EP 607: Ekonomika Makro III

Problem Set 3
Suggested Solutions

1. (10 points) In the two-period credit market model, what does a consumer do in response when the real
interest rate falls? How does your answer depend on whether the consumer is a borrower/lender initially?
Explain.
Solutions:
The decrease in the real interest rate reduces the slope of the consumer’s lifetime budget constraint, and
causes the constraint to pivot around the endowment point. The consumer experiences a negative income
effect, causing consumption to decline in both periods. But there is a substitution effect–consumption is now
cheaper in the current period relative to the future period. So, the substitution effect is for consumption to
increase in the current period and decrease in the future period. Therefore, consumption must decrease in
the future, but consumption in the present may increase or decrease, and savings may increase or decrease.
If the consumer is a borrower initially, the lifetime budget constraint will decrease in slope, and the constraint
pivots around the endowment point. So, this implies a positive income effect for a borrower, which will
increase consumption in both periods. But there is a substitution effect–consumption is now cheaper in the
current period relative to the future period. So, the substitution effect is for consumption to increase in the
current period and decrease in the future period. On net, consumption must increase in the current period,
and could fall or rise in the future period. Savings must fall in the current period, i.e. borrowing increases.
2. (20 points) Suppose that all consumers are identical, and also assume that the real interest rate r is fixed.
Suppose that the government wants to collect a given amount of tax revenue R, in present-value terms.
Assume that the government has two options: (i) a proportional tax of s per unit of savings, in that the tax
collected per consumer is s(y −c); (ii) a proportional tax u on consumption in the current and future periods,
uc0
so that the present value of the total tax collected per consumer is uc + 1+r . Note that the tax rate s could
be positive or negative. For example if consumers borrow, then s would need to be less than zero for the
government to collect tax revenue. Show that option (ii) is preferable to option (i) if the government wishes
to make consumers as well of as possible, and explain why this is so. [Hint: Show that the consumption
bundle that consumers choose under option (i) could have been chosen under option (ii), but was not.]
Solutions:
Let (c1 , c01 ) denote the consumption bundle chosen by each consumer under the first tax scheme with tax
rate s on savings, and (c2 , c02 ) the consumption bundle chosen if the consumer faces the tax scheme with tax
rate u on current-period and future-period consumption. Then, since the consumer’s budget constraint is
satisfied in each case, then:
c0 y0
c1 + 1 = y + − (y − c)s (1)
1+r 1+r
and
c0 (1 + u) y0
c2 (1 + u) + 2 =y+ . (2)
1+r 1+r

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As well, since tax revenue generated in each case is R, we have:
c0i y0
ci + =y+ −R (3)
1+r 1+r
for i = 1, 2. Then, equations (2) and (3) give
R
u= y0
. (4)
y+ 1+r −R
Thus,
0
y
c0 (1 + u)  c0  y + 1+r 
c1 (1 + u) + 1 = c1 + 1 y0
1+r 1 + r y + 1+r −R
y0
=y+
1+r
In the preceding equation, the first equality follows from equation (4), and the second from (3). Therefore,
the consumption bundle (c1 , c01 ) is affordable under the second tax system. But that was not the consumption
bundle the consumer chose. The consumer chose the consumption bundle (c2 , c02 ), which is not the same as
(c1 , c01 ), as the consumer’s marginal rate of substitution will be different under the two tax systems. As a
result, consumers are better off under the second tax system than the first, as the second tax system does not
distort the choice the consumer makes over current consumption vs. future consumption–under the second
system current and future consumption are taxed at the same rate.
3. (20 points) Suppose that the government introduces a tax on interest earnings. That is, borrowers face a
real interest rate of r before and after the tax is introduced, but lenders receive an interest rate of (1 − x)r
on their savings, where x is the tax rate. Therefore, we are looking at the effects of having x increase from
zero to some value greater than zero, with r assumed to remain constant.
a. Show the effects of the increase in the tax rate on a consumer’s lifetime budget constraint.
Solution:
Initially, AB in the left figure in the following set depicts the consumers budget constraint. The
introduction of the tax results in a kink in the budget constraint, since the interest rate at which the
consumer can lend,(1 − x)r is now smaller than the interest rate at which the consumer borrows, r.
The kink occurs at the endowment, E.

