BSc II Macroeconomics II Spring 2011

Quiz 2 (B)
Lahore School of Economics

Macroeconomics II

Spring Term 2011

Quiz 1A: BSc. 2

Instructions: Answer all questions in the spaces provided below. For full marks,
make sure to show all calculations. Calculators, pencils, pens, rulers, etc. cannot be
shared and cell phones cannot be used as calculators. Total points: 85 – Suggested
Solutions

Question 1

A. Qasim obeys two-period Fisher Intertemporal Choice model. He is consumption-

oriented and faces no borrowing constraints. Graph his budget line and optimal
consumption bundle. Now assume that he faces borrowing and saving constraints.
He can both save and borrow but only a certain amount. Graph his new budget
constraint on a separate diagram and label the optimal consumption bundle. (8
points)

For a borrower:

Budget Constraint: C1 + C2 / (1+r) = Y1 + Y2 / (1+r)

Figure 1: A Borrower

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Quiz 2 (B)

Budget line with lending and borrowing constraints:

Figure 2: Borrower with borrowing and lending constraints

B. Return to the original budget constraint in part A. Suppose interest rate goes up.
Is Qasim better off or worse off? Explain also the subsequent effects on C 1 and C2.
Show the effects of rise in interest rate on both periods’ consumption and budget
line when Qasim faces constraints in part A. (7 points)

If interest rate increases, then a borrower is worse off. Hence, his consumption in period
one falls as per the income effect. So savings increase. Since the price of consumption
increases, C1 still falls because of substitution effect. However, the affect on C2 remains
ambiguous. The budget line is steeper.
Without any constraints:

Figure 3: Rise in Interest Rate and it's effect on C1 and C2

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BSc II Macroeconomics II Spring 2011

Quiz 2 (B)

With borrowing and lending Constraints:

Figure 4: Rise in interest rate and it's effect on the borrower (with lending and
borrowing constraints)

C. Suppose that the government imposes a tax rate of t% on the interest rate. What
will be the new interest rate and how will it affect the budget line? Write the new
budget constraint and graph the model for Qasim after the tax imposition. Assume
there are no borrowing and saving constraints. (5 points)

If the government levies tax on interest rate, it will be given by (1-t)r; the new interest
rate is lower so r2 falls making the budget constraint flatter.

Budget Constraint:

C1 + C2 / (1+ (1-t)r ) = Y1 + Y2 / (1+ (1-t)r ) and Slope: - (1+ (1-t)r )

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Quiz 2 (B)

Figure 5: Fall in interest rate (due to tax) and its effect on the borrower

D. Suppose the interest rate tax is ONLY levied on borrowers. How would that
affect the budget line? Is Qasim better off then? Show graphically. (5 points)

But if the tax rate is only applied to borrowers, then there would be a kink in the budget
constraint, making the borrowers better off.

Figure 6: Fall in interest rate for borrowers only (due to tax) and its effect on the
borrower

E. Finally, show how would further increases in the tax rate affect the savers?
Graph appropriate model. Also graph the new budget constraint and consumption
bundle if the increased tax rate is levied ONLY on savers. (5 points)

If the tax rate applied to financial operations increases, the new interest rate falls. The
effective income of the saver would thus fall and the consumption in both time periods
would reduce. As consumption in period two becomes relatively more expensive, C2
falls. The affect on C1 depends on the relative magnitudes of income and substitution

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Quiz 2 (B)
effects. Savings might reduce if C1 falls but effectively they will fall because the saver
will save less due to low interest rate.

Figure 7: Fall in interest rate (due to higher tax) and its effect on the saver

But if the tax rate is only applied to savers, then there would be a kink in the budget
constraint, decreasing C2.

Figure 8: The effect of fall in interest rate applied only on savers (due to taxes) on
the saver

Question 2

If we apply the assumption of zero real interest rate of LCH on the Fisher’s two-
period Consumption Choice model, what would be the new Intertemporal budget
constraint? Secondly, how that can be used to explain that APC across high income
households may lead to recession? Make sure you explain both intuitively and
graphically. (10 points)

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BSc II Macroeconomics II Spring 2011

Quiz 2 (B)
If people keep saving more as their income increases, the average propensity to consume
falls, which decreases the aggregate demand, leading to recession or as per the
economists’ prediction, secular stagnation. If the interest rate is equal to 0%, then
according to two-period consumption model, C1 + C2 = Y1 + Y2. As consumption falls,
due to an increase in the savings, then income subsequently or eventually falls as well
implying recession. However, this prediction didn’t come out to be true over time.

