate
demand.
e. Both b and c are true.
Answer: a. Hint: PP452-453. 32
Multiple-Choice Questions
(2005 Exam Question)

(20) When a consumer borrows money to allow for


greater consumption, he is:
b. increasing his total income.
c. escaping his intertemporal budget constraint.
d. borrowing against his future income.
e. able to increase his consumption in all periods.
Answer: c.
Hint: P444.
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