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 b. How does the increase in the tax rate affect the optimal choice of consumption (in the current and
future periods) and saving for the consumer? Show how income and substitution effects matter for
your answer, and show how it matters whether the consumer is initially a borrower or a lender.
Solution:
The first figure in the preceding set shows the case of a consumer who was a borrower before the
imposition of the tax. This consumer is unaffected by the introduction of the tax. The second figure
in the preceding shows the case of a consumer who was a lender before the imposition of the tax.
Initially the consumer chooses point G, and then chooses point H after the imposition of the tax.
There is a substitution effect that results in an increase in first-period consumption and a reduction in
second-period consumption, and moves the consumer from point G to point J. Savings also fall from
point G to point J. The income effect is the movement from point J to point H, and the income effect
reduces both first-period and second-period consumption, and increases savings. On net, consumption
must fall in period 2, but in period 1, consumption may rise or fall. The figures above show the case
in which first-period consumption falls, which is a case where the income effect dominates.
4. (10 points) In the credit market model with asymmetric information, determine how a consumer will
respond to an increase in the fraction of bad borrowers in the population. And discuss how the credit
market model with asymmetric information shows how a financial crisis can reduce consumption.
Solutions:
An increase in the fraction of bad borrowers in the population acts to increase the loan rate faced by all
borrowers, and increase the interest rate spread between borrowing and lending rates. This shifts the budget
constraint in for good borrowers, who will therefore borrow less and consume less in the present. This has
no effect on lenders, as the interest rate they face will not change, and banks continue to earn zero profits.
In the credit market model with asymmetric information, the interest rate at which all borrowers borrow
reflects a default premium. This is because banks, which are doing the lending, have difficulty telling apart
good borrowers who never default from bad borrowers who always default. When there are more bad
borrowers in the population, as is the case in a financial crisis, the default premium rises, and there is a
larger spread between lending and borrowing rates of interest. For borrowers–even good ones–the interest
rates they face rise, as the credit market has become contaminated with potential default. So, facing higher
interest rates, even creditworthy borrowers cut back on their borrowing, and reduce consumption.
5. (20 points) Suppose there are two groups of consumers in a population, constrained and unconstrained,
with equal number of each. The constrained consumers look like the ones in Figure 10.5, while the uncon-
strained consumers do not have sufficient collaterizable wealth to support the amount of borrowing they
would like to do. The government decides that it will tax each constrained consumer by an equal amount in
the current period and distribute the tax revenue equally among the unconstrained consumers as transfers.
a. (10 points) Take the market real interest rate as given and determine the effect of the redistribution
by the government on the total demand for consumption goods in the current period and in the future
period. (Only determine the net effects on the demand for consumption goods, given the real interest
rate.)
Solutions:
The constrained consumer’s current consumption is:
pH
c=y−t+ .
1+r
The constrained consumer’s future consumption is:
pH
c0 = y 0 − t0 + − t”.
1+r

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 In this case, the constrained consumer’s lifetime wealth is:

c0 y0 t0
we = c + =y+ −t− − t”.
1+r 1+r 1+r
The unconstrained consumer’s current consumption is:

c = y − t.

The unconstrained consumer’s future consumption is:

c0 = y 0 − t0 + s(1 + r).

In this case, the unconstrained consumer’s lifetime wealth is:

c0
we = c + .
1+r

b. (5 points) What do your results tell you about a fiscal policy aimed at redistributing income toward
those who will tend to spend more of it?
Solutions:
The fiscal policy, in this case, is very restrictive as it does not help constrained consumers who are
already affected by collateralized wealth. Thus, the tax fiscal policy does not increase the general
economic welfare.
c. (5 points) Determine an efficient tax policy. This will be the tax policy that relaxes the limited
commitment constraint for consumers.
Solutions:

An efficient tax policy would be a tax cut for the constrained consumer at the same rate of interest.
The constrained consumer goes back to the initial consumption bundle at point G with the amount of
the tax cut −∆t.

6. (20 points) Consider a pay-as-you-go social security system where social security is funded by a pro-
portional tax on the age of the young (less before the age of 40, more after 40). In other words, the tax
collected by the government is sc, where s is the tax rate and c is the consumption of the young. Retirement
benefits are provided as a fixed amount b to each old consumer. Can social security improve lifetime wealth
for everyone in this situation? Use diagrams in your answer.
Solutions:
Under this regime, the disposable income for the young is y, but the price for current consumption is (1 + s).
Thus, in equilibrium, the intertemporal budget constraint is:

sc(1 + n) = b.

Over time, when talking about the young, regardless of age, the tax will be the same when taken in general.
This implies that the intertemporal budget constraint is:

y + y 0 + b = c(1 + s) + c0 .

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If n > r, then social security increases the welfare of old people. However, there is also a substitution effect
coming from the change in relative price between c and c0 . This substitution comes in no welfare to the
young.