Figure 7: Fall in both periods' consumption

Question 3

A. Briefly explain Simon Kuznets consumption puzzle. (5 points)

The consumption puzzle states that as per the cross sectional data or short term data, the
average propensity to consume reduces with an increase in income. But according to the
study of Simon Kuznets, on taking long term time-series data, the average propensity to
consume remained constant.

Note: Students should draw a diagram showing falling and constant APC for full
credit.

B. How does Modigliani’s LCH explain the puzzle stated in part A. (5 points)

In Life Cycle Hypothesis, people tend to smooth consumption over their lifetime. For
that, they save higher proportion of their income as the income increases leading to
falling APC in the short run. This also accumulates wealth over time. At later stages of
life, the propensity to consume does not fall because enough wealth had been
accumulated earlier to make up for that.

Use of equation: C = αY + βW is imperative!

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Quiz 2 (B)
C. How does Friedman’s PIH explain the existence of consumption puzzle? State
any assumptions. (5 points)

According to Permanent Income Hypothesis, people’s consumption is a function of

permanent income. As people’s income increases in the short run or temporarily, they
tend to save more and consume less leading to a falling APC. These transitory shocks in
income do not seem permanent and so the savings are high. However, over longer run,
these savings accumulate the wealth and hence, permanent income, and the propensity to
consume on average remains constant.

Question 4

Robert Hall said that changes in consumption at any time follow a random walk.
Why? Make sure you state his assumptions and also explain the random variable
concept. If an economy obeys Random walk hypothesis, would a tax increase on
income announced today but effective (implemented) next year change consumption
when the policy is actually implemented? (5 + 5 = 10 points)

The model basically says that people are rational entities. So in short run, as their income
increases, they take those as transitory shocks and save more of it. If anyone is expecting
a certain transitory change in income in future, then she would adjust consumption today.
Any decision on how much to consume tomorrow would depend on how much is being
currently consumed and some random variable, which could be seen as transitory shock
component.

So if tax increase is announced today but is effective next year, a rational consumer
would adjust consumption today and consume less or save more to maintain the
consumption pattern later when this policy is actually implemented. Hence, the
consumption won’t change when the policy takes effect.

Question 5

How did David Laibson explain the empirical studies emphasizing low savings rate
in most of the economies. (5 points)

Laibson said that people tend to consume today rather than in future. His work on ‘pull of
instant gratification’ showed that people like to consume instantly rather than saving and
consuming later in any other time period. Since consumption is high today, savings are
low and the savings are low in many countries because these economies are
consumption-oriented.

Question 6

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Quiz 2 (B)
Suppose the income of an average Pakistani grows constantly over time, reaches a
maximum and then falls constantly to zero at the end of life so there is no
retirement. Applying the assumption of consumption smoothing in LCH model,
graph the model under the following two conditions:

A. Pakistanis who have binding liquidity constrained (5 points)

Figure 8: LCH of an average Pakistani who is liquidity constrained

B. Pakistanis who are not liquidity constrained (5 points)

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Quiz 2 (B)

Figure 9: LCH of an average Pakistani who is not liquidity constrained

In the former, the Wealth is not negative and consumption is not smoothed out. In the
latter case, as consumer is not liquidity constraint, dissaving occurs and wealth turns out
to be negative in the beginning. However, the consumption could be smoothed out.

Question 7

Do you think that marginal propensity to consume out of current income would
differ between tenured professors who have a high degree of job security and
professional gamblers who never know when luck will strike? Explain in the light of
LC-PIH Theory. (10 points)
Yes, it will differ between tenured professors and professional gamblers. Professors have
a constant stream of expected income over their lifetime. Thus, their propensity to
consume is mostly a function of permanent income; it’s high and stable. For gamblers,
the expected income stream is not constant. High or low incomes in various time periods
are seen as transitory shocks and hence, propensity to consume out of transitory income
is kept fairly low.

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